Cap Rate and the 2% Rule

According to the 2% rule (for the rent-to-cost ratio), the cap rate of a property (assuming expenses are 50% of gross rent), should be 12%. I think that makes sense. And it makes me understand why the 2% rule is the 2% rule. As in, you should be getting a 12% cap rate. This point is so important, it bears repeating:

 

You should be getting a 12% cap rate on your rental property.
Anything less than a 12% cap rate for real estate sucks – because of:
  • opportunity costs and,
  • the illiquidity premium.

Historically, you could get a liquid investment returning 10% (i.e. U.S. stocks). So, at least with the 2% rule, you’re earning a 2% illiquidity premium.

The Illiquidity Premium

With a 12% cap rate (from a 2% gross-rent-to-price-ratio), you’re earning 2% more than U.S. stocks earned historically because real estate is illiquid. Unlike U.S. stocks, you can’t sell real estate in a nano-second. (You can literally sell U.S. stocks in a nanosecond.)

It’s inconvenient to be locked into an investment – such as real estate. As an investor, you need to be compensated for that inconvenience. If you are earning 2% more than U.S. stocks have averaged historically, then you are being rewarded for the inconvenience of illiquidity.

The 2% Rule for Real Estate Investing

 If you use the 1% rule, you’re getting a 6% cap rate (again assuming expenses are 50% of gross rent). A 6% cap rate is garbage. That’s because you’re earning 4% less than U.S. stocks – and your investment is illiquid to boot. Even at 1.5% for a rent-to-cost ratio, you’re earning a 9% cap rate – which again sucks compared to liquid U.S. stocks earning 10%.
The takeaway being – stick to properties that meet the 2% rule, or walk away.