There are countless systems and processes investors implement on a daily basis to limit their exposure to risk. After all, what is a good investor, if not someone who can limit the potential downside of an investment? Consequently, there are a number of things new investors should be doing to place the odds in their favor with each and every deal, not the least of which includes the 2% rule. This simple (but effective) strategy works to help investors simultaneously avoid a disaster while increasing their potential. Here’s how:
The 2% rule is a strategy implemented by today’s passive income investors to determine whether or not a rental property’s cash flow justifies its purchase price.
The 2% rule essentially “sets the bar” for buy-and-hold investors who want to know if a property’s cash flow potential warrants its impending acquisition costs. So if the cash flow is expected to generate more than 2% of the asset’s purchase price each month, it’s widely considered to be a “good” investment. In order for investors to purchase a $100,000 rental property for example, it should be able to generate at least $2,000 a month in rent.
It is worth pointing out, however, that the 2% rule isn’t perfect. There are a number of variables that may influence this particular strategy, which I will detail below.
It is important to note that nothing is guaranteed in the investing community, and the 2% rule is no exception. Consequently, investors need to realize that the 2% rule is neither fact nor fiction. Instead, the 2% rule is more of a guideline that walks a fine line between each; one that helps entrepreneurs interpret the numbers of a respective deal and avoid risky circumstances.
The 2% rule isn’t foolproof because it neglects to account for three very important variables:
The location of the asset
The asset’s current condition
The resulting cash flow
In other words, there are several factors investors must consider which aren’t included in the 2% rule. This is why it’s of the utmost importance to view the 2% rule as a guideline, and not the gospel truth. If for nothing else, the 2% rule shouldn’t be used alone, but rather in addition to several alternative valuation strategies.
While the 2% rule can’t give investors an objective indication as to whether or not an investment property will produce enough cash flow to make the investment worthwhile, it can help them make a more educated decision.
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In its simplest form, the 2% rule is used to help determine whether or not an investment is worth pursuing. More specifically, however, the 2% rule will tell investors if the monthly cash flow is worth the initial purchase price. It is widely considered that a rental property needs to bring in at least 2% of the purchase price each month to validate the investment. Anything less would suggest the asset isn’t worth buying. Therefore, any cash flowing rental property that brings in at least 2% of the purchase price each month in rent may be considered a “good” investment.
When used correctly (in conjunction with similar valuation strategies), the 2% rule may help investors determine whether or not an investment property is worth purchasing. However, this particular strategy isn’t without a few important caveats.
For starters, it neglects to account for the property’s location. That means—at the very least—demand, appreciation, and depreciation aren’t taken into consideration, all of which play integral roles in an asset’s cash flow. Without factoring in a property’s location, the 2% rule can’t make the necessary adjustments investors would need to make a more accurate and educated guess as to how well the asset will perform.
Additionally, the 2% rule also fails to include the property’s current condition as a variable in the equation, which could leave out additional costs. Provided the home needs to be rehabbed before it’s rented out, the incurred costs could negatively influence the results of the 2% rule, skewing it in a way that works against investors.
The 1% rule, much like its 2% counterpart, acts as an additional barometer to help investors decide whether or not a rental property is a good investment. Only, instead of requiring the cash flow to meet at least 2% of the acquisition costs, it only needs to meet 1%. Therefore, in order for a $100,000 rental property to fall under the “good” category, it must return at least $1,000 each month in rent; it’s exactly the same guideline as the 2% rule, but it is intended to be used in markets with tighter profit margins.
The 50% rule helps provide a rough estimate of what an investor’s operating expenses should be, relative to the asset’s operating income.
In other words, investors should pay special considerations to properties with operating expenses that exceed 50%. To be perfectly clear, investors will want to keep their operating expenses below this important level. It should be noted, however, that the appropriate level of probable operating expense will be relative to the age and condition of the property.
The 70% rule refers to the amount an investor should pay to acquire a rehab deal. This particular rule demands that investors should pay approximately 70% of the home’s after repair value (how much a home is worth once it is restored to the condition of local comparables). As a result, the 70% rule relies heavily on rehab costs and expenses. Specifically, the rehab costs are to be subtracted from 70% of the ARV. In other words, investors should look to acquire a deal for 70% of its ARV, minus the amount they expect to spend on rehab costs.
There are a number of rules and guidelines today’s real estate investors need to abide by. However, the most successful investors are those who are able to incorporate as many risk mitigation strategies as possible—not just one or two. Therefore, it’s important to note that while the 2% rule is important, it’s incomplete. For investors to truly benefit from abiding by the 2% rule, they must use it in conjunction with other valuation strategies to determine the viability of deals that come across their tables.