Sometimes this is how I feel when I’m analyzing rental property
Finding and analyzing rental property is a daunting task.
You may find a hundred or more potential deals in your target market and each one has its own income and expenses to consider.
It could very well take weeks to analyze every deal… and by the time you get through the list, everything will have been sold!
Obviously, that’s not going to work. So how do we get around this?
It’s simple. Use screening tools.
One of the most common screening tools is the 1% and 2% rules.
What is the 1% and 2% Rule?
There are a lot of “rules of thumb” floating out on the internet, and this is one of the more popular.
The 2% rule states that if your monthly rent is roughly equal to or greater than 2% of the total property price, then you will be able to generate positive cash-flow on the property.
- A $100,000 property should generate $2,000 per month in rent
- A $75,000 house that requires $50,000 in renovations should have an after repair value of $125,000 and rent of $2,500.
The 1% rule is the same as the 2% rule in the way that it’s calculated, but it says that a deal that earns 1% of the total price in rental income, you should break even, usually.
- A $100,000 property should generate $1,000 per month in rent
Where Does the 1 Percent Rule Come From?
The 1% and 2% rules aren’t just a random rule someone made up – it is a simple concept created using the Gross Rent Multiplier (read an in-depth article about it).
GRM is generally calculated on a yearly basis whereas the 2% rule uses monthly rent. If you’re familiar with GRM already, it’s pretty simple to convert the 2% rule over the gross rent multiplier:
$2,000/month * 12 months = $24,000 rent/year
We remember the formula for Gross Rent Multiplier from my article (linked above):
GRM = Asking Price / Gross Rents
So, the GRM for the above example:
GRM = $100,000 / $24,000 = 4.17
It’s important that I point out that the gross rent multiplier and the 2% rule are inversely related to each other.
The higher the rent as a percent of value, the lower the GRM is. So basically, the lower the GRM and the higher the rent %, the more potential income.
It makes sense, right? The GRM is how many years of rent you need to cover the cost of the property. The more rent you collect, the fewer years it takes to pay off. More rent means fewer years, that is an inverse relationship.
Anyhow, let’s just round the answer and say that the 2% rule means you need a GRM of 4.2 or lower. So, I’ll just round and say that the 2% rule means you should find a property with a Gross Rent Multiplier of 4.2 or lower.
How to Use the 1 Percent and 2 Percent Rules
As I mentioned before, the 2% rule should be used as a screening tool for investment property. It is not an accurate reflection of net income because it uses only the gross rent and doesn’t include any expenses at all.
Just like you wouldn’t buy every stock with a low P/E ratio, you may not want every property with a very low GRM, or one that meets the 2% rule.
A company with a very low stock price to earnings ratio may be undervalued, or it may actually be a company that is likely to fail. A property with an extremely low price compared to its rent may be a property with an immense amount of deferred maintenance, be in a C or D class neighborhood, or have any number of other issues with it. So, the gross rent multiplier is to real estate as the P/E is to a stock.
There are so many potential risks in real estate that you may not even be considering that could be affected the GRM of the property, so think carefully before jumping on any property that looks too good.
Use the 1% Rule as The First Screening Tool.
If the rents on a property are not at or near the 1% rule, immediately walk away.
There are a ton of decent deals out there that easily exceed the 1% rule. So, don’t waste any time on them.
It’s true, you might miss some massive value add opportunity where the rents will skyrocket after you take over…but this is rare.
Using The 2% Rule as a Screening Tool
Just like a window screen allows air to travel through, a real estate screen blocks most of the bad deals and only lets the potentially good deals through.
The process is very simple.
- Filter through all your potential properties and make a list of the asking price and total rents. If possible, give a very rough estimate of repairs necessary as well and add that to the asking price. Using this information, calculate what % the rent is of the total price.
- Sort the list from highest to lowest
- Take a closer look at every property that has a gross rent multiplier below 4.2, or exceeds the 2% rule.
- Once you’ve looked at the deals with the most positive ratios, start working backward to deals with worse ratios.
Imagine making a list of deals that look like this:
- $500,000 – $3,500 – 0.7%
- $400,000 – $4,000 – 1.0%
- $450,000 – $6,000 – 1.3%
- $350,000 – $5,000 – 1.42%
- $375,000 – $6,000 – 1.6%
- $200,000 – $3,800 – 1.9%
- $450,000 – $9,100 – 2.02%
You’d start by looking first at the $450k deal. Let’s say you find it has a ton of problems and needs a few hundred thousand in rehab, then maybe you pass and go take a look at the $200k deal, and so on.
By using this method, you may be able to exclude 80-90% of all the potential deals so you can focus on the ones that have the best potential. Hopefully, you can make some offers and close a deal.
If not, you can adjust the rule to fit your needs – keep reading to see how.
