The 1% Rule In Real Estate- Why It is An Inadequate Investment Rule?
Most Investors swear by the 1% Rule in Real Estate. But is this rule actually realistic? Do you really find properties that meet the 1% rule in today’s economy? Or, is there anything beyond this rule that you must know before investing in a rental property?
The 1% rule in real estate doesn`t project the complete potential of the investment property. The property may or may not be a suitable investment even though it meets the 1% rule. When investing, you must do more in-depth analysis and only use the 1% rule to simply filter out the potential investment options from the lot.
What is the 1% Real Estate Rule?
The 1% rule in real estate says that the monthly gross income (Rent Collected) from a rental property should be more than or equal to 1% of the purchase price of the property.
Monthly Rent >= 1% of the Purchase Price of the Property
According to the 1% rule, you should collect $2500 monthly rent if you are buying a Rental Property for $250,000.
Technically, if you are collecting anything less than 1% of the property`s purchase value. Then as per the 1% rule, it is not a good investment. And, in order to make it a good investment, either you should buy at a lower price or have to raise the rent someway.
Limitations with the 1% Real Estate Rule?
Real estate investors who quote the 1% rule as a thumb rule for investing must look beyond this inadequate rule. The 1% rule in real estate may provide a good foundation but has its limitations. A $200,000 property may get $2000 gross income every month. But, it doesn’t necessarily mean it is a good investment. There are still many more factors that affect the profitability of a rental property.
The Practicality of the 1% Real Estate Rule
Every investor is different and can have a different investing goal than yours. And applying the 1% rule in every real estate deal then doesn’t make practical sense. Let me illustrate this with a few examples.
Risk Vs Reward:
You may be comfortable investing in a low-income neighborhood where you can easily get 1% monthly gross income. Though, concerns related to maintenance costs and timely payments remain high with low-income neighborhood rental properties.
But imagine an old person who doesn’t want all such troubles of managing a low-income neighborhood rental property. He is rather okay with less return of maybe 0.6% he is getting from his A-class neighborhood property with nice tenants and fewer maintenance hassles.
“It can be possible that your property is meeting the 1% rule but you may not be making any profit in the long run.”
Cash Flow and Appreciation
When you invest with the 1% real estate rule, you only consider the cash flow and not the appreciation potential of the rental property. Though appreciation is deemed to be a speculative element in the real estate industry, it still is a good enough consideration while making an investment.
“Your property may not meet the 1% rule but still can be a good investment.“
A few years back, I bought a condo that was located in an upcoming neighborhood. The rent during the initial years was very low compared to the purchase price. Initially, the property was estimated to provide only 0.35% as opposed to the 1% rule. Though, this property was not meeting the 1% rule. Still, I chose to invest in it. And trust me, this was a wise investment decision that I took.
Getting second thoughts? Well, read this
- Being an upcoming neighborhood, the property had a huge potential for appreciation. And, in only 5 years, this property has appreciated by 1.75 times. If I choose to sell it today, the rate of return would be 15% every year, and that too just from the appreciation. The rent was low in the initial years. But after two years of purchase, the rent hiked and came as par with the 1% rule due to improved neighborhood and forced appreciation.
- Price is what you pay and value is what you get. Even though the property I have invested in wasn`t meeting the 1% rule. But still, it proved to be a fruitful investment for me.
Gross Income Vs Net Income
If you see, the 1% real estate rule is only concerned with the gross income from the property and not the net income. But, it is the net income that makes all the sense when it comes to investing in a rental property. After all, you are going to keep only the net income in the end.
Imagine you bought a rental property for $360,000 and it is giving you a gross income of $3600 every month. It means it is meeting the 1% rule. But what will you say about this investment if its cash flow analysis will somewhat look like this?
Purchase Price: $330,000
After Purchase Repairs: $15,000
Down Payment: $50,000
Monthly Mortgage Payment: $1625
Property Taxes: $250
Mortgage Insurance: $280
Monthly Rent: $3600
Vacancy Rate: 10%
Management Fees: $360
Other Expenses: $305
Tenant Turnover Cost: $1200 (Annually)
Annual Maintenance and Repairs: $2200
Gross Income= $3600
Vacancy Cost= (-)$360
Net Income= (-)$20
You are getting a negative cash flow of 20$ every month. Will you invest in such a property?
Furthermore, instead of making the downpayment of $50,000. You only put 3.5% in the down payment and financed the remaining money through the FHA mortgage. What will your numbers now look like? Your monthly mortgage in this case will be around $1850 instead of $1625. That means you will lose not $20 but $245 every month.
