2% rule across the board?

Question

Hey everyone,

My name is Luke Johnson, and I've been in the bar business for about ten years, and help to manage three of them presently.  My employer, the owner of the bars, started off as a builder, and his family has been in the housing industry for 40 years.  He wants to start a real estate company focusing on buy and hold properties.  We are going to stay in the local market for now (Quad Cities, Iowa), although I would be willing to try anywhere.  My question is about the 2% rule.  There are very few houses in the entire area that rent for over $1500 monthly, yet the homes that bring that rent are upwards of $100,000 consistently.  Are these people finding great deals, or do smaller markets and economies allow for rule variation?

Mike H. · Answer

Don't worry about the 2% rule. Do the numbers right and see if thats the kind of return that makes sense to you.

Run the numbers:

1) How much is the purchase price?2) How much for repairs?3) How much money are you having to put down to buy the home? Your financing will dictate that. i.e. Conventional loan where you have to put down 25% plus pay rehab out of pocket? Rehab loan that allows you to financing 80 to 90 to 100% of the purchase and rehab?

4) Then how much are you going to get for rent?
5) How much will your payments be?
6) How much will your taxes and insurance be?
7) How much will your estimate repairs, vacancy (figure 95% occupancy), and cap expenses be.

If you can answer those 7 items, you should be able to come up with a pretty good idea of whether its a good deal or not:
1) What is your actual cash investment (down payment, rehab, etc) to get the house?
Lets say 30k. And your loan will be 100k.
2) Whats your payment on 100k loan? $550/month?
Taxes and insurance another $350 a month?
So your PITI is 900 a month.
3) Rent is $1,500
That leaves you with $600 gross profit.
Minus vacancy, repairs, cap expenses ($175/mo?)

So your net profit might be $425/mo

On a 30k investment, thats a 17% return on your investment.
Then add to that the fact that your profit is going to mostly be tax free given all the deductions. And add to that the principal paydown of another $125/mo or so or 1,800 a year or another 6%. Plus, a historical average for appreciation of 2 to 3% a year on the house (150k) which means an additional 3k to 4,500 which is another 10 to 15% return.

And then see if thats acceptable to you.

Thats how you know if you're getting a good deal.

I don't believe one aota in the 2% rule and never will. I think it silly.
What I do believe is that you should begin to learn what a good deal is in your market based on your comfort level and what you find acceptable for a return.

Typically, I look at a good investment as one that I can be all in (my purchase price plus my rehab costs) at 70% LTV or better.

So if that house is going to appraise out at 150k when i'm done rehabbing it, I want to pay no more than 105k for the purchase and the rehab of the property. Also, my assumption is that I'm going to finance that entire 105k so I want to see a gross profit on that house of roughly $350 to $400 a month.

Thats what I target as a good deal for me. I like using the gross profit calculation because its the most consistent relative figure you can find.   To say something is a good deal based on 2% rule is so crazy its, well, crazy. I should buy a house for 50k if the rent is $1,000? What if its a house built in 1880 and the taxes are 5k?  Insurance $600. And payments $300. Thats $750.  No thanks.

Tons of variables in this business. But I look at gross profit (profit before vacancy, repair and cap expenses) of that $350 to 400 minimum amount and I feel comfortable with that number that I'm going to be ok. That, combined with the LTV of 65 to 70% and thats what I believe is a good deal.

One other thing with buy and hold. You can go a little higher on the LTV and still get a good deal. Just depends on the rents/prices in your area and, more importantly the taxes!

You may be able to get a house at 80%LTV (thats the all in price - purchase plus rehab) and still get it to cash flow at a gross profit of $500 a month. Gonna have to come out of pocket more to take it down. But that is still a good buy and hold deal to me.

Its all about cash flow and staying in areas/houses that have good long term potential for growth. i.e. 3/2, 1,500 sq ft, in areas with good schools that are not "renter dominated areas" which don't appreciate much.....

Jean Bolger · Answer

There is TONS of variation from market to market. Don't consider 2% a "rule", really. In some places it does work as a simple gauge to check whether a property might bear looking into. In your area that gauge might be 1.5%. In some areas you'll never find even that. It is actually a pretty crude tool for determining potential profitability. Use it as a preliminary step to help you weed out properties.

As the housing market improves we'll find fewer and fewer areas that can meet the "2% rule" but that doesn't mean there isn't money to be made in rentals

Josh Mitchell · Answer

2% rule is just the rule of thumb. 1.5% may work for you. Just have to write out what you are trying to accomplish. Ofcourse, if you can meet the 2% rule it would be great, but if you stay above 1% you usually can CF something.

Bill Jacobsen · Answer

You mentioned $1,500 per month rent and a price of $100,000.  Obviously this does not meet the 2% rule but is actually 1.5.

I assumed 20% down on a $100,000 house with a 30 year  loan at 4.5%.  I assumed cost of $5,000 to obtain loan.  I also assumed 50% expenses and a 5 year hold time, and 3% appreciation.

More assumptions are 8% on reinvestment of cash flow and a 7% cost of selling the property.  I calculated an annualized return of 19.2% on the $25,000 invested.

I could live with that.

Good Luck.

Bill

Michael Evans · Answer

Here's the link to the BP MFH or SFH Deal Analyzer.

Michael Evans · Answer

As a professional "analyst" and operations manager, I develop statistical real estate investment models in Excel.  There are many free models you find online and in the BP download area.  Find one that fits the types of deals you want to do, tweak them to fit your specific market and set your investment criteria (maximum investment amount, minimum ROI as a % and as a dollar amount, maximum risk, etc.).  Once you have your model developed, just run each potential deal through your model to see if it meets your investment criteria.  If it doesn't, move on to the next potential deal.  If it meets your criteria, go forward with putting forth the effort to get the deal done.

Models are just that, models, and they can't always predict the actual outcome.  The goal of any investment system is to develop an investment strategy where you have more winners than losers and you minimize your risks while maximizing your rewards.  That's my experience and it has worked for me in my 20 years of operations management and 8 years of real estate investment.

God Bless You!

Luke Johnson · Answer

Thanks guys, great advice.

Mohammed W. · Answer

@ Mike H. Great post Mike, that makes a lot of sense.

Luke Johnson · Answer

Thanks Josh, appreciate the advice.

2% rule across the board?

Most Popular Reply