The 2% Rule
The 2% rule states that any rental an investor buys should rent for 2% of the purchase price. For example, an investor should be all into a house that rents for $1000/month for no more than $50,000 ($1000/$50,000 = 0.02).
The 2% rule is, quite simply, a bad rule. It paints with far too broad a brush and thereby, I think it's far too restrictive. According to Gary Keller in The Millionaire Real Estate Investor, the national average rent/cost is 0.7%. Beating that three times over is not going to be easy.
The problem, of course, is not that it's hard to do this, but that focusing on 2% will push investors to do unwise things; namely invest in war zones where they get 2% but only a paper, or investors will hire subpar contractors or do subpar rehabs. Lord knows investors don't need any worse of a reputation in this area.
We have gotten 2% rent/cost before, mostly in the lowest quality areas we invest. But in solid working class/lower middle class areas, we settle for 1.5%. And in the nicest areas we go, we'll even go down to 1.3%.
For one thing, a property you're all into for $20,000 that rents for $400 will not cash flow as well as a property you're all into for $40,000 that rents for $800 even though the ratio is the same. The fixed costs of maintenance, turnover and what not outweigh the more variable costs of taxes and debt service. Insurance can even have an inverse relation to price.
We classify areas by what kind of rent/cost we can tolerate there, and of course we try to do better. But making 2% a hard rule is a bad idea in my judgment; It will lead you into warzones with bad contractors at your side.
The 50% Rule
The 50% rule states that, on average, the operating expenses of a property (not including debt service) will be 50% of the gross income (if the property is performing of course).
Unlike the 2% rule, the 50% rule is a pretty good rule of thumb. Although, first and foremost, it is nothing more than a rule of thumb. With apartments, you should look through the operating statement and construct what you think the real expenses should be based off the following 10 categories:
- Management Fee
- Rehab Supplies
- Contract Services
- General Administration
- Recurring CAPEX
That being said, 50% is still a good rule of thumb. But, if an apartment has any of the following characteristics, make sure to adjust it:
- All Bills Paid, or owner pays large amount of utilities: You should increase it to at least 55% and maybe even 60% (especially if it's an older building, speaking of which…)
- Old Building: If the building is older than 50 years old and especially if it hasn't been repositioned recently, it will almost certainly cost more to do the maintenance and upkeep.
- Brand New Building: In this case, the maintenance should be less
- Tax Abated Property: If the taxes have been abated for whatever reason, obviously this will lower your expenses, at least for a while
And some smaller, but notable issues, especially if in combination:
- Off the Beaten Path: (more advertising)
- Large Lot (more contract services)
- Flat roofs (more recurring capex)
- Galvanized plumbing, aluminum or knob and tube wiring, fuse boxes, an old boiler or cooler system. (more maintenance)
So while the 50% rule is a good rule of thumb, keep in mind these factors to help you make adjustments that will save you time in deciding which deals to pursue and which to discard.