What Is the 2% Rule?
The “two percent rule” (or, “2% rule”) is a real estate investing guideline. It recommends that monthly rent should be set at 2% of total investment. This helps ensure that a rental property generates positive monthly cashflow.
The 2% rule is a more aggressive version of the 1% rule that can be applied to both residential and commercial real estate investing. Both versions are more like useful concepts than iron-clad laws.
So how do you use it?
How To Use the 2% Rule
The two percent rule calculation is simple.
Start with your total investment cost. This includes the total payoff value of your mortgage plus the cost of repairs and/or upgrades. Multiply it by .02. The result is your suggested monthly rent.
Total investment * .02 = monthly rent
For example:
You have a mortgage with a payoff value of $90,000 and anticipate $10,000 for repairs, bringing your total investment to $100,000. 2% of 100,000 is 2,000. Therefore, you need to charge at least $2,000 in rent to abide by the two percent rule.
Of course, this is only a rudimentary tool to help make your P&L work. You should adjust it based on your specific strategy (which is why the 1% rule exists).
Moreover, passing the 2 percent rule doesn’t necessarily make a property a good investment. Nor does failing the 2 percent rule automatically make a property a bad investment.
It is a very basic calculation, which is both a benefit and a drawback.
Pros: When to Use the 2% Rule
The 2% rule has two main uses.
You might assume that setting rent would be one of them. But it isn’t. That’s because the two percent rule is best applied before you purchase a property.
Its strengths are:
- Filtering Properties – The two percent rule can be used as a broad filter when prospecting for investment opportunities. Apply it to the median rent in your target location to set a limit on your total investment costs. Better yet, use it in tandem with other rules or metrics like the gross rent multiplier, 50% rule, or your own unique calculations.
- Benchmarking Loan Terms – The two percent rule can help you clarify your targets for loan negotiations. Use it to set the bar for total payoff value and payment schedule terms. As you probably already know, your loan terms can make or break the success of your investment.
As far as real estate analysis methods are concerned, you could certainly do worse.
Still, the two percent rule is neither perfect nor comprehensive.
Cons: When Not to Use the 2% Rule
There are certain situations where it just isn’t all that useful.
The goal of the 2% rule is to set a monthly “break even” level and ideally ensure positive monthly cashflow. However, it can be very difficult to find properties that fulfill this criteria. Referring to our example earlier, you’d be extremely lucky to find a $100,000 property that you can charge $2,000/month for. Thus, you may need to adjust your expectations down to 1.8%, 1.5%, or even lower.
Moreover, it doesn’t work that well with certain strategies. For instance, house flippers may be better off throwing the 2% rule out in favor of the 70% rule.
Beyond that, it’s weaknesses are fairly distinct:
- Ongoing Expenses – The core formula for the two percent rule is fairly limited. More sophisticated investors may choose to factor in expected vacancy rates, property taxes, maintenance costs, or other operating expenses. However, this would make it even more difficult to find properties that fulfill the 2% criteria.
- Lacks Context – The two percent rule is inflexible and somewhat narrow in its application. In its textbook form, it does not take into account things like the local real estate market, the overall real estate market cycle, interest rates, or the regulatory environment. Under various circumstances, it may become obsolete or in need of very heavy modification.
How well the two percent works for you is highly dependent on the situation and your strategy.
Regardless, understanding how the 2% rule works is part of a strong foundation. From here, you should be able to use it to develop your own system to estimate month-to-month cashflow on any given property.