What Is The 2% Rule in Real Estate?

January 25, 2024

Produced by:
Richard Stevens

Richard Stevens is an active real estate investor with over 8 years of industry experience. He specializes in researching topics that appeal to real estate investors and building calculators that can help property investors understand the expected costs and returns when executing real estate deals.

A brief summary

Finding a profitable investment property is the main goal of real estate investing. While this may sound like an easily achievable task, it can more complicated. Investors should be armed with the right knowledge on how to decide which properties are worthwhile investments and which aren’t. One method that can be used is the 2% rule. Read on to find out what the 2% rule in real estate is and how you can use it.

Table of Contents

Real estate investors who are looking for the next profitable investment property can benefit from a few rules that exist in real estate. These rules are aimed at helping real estate investors to determine which properties are likely to be good investments. This is particularly useful in the initial phases of weeding out properties that aren’t worthwhile investments quickly, to further analyze ones that could be successful.

When it comes to rental properties, you may have heard of the 1% rule, but now let’s take a look at the 2% in real estate. We’ll delve deeper into how the 2% rule works, what the difference between the 1% and 2% rules are, how realistic the 2% rules is, and more.

What is the 2% rule in real estate?

The 2% rule states that a rental property is likely to yield a positive cash flow if the monthly rental income is 2% or more of the home’s purchase price.

This rule is used as a guideline, to indicate which rental properties are likely to be profitable and which aren’t.

For example, if a property is being sold for $300,000, then the rental income should be at least $3,000 per month for this property to fit the 2% rule.

How do you find properties that meet the conditions of 2% rule?

Not every property can fulfil the conditions set out by the 2% rule, so these can be difficult to find. To start searching for these properties you’ll need to consider two things, the location of the property and your real estate investing goals.

Location

Housing markets will determine the price of the home and how much rent you can charge for it. So, some areas are more likely to have houses that can meet the 2% rule and others aren’t. For example, houses in the mid-West and the South are more likely fulfill the 2% rule’s conditions than houses in LA or Boston. However, most metros will not contain many houses that meet the conditions.

You’ll need to pick an area that has a bustling rental and sales market, in order to meet the 2% rule. This could mean purchasing a property in an area that you hadn’t thought about, or on the other side of the country. Either way, if you find a property that fits the 2% rule, make sure that it isn’t in need of any major repairs or work.

Investing strategy

The 2% rule applies to investors who are specifically looking for properties with a positive cash flow, which will give them larger short-term returns. However, some investors are purchasing investment properties to buy and hold. In which case, they’re looking for property appreciation over time, for longer term returns instead of a specific cash flow every month. In this case, the 2% rule isn’t important.

So, finding properties that match the 2% is only necessary if it fits with your particular investing strategy.

What's the difference between the 1% rule and the 2% rule?

The 1% and 2% rules are very similar in concept, with the main difference being the percentage itself.

The 1% rule is used for the same purpose as the 2% rule when it comes to determining the profitability of a rental property. However, the 1% rule differs from the 2% rule as it can also be used to determine realistic rent prices. The 2% rule is unlikely to be a good indicator of how much rent to charge in most metros.  

The 1% rule is also about using a percentage of the property purchase price to determine rent prices, however instead of using 2% of the purchase price, it’s 1% of the purchase price. For example, if a house costs $100,000, using the 1% rule, the rent should be $1,000 per month to generate a good cash flow.

The 2% rule isn’t used as often as the 1% rule, especially not in current times where housing markets are in flux and people aren’t willing to pay high rent prices. In certain markets it can work, however the 1% rule is certainly used more often.

Is the 2% rule in real estate realistic?

The 2% rule is really more of a guideline in the world of real estate. Many properties won’t fulfil the conditions laid out by the rule, so it’s not a hard and fast principle to stick by. The 2% rule doesn’t account for some important aspects of buying an investment property. These are:

  • The condition of the house (repairs and renovations will change the cash flow)
  • The location of the property (housing markets determine the property and rent prices)
  • The investment strategy (buy and hold versus rental property)
  • Capitalization rate
  • Property appreciation (the focus is on monthly cash flow and appreciation isn’t factored in)

The only real use for the 2% rule is to measure the rent-to-price ratio of a property. Investors who are focused on cash flow can use it as a rough guideline, however they will need to be flexible around it because the conditions may be out of reach most of the time.

In today’s real estate market, the 2% rule is seen by many real estate experts as too broad and limiting for many investors. There are very few properties that exist within this range, and they can be hard to find. Investors can therefore miss out on other good opportunities, while trying to find the select few that may match the 2% rule’s criteria.

Do you have to abide by the 2% rule in all situations?

The 2% rule certainly doesn’t apply in all situations, in fact it only applies in a small number of situations. The reason is that the rule doesn’t account for various factors and therefore only properties that match the limited conditions will fit into it. As such, investors don’t need to abide by the 2% rule in many cases.

  • Buy and hold investors: With a buy and hold strategy, investors would disregard the 2% rule as they’re looking to buy a property and hold it, to allow it to appreciate in value. These investors will then make a profit when they sell. This means that the property is being used for long-term appreciation and not for short-term gains. This doesn’t fit in with the conditions for the 2% rule.
  • Certain housing markets: The 2% rule is unrealistic in a number of cities and states that have higher property prices. The likes of LA, Atlanta and Boston are the type of metros where the 2% rule cannot apply. Investors in these areas may even be lucky to meet the 1% rule as the markets are hot. This doesn’t mean that these properties are bad investments, it just means that the housing markets are different, and the area doesn’t allow for such high rent prices.
  • Estimated numbers: If an investor is looking at buying a property and basing their decision on estimated numbers instead of actual numbers, the 2% rule may not be a good idea to follow. This is because the actual numbers may be quite different, throwing the 2% rule out the window, and perhaps even showing a negative cash flow. Situations where the actual numbers are not yet given, therefore need to be taken on a case-by-case basis.
  • Different goals and strategies: There are some properties which may not meet the 2% rule or even the 1% rule, but this doesn’t mean they are bad investments. Depending on each individual’s goals and strategies, the 2% rule may not apply. The risk and return need to be considered on each property, and sometimes taking less return and less risk can work out better in the long run.

Final tips for using the 2% rule as a real estate investor

As with many real estate rules, the 2% rule is to be used more as a guideline to help you filter out properties that would be very clear bad investments. If you’ve got a list of properties that is 1000 houses long, this rule can be used loosely to narrow down the list to properties that you’d like to investigate further and you can then do a deep dive into the cash flow of these.

It’s a good idea to start with the 1% rule, filter out properties and then use the 2% to check further, however ruling out properties that don’t fulfil the criteria of the 2% rule isn’t wise. Properties that match the 2% rule are few and far between, so if you can find a market that is a little slower and outside the main metros, you may find a 2% deal that’s simply a steal. If not, the property may very well be a good investment still.

When deciding on which properties to look at more seriously, you should factor in cash flow but also:

  • Location and local housing market
  • Your investing strategy
  • Your expenses
  • Capitalization rate
  • Total income generated from the property (including sources other than monthly rent)

Once you’ve established which properties may provide a positive cash flow, these should be your focus. Positive cash flows are going to give you good returns on your investment, so these are very important when choosing the right rental property for you.

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