A Hopefully Non-Provocative 2% Rule Question

[Jake Kucheck]

Not trying to stir up the nest, just looking for an answer.

Obviously in the OC, I never think about the 2% rule. But... starting to look out of state, I was looking to clarify the following:

I know that the 2% rule states that if your monthly rent is 2% of your purchase price, the property has a good chance of cash flowing. My question is- is it supposed to be 2% of your purchase price, or 2% of your purchase price + repairs. Seems like the total acquisition cost (inclusive of repairs) would be a better number for determining your C on C.

[David Beard]

Jake, the 2% rule is a nice theory, just bear in mind a few things with respect to the true return on your invested capital.

1. These 2%+ rule properties (talking about SFR) are generally inexpensive and below lending minimums for banks, so you will generally not be able to leverage on the front end.
2. Even rehabbing and seasoning the property for awhile, it is difficult to refinance, as it's hard to get a decent appraisal due to foreclosure saturation in these "2%" areas; REOs/SS's tend to define the comps.
3. Banks are very collateral-focused, and the local banks have had poor default experience in these 2% areas and are further reluctant to even lend in certain areas as a result.
4. If you go out of state, you will have zero chance of getting financing as an "out of area" borrower.
5. If you have access to private financing, this can be a solution.
6. Otherwise, the 1.5% property (9% annual net using 50% rule) that can be leveraged will provide a better return, and a MUCH better after-tax return due to controlling more property and thus having much greater depreciation writeoffs. Yes, the loans add risk but as long as you maintain minimums for debt coverage ratios (gross rents at 3.5x P&I), and a minimum for absolute cash flow per door ($200 or so), you should be fine, as well as the fact that you're investing in a better area and thus should have better downside protection on the home value.
7. The 2% rule property probably also has expenses more like 55%, versus the 1.5% property at 45% (crappier tenants and higher fixed costs relative to home value).

I have a pile of 2.25 - 3.00% SFR properties, decent properties in decent areas doing quite well, but I'm reluctant to look at any more for the reasons cited, and will focus on a little better SFR property, as well as small apartment complexes (banks are pretty aggressive financing these).