Areas near Manhattan where the 2% rule can actually work?

Question

Hi how's it going. I just read Brandon Turners "The Book On Rental Property Investing" and he mentions the 2% rule for rent to purchase price. That's not even close to possible in Manhattan...An $800,000 apartment will not rent for $16,000 a month.

How would I go about finding areas where the rent is 2% of the purchase price? I understand the market dictates rent, and that all the 2% rule tells me is what I can pay for the property. But if rent on a NYC apartment is $3000, that means I can only pay $150,000 for the apartment. Again, that wouldn't fly in NYC.

I mention NYC as a central point because I don't mind exploring Jersey, Connecticut, Mass. These are all within driving distance. I'm from Long Island myself, not sure if there are areas around here. I'm brand new, and just looking to find markets to analyze deals and learn the ropes hands on. I feel like I just read a book, and realized I live in the wrong area to apply the principles of the book.

Any advice would be great.

Thanks

Jonathan Makovsky · Answer

@Shon Butanicongrats on reading Brandon's book and looking to get started. "2% rule-of-thumb" is more descriptive of the term. There are many markets within 100 miles of NYC that you can find plenty of 2% rules, however, just because a market does (or does not meet that rule) will it make sense.

As an example, there are plenty of Connecticut markets that you can invest in and find 2%'ers, however, that alone is far from making it a good investment. I think the 2% rule-of-thumb has its merits and can act as a quick and dirty way of performing a calculation. However, it's worthwhile understanding what 2% actually means:

Definition of "2% Rule-of-Thumb": If the monthly rent is 2% of the purchase price, then your Gross Potential Rent is 24%.

The issue with ONLY using this method as a way to invest is that it fails to take into consideration: 1) vacancies and bad debt (i.e. uncollected rent); and 2) operating expenses (including: taxes, insurance, repairs & maintenance, capital reserves and utilities, property management, super(?)).

As an example, you can find fairly easily in Waterbury, CT that many units will sell at $30K and rent for $700+ (2+%). However, your 24% gross potential rent will shrink very quickly for the following:

• About 15% to vacancies and bad debt so you are left with ~20.5%. 
• Then you will find yourself paying a premium for property taxes in this area (this is in part because the town is on a downward slide due to not much commerce and a declining population). 
• The insurance is likely to be higher than you think too because the insurer will value the building based on the replacement cost which is higher than the purchase price, so you will be paying a premium for that too.
• Many of the tenants in these areas also don't take as good care of their property as you might find in other parts, so you will likely find yourself repairing the units and building more than elsewhere.
• We also often see many tenants in these types of areas that don't pay for heat often have the heat blasting in the winter time and their windows open. So when you walk in you can actually feel your money being blown out of your pockets. :)
• Property management companies might charge more if there is more maintenance, and you might need a super if the tenants are not used to cleaning up after themselves
• If you total all these up the 2% rule-of-thumb may not be the returns you're looking for, especially when you factor in the tenant headache you are dealing with.
• Last point: often if you buy a property for $30K you will likely be selling it for $30K in 10 years, so don't expect to necessarily get rich off the appreciation.

With all that said don't let this stop you looking for property, because you MUST start somewhere - we all did. I always use the 1% and 2% rule-of-thumb as the first method of analyzing a property. In addition, I also will invest in [better] C-class areas because of the return, even though I might not get rich off the appreciation.

However, I don't buy a property without looking at the full picture (Collected Rents & actual Operating Expenses) and that's what the 2% rule-of-thumb fails to take into account.

Happy investing!

Jonathan Makovsky · Answer

Personally, I constantly traveled to 4 different states (NY, NJ, CT, PA) when I was starting out and met with brokers, local investors and staying putting together numbers, personal preference and my feasibility to get to each place.

I believe, the only way to get started is by getting on the phone and speaking to locals/local investors, then driving out to these places and seeing them for yourself.

There are also a ton of local BP meet-ups and other local real estate investment clubs where you can network with locals to understand an area better. After you see a number of different areas and properties, you will hopefully get a better feel for geography and the type of investment class/type that you're looking to do.

At some point you'll need to jump in, and if you have knowledge in a particular area, I would suggest first starting out there since it will cut your learning curve by a lot. If it's not feasible, you will start learning how to value deals and start writing offers.

Best of luck!

Shon Butani · Answer

Thanks a lot Jonathan. Very informative. Would you say I should literally just start looking at as many neighborhoods as possible, create maybe an excel sheet and categorize them as class A-C (or D), and go from there? It seems overwhelming on one hand to think "ok I have manhattan and a 100 mile radius, lets explore" but like you said, I have to start somewhere. Are there any more efficient ways of finding neighborhoods, and then properties?

Shon Butani · Answer

Thanks guys for the advice. I guess the other side to it is that if you invest in these class C areas with high vacancies and what not, appreciation is a much bigger risk than investing in a decent area? I guess you could get lucky though and invest in an area that really shapes up.

I appreciate the practical, situational advice though. I'm going to start networking in my area and finding out about different locations.

Ed Matson · Answer

I could not agree more with Jonathan Markovsky.  Our current B+ apartment complex is performing substantially better than the previous C- property even though the C- Pro Forma would look much stronger.  Its the total financial picture that counts, not just the ratio of Pro Forma rental income to purchase price. There are reasons those properties are inexpensive.

Michael Noto · Answer

As @Jonathan Makovskyand others have pointed out it get out in the different neighborhoods and see what you are dealing with to achieve your 2% on a conventional buy and hold. If you like what you see, go for it. If not, re-adjust your strategy to fit what works best for you.

1. Real estate is not a 1-size fits all thing in terms of "what someone should look for"

2. Real estate is not an exact science in terms of numbers.

3. Managing people (tenants) is a huge part of being a landlord. Figuring out the numbers is easy with all of the spreadsheets they have out there now.

David Faulkner · Answer

The 2% rule is a bad one in my opinion ... it will tend to lead new investors straight into the heart of the biggest ghettos of the midwest, deep south, or locally. You have to ask yourself at some point (in 2% neighborhoods) if housing prices are so low and renting is so much more expensive than owning, then why wouldn't everybody own in those neighborhoods? Your tenants will be the ones choosing (or forced to) rent, so it would be beneficial to understand the conditions and thought process that led them to that and what it means to you as their landlord. Now, if retail market price yields 1% and you can force appreciation through buying and rehabbing right to hit 2%, that's another thing entirely. Cash flow is an important thing, but it is not the only thing.

Areas near Manhattan where the 2% rule can actually work?

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