You can’t escape it. Everywhere you look – in online forums, blog posts even books – you will run into real estate investing rules of thumb that promise you an escape from doing boring, old-fashioned analysis.
There’s the “world famous” 2% rule: The monthly rent on a good investment property should be at least 2% of the purchase price. As long as the rent is 2% of the purchase price, your analysis is done. You set out on your quest to find these unicorn properties that abide by this golden rule. Single-family properties that sell for $150,000 and rent for $3,000 a month? Got it. Small multifamily properties that sell for $380,000 and bring in $7,600 per month in rent? Sure. I have some good news and some bad news about the 2% rule. The good news is that should you find such a deal you should jump on it because it is an absolute steal! The bad news is that such deals are at best, fossilized remnants of decades past and at worst, pure fantasy.
Then we have the reformed 1% rule: The monthly rent on a property should be at least 1% of the purchase price. Not as radical to be sure but you keep looking for properties that fit into that box and you find yourself being pushed to lower and lower quality neighborhoods. Properties in these neighborhoods attract more problematic tenants that lead to evictions and turnover and expenses. In the end, you have a terrible investment experience and your actual returns aren’t that good when it’s time to face your accountant and year-end.
Last but not least, the 50% rule: You can safely assume that operating expenses on your property will be 50% of your gross rent. No need to figure out actual expenses or put boots on the ground. The magical 50% has you covered. Then you realize that it’s much more complicated than that. Are you managing the property yourself or do you have a property management company? Is it an older property that requires lots of capital expenditures or a newer property that needs very little? Is the owner responsible for any utilities or are they all covered by the Tenants?
Look, I get it. There’s an allure to the simplicity of these shortcut rules. They offer an escape from the boring analysis, the mind-numbing figures, and the time-consuming due diligence. Furthermore, they can provide a template lens through which to view potential investment opportunities.
But in the end, real estate investing rules of thumb are the realm of amateurs and they’re a poor replacement for solid analysis. There’s no shortcut to actually looking at operating expenses and estimating vacancy and repairs. There’s no getting around learning the market and figuring out what price to rent ratios it offers for each type of property at this point in time.
Even worse yet, rules of thumb can provide an arbitrary filter that can keep you out of the investing game when the opposite is the preferred course of action. Rules of thumb can establish rigid anchors in your thinking and ultimately prevent you from achieving your goals.
If you don’t know how to do due diligence on a prospective property that should be the first thing on your agenda to learn. Skip the analysis and due diligence at the peril of your investing results.
Well said. I have always ignored these rules. I think they may have worked a decade ago in small towns in the middle of nowhere. At least those are the examples I have gotten from people. Buying a place for $30K and renting it out for $600. There’s your 2%.
With experience comes wisdom and a subconscious knack for being able to size up a property and deciding whether it deserves closer analysis. For everyone else a short hand method to sort through hundreds of properties would be useful.
What about the capitalization rate? If you know the cap rate in your local market and know what kind of rent you could get it’s easy to calculate how much you should expect to pay for the property. Just a thought.