What is the 2 per cent rule in real estate investing?

What is the 2 per cent rule in real estate investing?

What is the 2 per cent rule in real estate investing?

What is the 2 percent rule in real estate? We look at how this investing guideline works, and how it can be practically applied in real life.

You may have heard about the different "rules" in real estate investing.

There's plenty of percentage rules floating about; there's the 50 per cent rule,  70 per cent rule and the infamous 1 per cent rule.

While most of these rules are indeed very useful and can help investors avoid negative cash flow properties, low occupancy rates, and other risks in real estate.

But how foolproof are these percent rules? Are they feasible or should be completely disregarded as an idealistic concept?

In this article, we take a closer look at the 2 per cent rule and if it can be practically applied in real life.

What is the 2 per cent rule?

The 2 per cent rule, also stylised as  "2% rule",  is a rule of thumb that is used as a screening guideline for determining how much you should pay to buy a rental property.

The main idea is to only buy properties that produce monthly rent of at least 2 per cent of the purchase price.

So why 2 per cent?

The idea is that if a property generates a gross monthly rent of 2 per cent or more of the purchase price, it's considered as a "good investment".

It is widely considered that this rule of thumb will help you make a decent return on your investment property after factoring in your expenses for property taxes, insurance, maintenance, property manager, and mortgage.

According to the rule, a rental income of less than 2 per cent of the purchase price would suggest that the asset isn't worth buying.

To determine whether a property is a good investment using the 2 per cent rule, simply multiply its purchase price by 0.02.

For example, if you're going to purchase a property valued at $200,000 then the monthly rent should be at 4,000 or more  to meet the parameters of the  2 per cent rule.

When should you use the 2 per cent rule?

First of all, we must clarify that the 2 per cent rule is not strictly a "rule" that you cannot break and is infallible. Investors  are advised to consider the 2 per cent rule (as well as other percentage rules) as more of a guideline.

In terms of usefulness, it can only help you measure rent to price ratio, but not much more.

The two percent rule is especially useful when you have hundreds of deals to screen through in your market, as it will help you narrow down your options faster. If you’re scrolling through 100 properties in a shopping spree, it could help you  quickly eliminate the bottom-rung options.

You can also use the rule to get an estimate of how much you should offer on a particular rental property by multiplying by 50 (the inverse of 0.02). For example, if you find an investment property that currently earns a rental income of $2,000, the 2 per cent rule says that you shouldn't pay more than $100,000.

When should you not use the 2 per cent rule?

When used correctly (simultaneously with similar valuation strategies), the 2 per cent  rule may help investors determine whether or not an investment property is worth buying.

However, this particular strategy isn't without a few important caveats. Here are several factors investors must consider which aren’t included in the 2 per cent rule:

Property's location 

For starters' the 2 per cent rule fails to account for the property's location. That means that the demand, appreciation, and depreciation of investment properties aren't taken into consideration, all of which play important roles in an asset’s cash flow.

Without factoring in a property's location, the 2 per cent rule can't make the necessary adjustments needed to make a more accurate and educated estimate as to how well the real estate investment will perform.

Let's say you find a property that meets the 2 per cent rule. However, investors usually find that properties that meet the rule are often located in run down buildings or in unappealing neighborhoods.

Additionally, this could hurt your investment long term as property prices will grow in value at a much slower rate than the better neighborhoods in the area where your property is located.

This can hurt your investment in the long run, as it will limit your pool of potential buyers because demand won't be as high as in other nearby areas.

Property's condition 

The 2 per cent  rule also fails to include the property's current condition as a variable in the equation, which could result in investors overlooking additional costs.

Most of the properties that meet the rule are outdated real estate that are typically in terrible condition and are what investors dub as "money pits."

Provided the property needs to be restored before it's rented out, the incurred costs could negatively influence the results of the 2 per cent  rule, skewing it in a way that works against investors.

While the purchase price of the property and its rent all fits the guideline's bill, you may find yourself frequently paying for several property issues (plumbing, mold, water damage from rain), if the condition of the property is not up to standard. 

In the long run, all of these expenses add up and hurt your bottom line and hit your cash flow. 

Cash flow

The 2 percent rule only focuses on the gross income of a property and not the net income, also known cash flow, you'll be pocketing each month.

Most investors do not adhere to the 2 percent rule because the rent to cost ratio doesn't correlate with cash flow very well.

As mentioned above, the rule does not factor in some operating costs,, such as property taxes, which can be the biggest deal killers of all. Not knowing how much the property taxes are for a property after sealing the deal can be a rude awakening for investors.

Is it possible to find a property that meets the 2 per cent rule? Yes. However, it poses such a high-risk investment due to location, property quality, tenant quality, or a declining market that the projected cash flow will never pan out.

How realistic is the 2 per cent rule?

With all that said, is the 2 per cent rule a realistic guideline for investors to follow?

The 2 per cent rule is a great place to start your analysis and get a quick read for how well a property will perform. Finding properties that follow this rule can save you time, energy and resources when you sift through your choices when buying a property.

But while the rule can help investors learn how to find positive cash flow properties, it cannot stand on its own as an indicator of how good an investment property is. It does not tell you anything about the property's condition, the property's location, net rental income, cash on cash (CoC) return, cap rate, or appreciation.

There are a number of several rules of thumb and guidelines today's real estate investors feel like they should abide by. However, the most successful investors are those who are able to incorporate as many risk mitigation strategies as possible.

Therefor, it's important to note that while the 2 per cent rule is important, it's incomplete. The 2 per cent rule should only be used as a screening tool and is by no means a replacement for solid underwriting and good, old-fashioned deal analysis.

To learn more about the different percentage rules in real estate investing, explore Smart Property Investment's website today.

Source : www.smartpropertyinvestment.com.au/buying/what-is-the-2-per-cent-rule-in-real-estate-investing

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