I recently had a conversation with another investor who was adamant about finding investment properties that met the 2% Rule. This was their primary criteria for offering on rental property.
Our conversation went something like this.
2% Investor: What rent-to-price ratio are you getting on your properties?
Me: About 1.25%.
2% Investor: That’s not very good. You should shoot for 2%. I’m hitting 2% on my properties.
Me: Umm, well…. That’s great. (nice comeback)
Other than me feeling a bit patronized, what can you gather from this brief dialogue? Did you think it was strange to pass judgement on an investor’s rental property based solely on the rent-to-price ratio?
If you’re thinking yes, well I certainly thought so too. I just wasn’t quick enough to articulate a comeback.
To simply say 1.25% rent-to-price is bad and that 2% is good without getting into any details such as price or property class is a huge oversimplification. What about some other metrics like cash flow and cash-on-cash return? All I shared was my rent-to-price ratio. Sure, a helpful metric, but enough to entirely assess an investment?
I want to highlight 2 inherent assumptions that the outspoken investor had in the above conversation.
- Higher rent-to-price ratios are always better.
- It’s all about the rent-to-price ratios.
In this post I’m going to dig into rent-to-Price ratios.
Sure, higher seems better because you’re earning more rent, which only drives your cash flow and returns up. Though I want to explore the link between Rent-to-Price ratios and your Cash Flow or Cash-on-Cash Return goals.
Questions that I’m going to address in this post are the following:
- If I have a cash flow goal, let’s say $200 per month, does that correspond with a specific rent to price ratio that I should be targeting?
- Do these % Rules depend on the property price?
- Why doesn’t everyone shoot for the 2% Rule?
- Is there a minimum (e.g. 1% Rule) that I should shoot for?
Some Basic Definitions on Rent-to-Price
Before we dive any deeper, let’s just make sure we’re all on the same page with the definitions. I apologize if the above conversation went over anyone’s heads because I didn’t define these up front.
What do we mean by Rent-to-Price Ratio (aka Rent-to-Cost)?
The Rent-to-Price Ratio is simply the monthly rent divided by the total cost to acquire that property (purchase price + rehab).
2 important caveats.
- The Price here includes both the purchase price plus any rehab that’s needed to get the property to a condition that will achieve the rent used to calculate the Rent-to-Price ratio. I agree, it’s poor terminology. I prefer to use Rent-to-Cost because referring to cost more clearly shows that we’re talking not only about the purchase price, but the upfront rehab cost as well.
- Rent-to-Price (aka Rent-to-Cost) ratio is often expressed as a percentage so that you can easily compare it against the 1% Rule.
Most people tend to refer to the Rent-to-Price ratio so we’ll use that term instead of rent-to-cost from here on out. Just be aware that when someone quotes you a high Rent-to-Price ratio, they may not be including the rehab cost.
So what’s the 2% Rule you ask?
The 2% Rule states that an investment property should rent for at least 2% of the purchase price.
In other words, the 2% Rule is a 2% Rent-to-Price Ratio. So if you buy a property for $80,000 and put $20,000 rehab into it, then it should rent for at least $2,000 ($100,000 x 0.02) per month.
Now what about the 1% Rule?
The 1% Rule states that an investment property should rent for at least 2% of the purchase price.
As you can guess, the 1% Rule is a 1% Rent-to-Price Ratio. Sticking with our same example, that $80,000 property with $20,000 of repairs should rent for at least $1,000 ($100,000 x 0.01).
Do I Shoot for 1% Rule, 2% Rule, or Something in Between?
You should prioritize your effort on hitting these metrics instead of focusing on the rent-to-price ratio. At the end of the day, you want to have a profitable rental. As long as you’re hitting your buy and hold metrics, you won’t care whether you’re rent-to-price ratio ends up being 1.5% or 1% or even less.
But knowing your target rent-to-price ratio can be a helpful screening metric. So if you know what rent-to-price ratios tend to meet your cash flow and CoC returns, then it becomes useful as a quick screening metric to know when a property needs further analysis.
Consider an investor with the following goals:
- $200 Cash Flow per month
- 12% Cash-on-Cash return
So can we convert our goals to a specific rent-to-price ratio?
Yes, we can!
First we need to make a few assumptions.
My Purchase Assumptions and Investor Criteria
Here are the assumptions I made.
