Investors get burned following the 2% rule in low income areas.
As a new investor, I lost a stunning amount of money on low-end properties.
On paper, the numbers look gorgeous: “I can charge $1,000 in rent for a $30,000 property?! What can go wrong?”
A lot, it turns out. But these costs are not always obvious, and even when they are, they’re not always politically correct to talk about.
The “2% Rule” claims that a property that rents for more than 2% of the purchase price is usually a good deal. But these sorts of shorthand rules can be deadly, especially for new investors. I touched on this as one of the 7 Lessons I Wish I’d Known When I Started Investing, and it’s worth a closer look.
Here’s how low-end real estate can end up ravaging investors and how to avoid losing your shirt.
A Tale of Two Properties
These numbers may look imaginary, but they’re actually rounded versions of real properties I’ve owned.
Francis Street (or “Francis” for short): The purchase price and closing costs totaled roughly $15,000, and it needed around $25,000 in repairs ($40,000 for the non-mathematically-inclined). It’s in a rough neighborhood and rents for $1,000/month.
Chester Street (henceforth “Chester”): With a purchase price and closing costs of $160,000, Chester needed roughly $15,000 in repairs ($175,000 total). Young professionals live in this neighborhood, and Chester rents for $2,000/month.
At first glance, you could buy nearly four and a half Francises for the price of one Chester and earn over double the cash flow. You could also diversify your investments, with four or five properties spread across different neighborhoods rather than all that capital tied up in one property.
But here’s the thing—cash flow involves a lot more than just the cost of the property and the rent.
Cash Flow & The Real Cost of Ownership
There are entire articles, entire chapters in books devoted to how to calculate cash flow properly. We’re just going to hit the highlights here.
Cash flow is not rent minus mortgage. Beyond the principal and interest of the mortgage payment, here are just a few of the most common costs:
There are other costs that sometimes apply. For example, some properties have homeowners’ association or condominium fees. But you get the idea.
These costs are almost always higher for low-end properties in “tough” neighborhoods. The vacancy rate for Francis is a whopping 20%. But Chester’s vacancy rate? A mere 4%. That’s a difference of five times.