THE 2% RULE ISN’T A RULE, So Make it Your Own
Now, you could stop here and take the basic information and run off into the world trying to buy property.
The reality is that real estate is very local, so it’s pretty obvious that nothing can be a ‘rule’. You wouldn’t expect the ratios to be the same in Florida, Oklahoma, or California.
Just a quick anecdote – insurance rates in Florida are at least double the rates of where I’m from in Massachusetts. So, obviously, when analyzing deals in these two states, we cannot use the same set of assumptions.
How to Determine a Good income Ratio in Any Market
1) Determine Your Cash on Cash Return Goals
The first thing you want to do is to create a goal for the return on your cash investment. Let’s say your goal is to earn 15% cash on cash return on any particular deal.
- If I buy a $100,000 property, that will require around $20,000 down payment.
- I need to return $3,000 per year in order to earn 15%
You can use any percent you want, but make sure it is pretty high. Properties with leverage should have high returns.
2) Estimate Your Expense Ratio
This is where the 50% rule comes in. Again, no rule works in all markets, so you should understand the expenses in your particular market before using any rule. You may find your expenses are 55% or 40% or whatever. If you want to know why we picked 50%, read that article for a deeper understanding.
Once you analyze several deals in your market and gain more experience, you’ll know how much properties cost and you’ll know how you manage them. For now, let’s just stick with 50% of our total collected rent going to operating expenses.
3) Estimate Mortgage Expenses
Use a mortgage calculator in order to calculate your monthly mortgage amount. You can also download my FREE calculator which includes a mortgage calculator in it as well as helps estimate cash on cash return, expenses, etc.
For simplicity, let’s say we have an $80,000 loan at 5% for 30 years. That is a monthly payment of $429 or $5,148 per year.
4) Calculate Your Own Rule of Thumb
Now it’s pretty simple to figure out.
We know we want to earn $3,000 per year. We know our expenses are 50% of our income, and we know our mortgage payment is $5,148 per year.
Now just solve it:
(1/2)Rent – $5,148 = $3,000
(1/2) rent = $8,148
Rent = $16,296
Monthly Rent = $1,358
$1,358 / $100,000 = 1.36%
For you, you’ll want to find a deal that has rents at least 1.3% or 1.4% of the total price.
Use Caution when Using the 2% Rule (or any other Rule)
As you can see with my calculation, the ratio is affected by your down payment, interest rates, expense ratio, and desired return. By changing any one of these, you will come out with a different “rule” to follow and every market will likely have a different result.
We are fortunate though that it is extremely conservative. Whoever created this concept made it very vague and set the expected returns very high. It is generally said that by following the 2% rule, a property should have positive cash flow.
Think about it this way – someone is trying to create a blanket rule that applies to everyone, everywhere. This is probably not a good idea.
The same holds true for the 1% rule. 1% might break even in one state and make you lose your shirt in another state.
That’s why it’s best to know your market, set your expectations, and look for deals that fit that.
Money tends to flow toward high returns, so markets with consistently high returns will find capital flowing into those areas. That money will cause properties to appreciate until profits shrink to a “normal” level (as compared to other investments such as the S&P 500). So, if you set your goals too high, you might not find any deals. If you set them too low, you’re shooting yourself in the foot.
Problems With the 2% Rule and Calculating Your Own Real Estate Screening Ratio
This equation begins to fall apart under two circumstances. First, if the down payment becomes very small then the ratio will become very low, well under 1%. Since the 2% rule is based upon cash on cash return instead of return on equity, the less cash you have in the deal, the less you need to reach your desired profit.
Think about it, if you were so fortunate to only have to put $1 down to buy a property, you could earn just 50 cents and have an amazing 50% cash on cash return.
This doesn’t sound very good, does it?
The other situation where the equation begins to fall apart is when the down payment becomes too large and the mortgage amount drops. As this happens, the ratio will begin to approach:
X = Cash Return/Expense Ratio
This will create a very high ratio. It intuitively makes sense though – the more money you put down, the lower of a GRM (higher rent as a percent of value) in order to achieve that very high cash on cash return.
For example: with a 15% goal for return with a 50% expense ratio, we would follow a “3% Rule”, which is pretty high and unlikely you’ll ever achieve it.
People put more money down to reduce risk. Lower risk means lower returns. So, if you put more down, you need to adjust your expectations.
The Failings of This Screening Tool Simply Confirms What We Intrinsically Know About Real Estate Investing
That is – the less you put down then the higher the return on your cash investment.
If you put only $200 down, earning $100 is a 50% return. That is way better than earning $10,000 on a $100,000 investment.
But, does it make sense to do the smaller deal that earns only $100? The percentage is high, but in order to earn any meaningful amount of money you’d have to do hundreds of deals…and no one has time for that.
I know I’ve thrown a ton of numbers at you. That’s why you need a calculator to help you screen deals. It will save you a ton of time and ensure you are right more often.