- Properties purchased with a 30 year loan, 5% fixed annual interest rate, and 20% down payment
- Expenses estimated using the 50% Rule
- Closing costs fixed at $3000
Here’s my target criteria for cash flow and cash-on-cash return.
I color coded the cash flow and cash-on-cash returns based on investing criteria that I most commonly hear from the real estate investing community. Basically, negative cash flow and returns less than 3% that don’t even keep up with inflation are bad (red). Cash flow under $100 and single digit returns under 8% are okay (yellow). Ideally, we’re shooting for $200 cash flow and double-digit returns (dark green).
Cash Flow vs Rent-to-Price Trends: The Results
For a given rent-to-price ratio and purchase price, I then calculated my cash flow. I basically made a big spreadsheet to do all the calculations and color coded the results based on our above criteria.
How to Read this Table
There’s a lot of numbers on this table and it’s small. Click on the image and it will open in a new tab.
Okay, here’s some observations to help get you situated with what the heck you’re looking at.
- Across the top you’ll see the purchase price range from $30,000 all the way up to $190,000.
- Across the leftmost column, the Rent-to-Price ratio ranges from 0.75% up to 2.25%.
- Each cell shows the calculated monthly Cash Flow for a given purchase price and Rent-to-Price ratio. For example, at 1% Rent-to-Price, the Cash Flow for a home purchased for $100,000 comes out to $71 per month. Here’s the quick math: $100,000 x 1% x 50% – $429 monthly debt payment equals $71 of Cash Flow.
- As you go to the right on a given row, the Cash Flow grows by a steady fixed amount. For instance, on the 1% ratio line, the Cash Flow grows about $7 for each column you move to the right.
- Observe as you go down a single column, the Cash Flow increases because with higher Rent-to-Price ratios, you’re charging more rent for the same home price. Meaning higher incomes and higher expenses because of the 50% Rule, but what stays the same is your loan payment. Therefore, your Cash Flow increases.
3 Major Takeaways
1.) Based on the 50% Rule, there’s a minimum Rent-to-Price ratio that must be achieved in order to cash flow positive.
That minimum Rent-to-Price ratio to cash flow positive is between 0.85% and 0.90%. The exact percent will vary on the loan assumptions, but for this case (30 year loan, 5% interest, 80% LTV) we begin to cash flow positive at a 0.86% Rent-to-Price ratio.
2.) If you’re goal is $100 Cash Flow per month, the 1% Rule will only work if you are buying homes that cost about $150,000 or more.
So if your price point is below $150,000, then your target Rent-to-Price ratio needs to increase in order to achieve that $100 Cash Flow goal.
For instance, here’s what it takes to hit a $100 Cash Flow target for varying purchase prices.
- House purchased for $100,000 will need to rent for more than $1050 (1.05% Rent-to-Price) a month.
- House purchased for $60,000 will need to rent for about $720 (1.2% Rent-to-Price) a month.
- House purchased for $30,000 will need to rent for about $465 (1.55% Rent-to-Price) a month.
And if you’re goal is $200 Cash Flow per month, then the 1% Rule will only work when buying homes greater than $280,000.
Here’s what it takes to hit $200 Cash Flow for varying purchase prices.
- House purchased for $100,000 will need to rent for more than $1250 (1.25% Rent-to-Price) a month.
- House purchased for $60,000 will need to rent for about $900 (1.5% Rent-to-Price) a month.
- House purchased for $30,000 will need to rent for about $645 (2.15% Rent-to-Price) a month.
3) If you’re targeting cheap properties under $40,000 and you want to cash flow $200 per month, then you need to hit close to the 2% Rule.
So the cheaper the home, the higher the rent-to-price ratio an investor needs to hit. Almost by necessity. You can see at around the 1% Rule, these cheaper homes won’t cash flow much. High rent-to-price ratios are needed in this price range.
Cash-on-Cash Return vs Rent-to-Price Trends: The Results
I then took the cash flow table from above and took it one step further by calculating the cash-on-cash return. Remember, I assumed 20% down and $3000 in closing costs, which became the cash invested into the deal. Dividing the cash invested by the annual cash flow, we end up with the cash-on-cash return as shown in the table below.
The color codes really help identify at what point we hit our 12% cash-on-cash return goal. For a $100,000 house to hit 12% return, the rent-to-price ratio needed is about 1.3%. What does that mean in terms of rent? That’s a $1300 monthly rent.
Shortcomings of this Analysis
I’ll be the first to admit that any analysis is only as good as the assumptions being made.
