There are several metrics you can use to evaluate whether a rental property investment has potential, including the 2% rule. The 2% rule in real estate dictates that a property’s rental income should be at least 2% of the purchase price. Understanding this rule can make it easier to evaluate whether a particular rental property might be right for you. A financial advisor can help you create a financial plan for your real estate investment needs and goals.
What Is the 2% Rule in Real Estate?
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
For example, say you plan to purchase a property that costs $200,000. Using the 2% rule, that property should generate at least $4,000 per month in rental income. If you could only collect $2,000 in rental income then it wouldn’t pass the test.
The 2% rule is a variation of the 1% rule, which says that a property’s rental income should be at least 1% of its purchase price. If you were applying the 1% rule to the property in the previous example, then the property would pass with flying colors.
How to Calculate the 2% Rule
To calculate the 2% rule for a rental property you just need to know the property’s price. You could then take that number and multiply it by 0.02.
For example, say your budget for purchasing an investment property is $175,000. If you multiply $175,000 by 0.02, you’d get $3,500. That number represents the minimum or the base amount you’d need to rent the property for.
The 2% rule is by far one of the simplest calculations you can make to evaluate the projected return on investment for rental properties. You don’t necessarily need to know the property’s operating expenses or factor in any debt service if you’re planning to borrow in order to buy it.
What Does the 2% Rule Tell You?
The 2% rule tells you where to set the bar when establishing rental rates for an investment property. Essentially, it’s a measure of the projected rent versus the property’s sale price. It does not, however, tell you whether you’ll actually be able to collect that amount of money.
For example, say you want to invest in a luxury property that has an asking price of $600,000. In order for it to qualify as a good investment using the 2% rule, you’d need to be able to collect at least $12,000 per month in rent.
That may or may not be possible, depending on the rental market where the property is located. If rents for comparable properties are in the $7,000 to $8,000 range, then $12,000 might be an unrealistic goal. At that point, you’d have to consider how much you’ll need to invest in the property and how much of that might be returned to you in profit.
Where the 2% Rule in Real Estate Falls Short
The 2% rule can be helpful in measuring a property’s cash flow potential but it’s just one small part of the overall puzzle. There are several things the calculation cannot tell you, including:
How vacancy rates for a particular may affect the property’s ability to generate rental income
What you’ll make in profit after deducting operating expenses and debt service
How much you might need to invest initially to get the property rental ready
The amount of maintenance and upkeep the property requires
What you’ll pay for property taxes and homeowners association fees, both of which may adjust annually
While the 2% rule can be a good starting point, it’s really just the tip of the iceberg in determining whether a rental property is a good investment. It’s also important to look at how much money you’ll invest upfront and on an ongoing basis in order to get a better sense of how much profit you’re likely to realize.
How to Evaluate Rental Property Investments
Finding a good investment opportunity isn’t an exact science and there are several things to weigh when choosing a rental property. If you’ve done an initial 2% rule calculation and found a property that looks promising, the next step is taking a closer look under the hood.
You can start by looking at the condition of the local market. For example, are rental rates increasing or have they stabilized? What’s the typical going rent for properties that are comparable in terms of size, age, condition and features? It’s also helpful to consider vacancy rates for the area.
Rising rents and low vacancy rates can indicate strong demand for rental housing, which is a good thing if you’re concerned about the property sitting empty for long periods of time. Aside from that, you can look at the desirability of the area and what type of renters it’s attracting.
Good schools, low crime and convenient access to shopping and other amenities can be strong attractors for renters. The more appealing an area is, the more you might be able to charge for rent. However, it’s important to weigh all of that against your costs. That includes what you’ll pay for a mortgage if you’re not buying a property with cash, how much it’ll cost to maintain the property and the going property tax rates.
Finally, consider what’s happening with the housing market and the economy as a whole. Renting and commanding higher rental rates is typically easier to do when the economy is booming. If there are hints that a recession might be waiting in the wings or inflation is pushing up the price of maintaining a rental property that could affect the level of profits you’re able to bring in.
The Bottom Line
The 2% rule is just one guideline you can use to decide if a rental property investment is worth your time and money. It’s important to remember that while a property may look good on the surface, you’ll still want to perform your due diligence to confirm that it’s a worthwhile investment.
Consider talking to your financial advisor about how to use the 2% rule to evaluate rental properties. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’d like to reap the benefits of rental property investing without owning property, there are a few ways to do it. A real estate investment trust (REIT), for example, owns and manages rental property investments. When you invest in a REIT, you can collect dividend income passively without having to worry about managing properties firsthand. Real estate crowdfunding allows you to pool money with other investors while leaving the management of the property to someone else. Finally, you might consider exchange-traded funds (ETFs) or mutual funds that concentrate their holdings on real estate investments.
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