If you ask 10 real estate investors a question about what kind of properties they recommend, you might get 10 different answers.
Some investors fix and flip, some buy and hold. There are investors that buy commercial, and others residential. Builders and land investors buy raw land, to build a new home, or to subdivide into smaller plats.
There are real estate investors that hands off (like REITs), and investors that do alot of work on properties themselves.
But there is usually one thing they all can agree on: do your due diligence before investing in a piece of real estate.
The 1 rule in real estate, or 1% rule correctly called, is a quick and easy way to measure up a rental property, comparing the rental income to the price of acquiring the asset.
The 1 percent rule in real estate investing: gross monthly rental income ÷ purchase price and repair cost = .01 (1%)or greater
So, if the property is $250,000, it should generate at least 1% of that ($2,500) in monthly rental income (before deducting expenses).
If you follow the rule, you can also follow the rule to figure out an offer price. If the property you are looking at rents for $1,600/ month, multiply by 100 to find your target price of $160,000.
Why The 1% Rule Is Good
The 1% rule has gained notoriety because it is a fast way to evaluate a property when deciding whether to add it to your portfolio.
And, it generally is a good way of thinking. Properties that rent for more compared to their value have great potential for returns both in the short and long term.
It is also good to as a quick screening tool if needed.
And if you know the neighborhood that your subject property is in, quick calculations like this become even more powerful.
Why The 1% Rule is Limiting
If I strictly followed this rule, I would only have bought 1 of the investment properties that I own so far.
And I am glad that I did not follow it rigidly, because I am happy with all of my investments.
Here is why this rule can be limiting, and why you should go deeper on any property you evaluate.
1. Qualifying properties may not exist in your market. The 1 property I bought that exceeded the 1% rule was a condo. There are virtually no single family homes or other properties that sell with that rent/price ratio in my area.
2. The equation does not take into account expenses. Different properties will have different fees. For example, condo fees can be significant. Maintenance costs on single family homes tend to be higher than other types.
3. You could get convinced to go to a different area. If you become rigidly obsessed with getting properties that fit this criteria, you could be buying in an area you know nothing about.
There is nothing inherently wrong with buying in another area/state, but I like to invest where I am an expert. If I do go into a different area, it will not be to chase the 1% properties, but to find the right property for my portfolio.
4. It does not give you the full picture of ROI. I focus on monthly cash flow and cash on cash return for this.
Here is some more information about the 2 calculations I focus on for evaluating all of my potential investments. Sometimes, I also add others depending on the situation.
You Can be Thorough and Quick
Once you evaluate enough properties, you will become good at knowing which properties have potential and which do not.
Then, run your (full) numbers on the property, and you can decide if it is worth an offer.
You have to choose what final equations are important to you.
But, you will want to know the raw numbers before you can do that. You can even make or download a spreadsheet for evaluating properties quickly.
But here is an example of what I write out (many times with a pen and paper, not sure why but I like the old fashioned way).
Then, you can use this raw data for lots of different calculations.
This is an example of some of the expenses, purchase details and monthly expenses.
|Purchase Info||Monthly Rental Income||Monthly Expenses|
|Purchase Price||Monthly Rent||Taxes|
|Down Payment||Vacancy Allowance||Interest|
|Total Monthly Payment|
|Monthly Net Cash Flow:||Cash on Cash Return (first year):|
Below is a property that I actually did purchase, here is the breakdown of the first year cash on cash return and also the monthly cash flow for the property.
This is an example of some quick math you can do with minimal effort.
|Purchase Info||Monthly Rental Income||Monthly Expenses|
|Purchase: $310,000||Monthly Rent: $3,200||Taxes: $430|
|Down Payment: $97,500||Vacancy Allowance: -$267||Interest: $899|
|Repairs: $80,000 (financed)||Maintenance: $425|
|Int: 4.75%||Insurance: $85|
|Payment: $1,721/mo||Acct Software:$25|
|Closing Costs: $11,000||(*Principal: $822)|
|Monthly Net Cash Flow: $247||Annual Cash on Cash Return (1st yr): %11.8|
Here is how I got these numbers.
• Cash flow: monthly rental income – monthly expenses (and principal payment). This tells me how much actual cash will come to me per month.
• Cash on Cash return: NOI (net operating income) ÷ total initial cash invested (down payment, repairs closing costs) This lets me know how much return I will get on my money percentage wise.
In this property, I used a construction loan so the repairs were financed. I assumed 1 month vacancy (close to accurate). And I made $247/month, and 11.8% yearly.
The cash on cash equation is really useful when comparing returns across different types of investments, and deciding whether to pay off debt or invest.
To me, this is what I need to know about a property, along with the “intangibles” below.
This is one the best buy and hold properties I have ever come across in my market. Now, it did take up a lot of my time because it was in bad condition (hence the construction loan).
But how did my real estate deal stack up to the 1 percent rule? 3,200 ÷ 390,000 = .008 (.8%). So although it got close, if I was rigidly following that guideline it would have missed.
And the property I did buy at that met the 1% rule? It had $550 in monthly condo fees. So was inferior the deal I spelled out above.
And the truth is, the 1% rule is good for some, but I do not use it anymore. I do the above equations and have done them so many times I can do them for a property in 10 minutes.
The reason I prefer to mostly invest in properties local to me is simple: I can make a judgement call on the factors affecting the future of a property that won’t show up in the math.
For example, the property referenced above was an older single family home in an area where I knew that builders were just starting to look at to tear down the old homes and replace with new construction homes.
Right after I closed on the property, I talked to a builder who ended up buying 3 lots on the same street (so my prediction was correct).
Other neighborhoods in the area that had this happen saw a sharp increase in the home values as builders put pressure on the price of the land.
What does this mean for me? My investment property will appreciate faster than average, and one day I can possibly build a new home there to sell when the time comes.
My other investment properties have had similar intangibles. I knew of future development that was going to bring an influx of jobs, walkability to the university in our area, the right financing deal (like owner financing).
These were all factors that influenced my decision to buy different properties.
These intangibles are usually related to future rent increases, property appreciation or lowered risk.
The 1% rule of real estate investing can be useful in some situations. It is even more useful in certain markets and situations.
But you want to go deeper and there many more calculations that will give you more information about a property. Once you get good at doing these calculations, they may be a much better match for your evaluations.
There are also other aspects of an investment property that you want to take into consideration, and the more familiar you are with an area the better grasp you will have on these “intangibles”.
To focus so much on the 1% rule that you buy or pass on a property based on it is not likely a good long term plan to real estate investing.
To read more about my journey into real estate investing, check out this article.