There are several metrics you can use to evaluate whether a rental property investment has potential, including the 2% rule. When used with the property’s capitalization rate this rule helps investors get a sense of what a property’s rental income should be as a percentage of the purchase price. Understanding this rule and how to use it can make it easier to evaluate whether a particular rental property may 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?
This is a general rule of thumb that determines a base level of rental income a rental property should generate. Following the 2% rule, an investor can expect to realize a gross yield from a rental property if the monthly rent is at least 2% of the purchase price.
To calculate the 2% rule for a rental property you 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 dollar amount represents the minimum or gross yield you would need to rent the property for.
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, the rental property would have a better chance of making a good investment.
Using the 2% Rule
The 2% rule should be the first step in determining whether a prospective rental property would be a good investment. For example, it does not, when used alone, tell you how much more than that amount will be needed to cover operating expenses. These include taxes, insurance, utilities and maintenance. Adding these operating expenses to the projected gross yield renders net operating income (NOI), which is all the revenue a property generates over the course of a year minus the total amount of money required to maintain it.
Once you’ve calculated the NOI, you’ll need to divide that number by the property’s sale price and multiply it by 100 to get what’s called the capitalization rate (or cap rate). For example, let’s say you’re considering a property that’s priced at $350,000 and the NOI comes to $25,000 a year. The cap rate in that scenario would be just over 7%, which is the amount of profit you could reasonably expect to see from year to year.
Limits to the 2% Rule in Real Estate
There are some important limits to the utility of the 2% rule. For openers, this rule is only the start of measuring a property’s cash flow potential. There are several things the calculation cannot tell you. It won’t tell you how vacancy rates for a particular property may affect the property’s ability to generate rental income. Nor will it tell you how much you might need to invest initially to get the property rental ready. Additionally, it doesn’t tell you what you may have to pay in homeowners association fees, which may adjust annually.
In other words, 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.
Other Factors to Evaluate in Assessing Rental Properties
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. How supportive are local authorities to landlords seeking to evict tenants who don’t pay rent or otherwise violate terms of their lease agreement.
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. Consider it as a starting point in your analysis of a prospective rental property.
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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