The 2% Rule: Why new investors should be EXTREMELY wary of it

[Troy Zsofka]

“The 2% Rule” seems to be a fast favorite among new investors, and since I’m a tell-it-how-it-is (or at least tell-it-how-I-think-it-is) kind of guy, I figured I’d write a post to call it out.

Before I go into why I think it's so dangerous, first let's understand what it really signifies. Mathematically, it is simply the inverse of the Gross Rent Multiplier (GRM), using monthly rather than annual rents. So, a property that reaches the 2% rule has a GRM of 4.167. (2% X 12months = .24, and 1 / .24 = 4.167). By definition, the "X% Rule" has the very same benefits and drawbacks as GRM. Yes, I said benefits – it is not entirely useless. In fact, these measures can be extremely handy as quick and easy INITIAL evaluations of a SPECIFIC type (SFR, Multi, Office, Retail, Industrial, etc) and class (A, B, C, or D) of property, in a SPECIFIC market, at a SPECIFIC point in time, with a SPECIFIC lease structure. Any attempt to judge a property based on a certain expected GRM (or X% rule) across multiple property types and classes, locations, or time periods, and you will only serve to mislead yourself. This is why I think it is so dangerous to put an actual number to "X", and then to call it a "rule". It leads newbies to believe that they should be seeking it out when analyzing properties.

Here’s, more specifically, why it’s so dangerous:

1) Ambiguity (this is where asset type, location, and lease structure come into play).

Overall, the X% Rule, as well as GRM, leave too much out. They do not take into account operating expenses at all. That is why Cap Rate (or its inverse, Net Income Multiplier – key word being "Net") are far superior means of estimating what you should pay for a given investment property. As an example, let's combine "The 2% Rule" with "The 50% Rule". According to these, you will have a CAP Rate of 12%. This is because the 2% annualized yields 24% for the rents, and then applying the 50% rule leaves an NOI of 12% (these are all percentages of purchase price, or purchase price plus capital outlay to achieve stabilization). That all sounds nice, but what if the 50% rule is drastically off? What if the lease is NNN? In that case the expenses would be close to zero, and a 1% rule property (8.33 GRM) would perform at more-or-less the same Cap Rate of 12%. Also, what if you're comparing 2 properties in different towns with different tax rates? Here in NH, the taxes in one town might be 1.5% of the assessment, and in the town right next door they might be 3% of the assessment, and the rents don't make up the difference. In that situation, one property might meet the 2% rule and still cash flow much less than the other one, even if it doesn't meet the 2% rule. As a final example, what if you're comparing small multifamily properties where one has split utilities, and the other has just one heating and one electrical system where the utilities costs are borne by the landlord? Just because one may have rents that represent a greater percent of acquisition costs (greater X% rule), does NOT necessarily mean that it will cash flow better. There goes your 50% rule, and there goes the utility of the X% rule in that situation as well. On the other hand, if you know the expected GRM or X% Rule for that type of property with that typical Operating Expense Ratio in that specific market location at that specific moment in time, it's fine to use it for a quick peak, but just make sure to run the CAP Rate before you get too excited.

2) Trade-offs (this is where class of property comes into play)

There is more than one way to make money in buy-and-hold. I’ll mention 2 here: Cash Flow and Appreciation (yes, I know that it’s become popular to claim that considering appreciation is “speculating”. I disagree. While I do agree that is (usually) inadvisable to invest in a property with negative cash flow, and to thereby “bet” on the appreciation, I do believe that considering the appreciation potential is an integral part of investing. After all, ever know of any stock investors who choose stocks solely based on dividends? Anyway, this is a whole other topic, but give me the benefit of the doubt that appreciation is one of the ways that we buy-and-hold investors profit from real estate so I can make my point).

Most investors would agree that a C or D class property is going to have greater cash flow, but little to no prospects for appreciation. So, if you're focusing too heavily on meeting or exceeding the 2% rule, there's a good chance that you're going to end up investing in bottom-of-the-barrel markets with little to no equity growth (other than through loan amortization). Another thing to consider in this regard ties right back into #1 above. If you target a 2% property that ends up being C or D class, there is a good chance that you will experience increased credit loss (uncollected rents), vacancy, legal expense (for evictions), and repairs and maintenance. If your 50% rule then turns into a 62.5% Operating Expense Ratio, then your 12% Cap Rate just went down to 9%. Is a 9 CAP bad? Well, on a high-maintenance investment that doesn't appreciate, I would say that yes, yes it is. Using the actual vacancy and credit loss, and the actual expenses to determine NOI and then CAP Rate will avoid this potential pitfall. As an extreme example, if the 2% rule is all you care about, then why not just invest in Detroit where you can probably get a 5% rule property – if, that is, you can actually collect the rent, keep the property occupied as opposed to vandalized, and not get mugged.

To summarize, I don't have a problem with GRM (or even its wet-behind-the-ears little brother, "The X% Rule"), when used responsibly. If you know what it should be (in that type of property, in that class of neighborhood, in that geographical location, at that point in time, with that type of lease structure, and with a predictable OER), then it's a great way to get a quick-and-dirty look before going through the trouble of collecting income/expense info to calculate the CAP Rate (which is also location-, class-, and time-specific, but takes into account any potential variance in OER).

What concerns me is the idea that new investors may be led to believe that "The 2% Rule" is some sort of golden be-all and end-all of real estate investment analysis. It is NOT, and it should only be used when holding all else constant, and even then, only as a quick-and-dirty initial glance. It must be followed with more thorough analyses of actual numbers, using more robust measures such as CAP Rate, PV, and IRR.

All that said, any serious investor really needs to educate him/herself on the more accurate and conclusive measures for investment analysis. If you're new, and you aren't fortunate to have a background in commercial real estate finance, then read a book or study some of the more in-depth blogs on BP. Frank Gallinelli wrote a book on cash flow and other analysis measures that is a great place to start. While most of the stuff in his book is targeted for commercial properties, I believe it to likewise be useful for 1-4 unit residential investment property. After all, you're investing to make money, so any calculations that can analyze financial performance will work for residential properties as well as commercial for your purposes; they just won't hold as much significance from an appraisal or lending perspective, or for the purpose of projecting appreciation. However, I find that doing a commercial-grade financial analysis on your SFR's will show a local portfolio banker that you're a serious investor and know what you're doing.

Happy investing,

Troy