The 2% Rule
Here’s a great rule of thumb for buy-and-hold investors (rental property owners) who focus on single family houses. And again, this is a good rule of thumb to use to perform a quick, first-pass financial analysis on an investment to determine whether it’s worth looking at further.
The 2% rule states that, to make a good profit on a single family investment property, the gross monthly rents should be at least 2% of the total purchase price of the property. For example, if you could charge $1200/month in rent on an investment house that costs $60,000, you would make a good profit.
It’s important to understand that the 2% rule is a very conservative rule. I prefer to look at this rule as a “sufficient, but not necessary condition” to make an investment, meaning that if you find a property that meets the 2% rule, you likely will want to buy it, but just because a property doesn’t meet the 2% rule doesn’t mean that you don’t want to buy it. In fact, in many parts of the country, it can be very difficult — if not impossible — to find properties that will generate rents that are 2% of the purchase price of the property. But this certainly doesn’t mean that you can’t make money in these parts of the country…you just need to work harder to evaluate deals.
Let’s look at an example of the 2% rule in action, and see why it works:
Say you find a single family investment property for sale for $25,000. Additionally, let’s say that based on your research of the local market, you believe you can rent that property for $500. As you can see, this property meets the 2% rule — monthly rents are 2% of the total cost of the property.
With a gross rent of $500/month, using the 50% rule, your monthly NOI (amount remaining for mortgage and profit) would be $250:
NOI = Gross Rents * 50% = $500 * .5 = $250
Assuming a 100% fixed interest loan at 6% for 30 years, your monthly mortgage payment would be exactly $150, leaving exactly $100/month in profit:
Profit = NOI – Mortgage = $250 – $150 = $100
Most SFH investors consider $100/month to be minimum acceptable return per month, and any property that meets the 2% rule will generally return at least $100 per month. Also notice that in this example, the investment generated a good return on property that was 100% financed. If you were to put 20% down on this property, the cash flow would be even higher.
Remember, the 2% is great, conservative financial estimation tool, but it may not work in your local market or for the properties you’re considering. Just because the 2% doesn’t work in your area doesn’t mean you can’t make money; but if it does work (or you can make it work), you’re sure to find some great investments!