The property is meeting the 1% rule but still is losing money every month. The above example clearly indicates the limitation of the 1% rule. As an investor, you solely can’t rely on this rule and must do a more thorough analysis when investing in a rental property.
The Unlikeliness of the 1% Rule in Today’s Economy
If you follow the real estate trends, you might know that real estate prices have skyrocketed. According to data from Zillow, the nationwide home prices have been up by 10.61%. But does the rent follow the same trend? No, the rents have only budgeted by 0.87%.
What this means is that investors today are paying more prices for real estate. But, not getting more rents. This is making it harder for investors to find properties that meet the 1% real estate rule. Even to your surprise, earlier investors go by 2% and 4% rules which now have shrunk to 1%. And, with present market conditions, the investors aren’t able to even catch up with the 1% rule.
Although, there are still some markets where you can find properties that meet the 1% rule. My friend Brian from Spark Rental has put down a great resource around the cities where it makes the most sense to invest in today’s economy. But my question to you is will you invest in Chicago when you live in Boston? Not every investor feels comfortable investing in out-of-state properties.
Though, there is a saying that you should invest where it makes sense. And if you are looking to invest in an out-of-state property, here is what you need to know before taking this move.
Looking Beyond the 1% Real Estate Rule
The 1% Rule in Real Estate is an overgeneralized rule. It works but an investor should use it for what it actually is worth. It is a great tool for pre-screening potential real estate investments and that’s the end to the story.
You can make better than 1% on lower value properties and will make less on high-value properties. There are many ways investors calculate the potential of an investment property. Cash on Cash Return, Cap Rate, Gross Rent Multiplier are different ways to calculate the potential of an investment. And the 1% rule is just one way of doing that.
Apart from all these rules, what matters the most is how much income you are taking home at the end of the day. The Cash on cash method is closer in providing this measure. And that’s why I personally feel the Cash on Cash Return method is the better of the lot.
Suppose I have invested $20,000 out of my pocket and if I get a 12% annual return i.e $200 every month, I am satisfied. Your case can be different. You may still be okay if you are getting a lesser return of 9%. So, I believe it totally depends upon the investor and his goal behind investing.
The 1% rule is just the beginning. In order to filter out the best investment, you must understand the cash flow analysis, your goal, and the near-future prospect of that property.
The Right Approach to Buy an Investment Property
You sure can make the 1% rule as your thumb rule for investing. But if you are solely relying on this thumb rule, you are using an inadequate approach towards investing. The right approach should be understanding all other factors that can influence your investment`s potential.
The Cash Flow Analysis is the perfect recipe to understand the profitability of an investment property. But even before that, you need to understand a few basic fundamental factors to make the right investment.
Type of Investment Property
There are various types of investment property you can invest in. It can be a multifamily unit, a single-family home, or condominium, or maybe a commercial apartment complex. All these are investment properties but vary in terms of returns they provide. And the effort required to churn that return.
A Multi-Family Property has better cash on cash return potential as compared to a single-family home. But a single-family home tends to appreciate better as compared to a multi-family home. You may require more effort to manage a multifamily unit. A single-family requires less effort. So, it is better to analyze what type of investment property you should invest in even before worrying about the 1% rule.
Location of the Property
Location plays the most crucial role when you invest in a rental property. A good location can do wonders for your rental business. Two Properties one lying in the city center of a university town and the other in the suburbs. Both the properties meet the 1% rule. But which property do you think has a better chance of making a good profit? You get my point, why choosing the right location is important.
Like the 1% rule, investors also use the cap rates as an indicator for finding the potential investment options. The Cap Rate provides a good estimate of the profits that you can expect from investing in a rental property.
The Cap Rate is a measure of Net Operating Income divided by the purchase price of the property. And if you see, the cap rate takes into account the net income, unlike the 1% rule which accounts for the gross income. You can easily find cap rates of rental property in a particular city online. Knowing the cap rates, you can easily understand whether you are buying at the right price and if it is profitable or not.
These are the very basic 3 fundamental factors you can take into account when buying an investment property. There can be various such factors that influence the potential of your investment. If you wish to know more about such factors, I have identified about 10 crucial factors you should consider when buying an investment property.
The Bottom Line
Look beyond the 1% real estate rule if you actually want your rental property to deliver the returns you are expecting. The 1% rule doesn’t paint the complete picture and is more of an incomplete thumb rule of investing. You must use the 1% rule only for the purpose it is intended for. A great tool for pre-screening potential properties but still inadequate.
That’s it for the 1% real estate rule from my side. I would also love to hear your thoughts. Do share the factors you consider when buying an investment property. And what weightage does the 1% rule have in your investment strategy?