Is the "2% rule" a valid way to identify properties in expensive markets?

Question

As a new guy around here, I just read the "Ultimate Beginners Guide" to real estate investment.  One thing I found during my reading was the 2% rule of thumb for evaluating properties.  This rule suggests that monthly rent from a property should be at (or above) 2% of the purchase price of the property.  The text gives some pretty clear and simple examples of how this rule is applied, which demonstrates that I understand what it's suggesting.  I'll admit that it has a caveat in the text that this can be a difficult number to achieve, but I can't see getting even halfway there in my market.

What I don't understand is where I find a property that would come close to meeting that criteria in the area where I live (suburban Denver). For example, I think it's safe to say that the average property in my neighborhood is priced between $240-290K at the moment. These properties appear to carry average rental rates of $1300-2000K per month ($1500-1800/mo being most common).

So, even if we looked at the lower end of the price range (say $240k) and the higher end of the rental range (say $2k/mo), we'd still only have a 0.8% number, which is a far cry from the "2% rule".

Should I take this to mean that the properties in this area simply aren't a good value for rental income, or should I assume that there is a problem in applying such a guideline to homes in an area that is priced like Denver? Obviously I realize that this is just a simple rule-of-thumb, but I couldn't help but notice that I can't identify any properties meeting this criteria right form the very outset.

In a quick search online the cheapest single family home I found around my immediate area is priced at $174K. It's smaller than my own home, and pretty outdated. If I had to take an educated guess, it would rent for $1300-1500/mo, at most. Even at the high end of that rental range we're still only looking at 0.86%, which is similar to the example I provided above for the "typical" property around here.

So, where does one go to find a property that falls within the 2% rule in a market like this? Even in the undesirable areas of Denver I can't picture finding a $100K property that would rent for $2,000/mo. Of course, that's why I'm asking for advice from experts like all of you! ;)

Jay Hinrichs · Answer

@Kevin  H.

I am not suggesting one way or the other of were or how you should invest... I am just commenting that 2% by its nature is in a rental driven market were values are low and rents comparitivly are high.. and that usually brings with it everything from ghetto dogs to high work load and management intensive properties as to take the extra risk of owing these one needs to be compensated.. If you buy in the more expensive areas that are not flooded with rentals.. you will never get close to 2% you will see  1/2%  to maybe 1% if your lucky... but GENERALLY your in a much nicer stable investment that will not be as I stated so management intensive... I hit the 1% rule in MS with new construction I bought there for go zone...well not quite 1%  160k houses rent for 1250... but they are never vacant never have any of the issues you have with low end rental wear and tear.. NO SECTION 8 and all that drama.. Renters with 700 fico's and steady long term jobs. etc etc.

But yes if your bound an determined to be a landlord these are the decisions you need to make... risk reward... Me personally I am done with landlording I had 350 B to C class mis west homes and I sold them last year.. I have 7 more rentals left ( new construction I bought for go zone  bought 11 originally)  when there gone they will not be replaced. Only income property going forward I would consider would be a Class A or B apartment on the west coast with on site management that is managed by one of the big commercial PM's. What is actually truly passive.. Or a Class A or B mobile park on the west coast.. Not to confuse a Mobile park with anything in the mid west or east.. which many are worse than the worse Ghetto dogs... But for now .. I like moving money and getting returns that are double to triple what I could make in buy and hold... Anywhere in the country

Jay Hinrichs · Answer

2% works in cheapo markets that are flooded with rentals.  not in highly desirable owner occ areas and basically anything on the west and east coast...

If you limit yourself to thinking you need 2% rule to be in the game your going to be taking some pretty heavy risks if your investing out of state.. If you live in markets that happened to be flooded with 2% or better then your much more likely to succeed

Stan Butler · Answer

Rent does not scale with the price of the home, so a $200k house is not going to rent for twice as much as a $100k house.  In my target areas you could never achieve a 2% rent, but you could get 1.5% on a great deal and have great cash flow.  I think the key is to find the "sweet spot" in your target market and look for properties.  If you can find one that meets your investment criteria then who cares what % it is.

Robert G. · Answer

Correct.