First, the 50% Rule. The above results assume expenses will average 50% of the rent regardless of the price of the home. The consequence is that for a $30,000 home, expenses will be underestimated resulting in a higher cash flow than reality. On the flip side, for a $200,000 home the expenses will be overestimated resulting in a lower cash flow than expected.
The 50% rule will tend to underestimate expenses for cheaper properties (i.e. cheaper rents) and overestimate expenses for more expensive properties (i.e. higher rents)
Second, I didn’t adjust the closing costs based on the purchase price. Keeping it a fixed $3000 may be a bit on the low side for a more expensive home and slightly on the high side for an extremely cheap home.
Despite these assumptions, the trends should still hold. Adjusting these assumptions based on home price should have marginal effect on the overall outcome of the analysis.
So Why Doesn’t Everyone Just Shoot for the 2% Rule or the Highest Rent-to-Price Possible?
Some new investors want the biggest and best returns possible. They want to earn more than $200 per month in cash flow, but can only afford to buy cheap homes under $50,000. To hit those goals, that means searching for properties with very high Rent-to-Price ratios (2% or higher).
On paper, the numbers look great.
In reality, these properties tend to be much riskier investments.
Compare a $25,000 class D property and a $250,000 class A property?
Achieving 2% may not even be possible for the higher class properties and that’s okay. 1% of $250,000 is still $2500 per month and using the 50% rule, expenses are conservatively at $1250. So with a net operating income of $1250, depending on your debt payment you can still cash flow quite nicely.
Now take the class D property at $25,000 renting for $500. It’s hitting the 2% Rule so it may look great at first. Now in terms of expenses, when you think about the 50% Rule here, is $300 a month really enough to cover everything that can happen?
As stated earlier, the 50% rule will tend to underestimate expenses for the cheaper properties (cheaper rents) and overestimate expenses for more expensive properties (higher rents).
So will that $300 per month cover all your expenses? There’s the usual insurance, taxes, management, and maintenance items, but with very low priced rentals you’re dealing with a whole different tenant class. That class D property may have tenants who stop making payments, tenants who then trash your place when trying to evict them, major turnover costs, and my sanity.When you factor all this in, your expenses may well exceed the 50% Rule for these lower priced rentals.
In general, these 2% Rule (or higher) properties are often located in the roughest parts of town. We’re talking no higher than Class C properties in neighborhoods with higher crime and have higher vacancy rates. The low rents will attract tenants that will be much more management intensive. The likelihood of property damage and evictions are much higher when dealing with this tenant class.
The danger in chasing the 2% rule is that it steers a new investor into pursuing the most difficult to manage of rental properties at a time when they are still learning. Sure, there are investors who are successful at this price range, but they’ve probably been doing it for a while.
So if you’re just starting out, understand that the 2% Rule may get you into riskier deals that you may not be comfortable with. Consider the location of the property, the tenant class that property is suited for, and whether you’d be comfortable holding such a property over several years.
One cannot simply judge an investment property solely based on the rent-to-price ratio. Don’t be like that investor I talked to and start judging them based on their rent-to-price ratio alone.
In this post, we showed that for a given price of a home, the rent-to-price ratio needed to hit your cash flow and CoC return criteria can drastically vary.
One investor hitting the 1% Rule on a $200,000 home, may be cash flowing just fine. This investor may use the 1% rule as a great rule of thumb when looking at properties in this higher price range. Whereas another investor looking at $50,000 homes, will need to achieve much higher and may think that 2% is the way to go for them.
In either case, an investor should ultimately be concerned with what their bottom line is. So figure out the cash flow and cash-on-cash return. Stick to these metrics and prioritize them over general rules. Use the rent-to-price ratio only as a guideline or as a helpful screening metric. Don’t base your decision to buy a property on the fact that it meets the 1% or 2% Rule.
Lastly, properties that meet the 2% Rule or higher often come with much greater risk. These properties tend to be class C or lower and tend to be located in dangerous neighborhoods with a riskier tenant.
Did it all make sense? Still awake?
What do you think of the results? Were you surprised by these trends?
I hope this post helped shed light on rent-to-price ratios and let me know below of any comments or questions you have.
For anyone who wants a FREE copy of this spreadsheet, click here to subscribe and I’ll share the excel file with you. It’s easy to use and I recommend inputting your own investing criteria to see what Rent-to-Price ratios are required to meet your goals.