What is the 2% Rule?
There are a lot of factors to consider when deciding whether or not to purchase an investment property. The 2% rule is the nickname given to a quick calculation that investors can make to gauge how likely a specific real estate investment will be able to produce positive cash flow.
The 2% rule is this: a property that can consistently produce monthly rent payments that equal at least 2% of the total investment cost is more likely to cover necessary expenses and produce positive cash flow than a property bringing in monthly rent of less than 2% of the total investment cost.
Philosophy Behind the Rule
The 2% rule is used by some real estate investors to screen out potential investments that would be far too difficult to make profitable.
If you can’t generate revenue of at least 2% of what it cost to buy the property, it’s going to be difficult to make money after expenses. That doesn’t mean it’s impossible. Some property investments that wouldn’t make the 2% cut could still be worthwhile. But you’ll need to consider other factors and have a plan.
Calculating the 2% Rule
By running the formula above, you’ll get a percentage. If it’s less than 2%, then that would mean the amount of monthly rent would not be enough to satisfy the 2% rule, based on the purchase price of the property.
You want to avoid paying too much for a property where the market will not support a profitable rental rate. You also want to avoid charging too little in rent when it’s not enough to make money after covering expenses.
Example
If you were to purchase a rental property for $150,000, the 2% rule would suggest that you ought to collect at least $3,000 in rent monthly in order to give yourself the best shot at consistently producing a stream of positive cash flow.
Should I Use the 2% Rule When Investing in Real Estate?
Whether or not you should utilize the 2% rule when selecting investment properties is a personal choice. It’s a screening calculation that some take seriously, while others view as merely a guideline or an outdated measurement.
There is no hard-and-fast rule about any sort of exact ration for purchase price versus monthly rental income. Of course, the more you minimize your risk, the less likely you are to lose money. But you may also be missing out on a great investment, even if the property and rental market don’t quite meet the 2% rule criteria.
Our advice to our property owner clients is to make sure you know your market, your risk tolerance, and your investment strategy!
Get Help With Your Real Estate Investing
With years of experience both owning and managing investment property, the professionals at Joseph Thomas Property Management help real estate investors throughout Utah build successful strategies and profitable portfolios.
Let us know what guidance or service you stand in need of, and we’ll show you how we can make your life easier and property ownership more rewarding.
FAQs
What about the 1% rule?
The 1% rule is a formula used in basically the same way as the 2% rule, but with a less-conservative approach to the formula. The only difference is that the 1% rule accepts more risk by qualifying investments that only produce 1% of the investment cost each month in rent.