I'm in Miami and I see the same exact scenario.  Too hot of a market, too many buyers willing to speculate on appreciation.  The rental incomes just don't justify the higher purchase price (plus, down here we also have high property taxes and insurance costs).

Some markets are great for flips, others are great for buy-and-holds.  You either need to adapt to your market, or change markets so you can successfully accomplish your investing goals.

Ned Carey · Answer

Yes and no.  The number that works for you and your area may not be 2%. Perhaps it is 1.5% or even 1.25%. However once you find that number it can be a quick crude screening tool. But remember this is about a crude a rule of thumb as you will find in real estate.

Of course you can argue it works great because it tells you not to buy anything in your market. If that keeps you from having negative cash flow properties, then the rule has done it's job; kept you from making a bad investment decision.

It is quite likely that the properties you describe will not come close to cash flowing. However you may find there are homes that will cash flow within 1 to 1 1/2 hours from you that you just don't know about.

Kevin H. · Answer

Jay,

Thanks so much for the clarification.  I'm just starting down this road, so I could find myself going in a different direction before it's all said and done.  I'm still trying to figure out what works well in my area.  I've talked to people in the past who did well with the fix-and-flip model out here, but they were skilled tradesmen who knew how to do the grunt work themselves (earning true "sweat equity").  I'm reasonably handy, but not to the point that I would try to gut and rebuild a house at this juncture.  My full-time employment in another field also keeps me from feeling like I'd want to start with a project that might require immediate, full-time, constant attention (like rebuilding a home).   Obviously there are many avenues I might still explore before I throw the first big check on the table for an investment property, but I've always been intrigued by the buy-and-hold philosophy as a means of long-term wealth building.  As you mentioned, there are some problems and pitfalls with that idea, too!  I have a coworker who buys all the ghetto properties he can get his hands on, and does a lot of Section 8 stuff.  I think I'd prefer to have properties that attract a better clientele, which hopefully won't get destroyed on a per-renter basis!  He's quite fond of his "slum lord" model, but I'm not sure it's for me… maybe his bottom line would convince me otherwise (I might have to call him and have a chat about that sometime), but I kind of doubt it.

Kevin H. · Answer

Thanks for your post, but please allow me to ask for some clarification.  Are you suggesting that it's okay to jump into the rental market in areas where the 2% metric clearly cannot be met, or are you merely suggesting that I find some other avenue for my real estate investments?    I'm not really interested in doing the out-of-state thing at this time, just due to the troubles that come with owning a buy-and-hold property that I can't easily see, inspect, fix, maintain, etc.  But, I definitely agree with your assessment that meeting the 2% criteria is not going to happen in the places where you and I live. And, to clarify on some of the other comments I've read in this thread, I definitely understand that this is just a rule of thumb, I'm only hoping to assess how I should approach things in my particular market, given the nature of things here in Colorado.  If I was still living in Cleveland I'd be willing to bet that I could find some properties in the region that would qualify under the "2% rule", but it sure looks unlikely in this area!

Adrian Tilley · Answer

This.  You have to find a way to get properties cheaper or find another place to buy as others have suggested.  You can also go the multifamily route.  Denver is a really tough place right now to find cash flowing properties.

Andy Robison · Answer

Rule of thumb* its not a rule hard and set in stone guarded by Marines, with a Phalanx of Spartans guarding it. Its just a rule of thumb. If you run your numbers and still cashflow at $x at the end of the month your set.  You will normaly find the 2% rule in midwest markets in the lower income areas seems to be the most common answer here in BP. I have a curent rental I bought for 32k Rents out for $675/month. I wont see any major price increase when it comes time to sell so that's a bad thing but for now it got me into the game. Search the website for 2% rule and you'll see its been addressed a lot and argued about. A more common thing you'll hear is the 50% rule. Over the average across multiple properties 50% of income will go into repairs and vacancies and misc other stuff.

Jason C. · Answer

The 2% rule is easier to find in cheaper towns, where houses go for 30-40k and rent for 600-800.

Every market is different.

Is the "2% rule" a valid way to identify properties in expensive markets?

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