The 1% rule for actual property investments
Real estate doesn’t have to follow the 1% rule in order to achieve an acceptable return on investment. Discuss exceptions and a word of caution.
Today’s classic is being republished by White Coat Investor. You can see the original Here.
Many direct real estate investors like to use the 1% rule to check real estate for possible purchase for rental income. The idea is that if the monthly rent is not 1% of the price of the property, it is not a good deal.
- If a property costs $ 100,000, you want to be able to charge at least $ 1,000 a month in rent.
- For a property valued at $ 200,000, $ 2,000 / month.
- For a $ 1 million property, $ 10,000 / month, etc.
Like everything else, this strategy / rule of thumb has its strengths and weaknesses. The main strength is that it is quick and easy to calculate in your head as a base screen. The main problem is that a property with a higher percentage does not necessarily have a higher return than a property with a lower percentage. Let’s take a look at what it really means.
According to the 1% rule for real estate
For example, let’s say you buy a $ 100,000 rental property that rents for $ 1,000 per month. Let’s say you buy Dave Ramsey Style, all cash.
Another reasonable rule of thumb, sometimes referred to as the 45% rule or the 55% rule, is that 45% of the rent is used for the non-mortgage expenses including insurance, taxes, repairs, vacancy, maintenance and administration.
So this property has a gross rent of $ 12,000 per year and a profit of $ 6,600, which is a capitalization rate of 6.6.
If the property is also making a reasonable 3% per annum value, the total return should be 9.6%, not counting the depreciation benefits.
Since you can depreciate the property over 27.5 years, let’s say the lot is worth $ 30,000 and the building is worth $ 70,000 and $ 70,000 / 27.5 = $ 2,545. Of the $ 6,600 you earned, $ 2,545 is not taxed. It may or may not be taxed later. However, if you have a marginal tax rate of 42% like me, that depreciation could be worth up to $ 2,545 * 42% = $ 1,069, basically another 1.1% on the return. So 10.7%. Leverage could potentially result in a higher return on investment, but many investors would consider 10.7% a reasonable return on their investment.
In the real world, where most rental properties purchased are leveraged, the 1% rule can help ensure that your property has positive cash flow. If you use it at 5% for 30 years (i.e. 0% less), your payments will be $ 6,500 per year. That first year, you take out $ 12,000 in rent, pay out $ 5,400 in non-mortgage charges, and pay out $ 6,500 in mortgage charges. That leaves you with a cash flow of $ 100 (fully protected by depreciation), an appreciation of $ 3,000, and a mortgage payment of around $ 1,475. You ended up making over $ 4,500 without filing anything!
More realistically, you might lower the property’s value by 30%. Now your mortgage cost is $ 4,554, your mortgage payment this first year is $ 1,033, and your cash flow is $ 12,000 – $ 5,400 – $ 4,554 = $ 2,046, all of which will be written off. With an appreciation of $ 3,000 plus $ 2,046 cash plus $ 1,033 repaid on the mortgage, your return is just over 20% on your down payment of $ 30,000. Not a bad investment, is it?
Failure to comply with the 1% rule for real estate
So what if you don’t follow the 1% rule? As it turns out to be in many regions of the country (usually the high cost of living), you simply cannot find a property for sale that meets these criteria. For example, let’s look at a random property in one of my favorite cities, San Francisco:
For simplicity, we’ll just use the Zillow estimate of what the property is worth and what it’s renting out for. This two bedroom property costs $ 5,809 / month ($ 69,708 / year) and is worth $ 2,324,798. The 1% rule is not met. In fact, it doesn’t even pass the 0.25% rule without rounding up. What would it take for this property to actually be a worthwhile investment? How much would you have to invest to generate positive cash flow? How much would it have to appreciate to give you a 10 percent return? Let’s take a look.
The total rent is $ 69,708 / year. Under the 45% / 55% rule, after paying all non-mortgage expenses, you have $ 38,339 that could be used on your mortgage. What could a 5% mortgage be for a 30 year fixed mortgage? About $ 585,000. That would mean you would have to wager $ 2,324,798 – $ 585,000 = $ 1,739,798, about 75%. Do you really have $ 31,368 in non-mortgage expenses? Maybe not.
Let’s say you’ve done a really great job selecting and managing a property and you can cut it in half. How much bigger can your mortgage be now and still have positive cash flow? You could get a $ 830,000 mortgage right now. You would still need to put down $ 2,324,798 – $ 830,000 = $ 1,494,798 or 64% of the value.
If you cut just 30%, again following the usual 45% / 55% rule, you’d have to feed this property over $ 67,000 per year ($ 5,600 per month).
What appreciation would you need to see to get a 10% return on your investment if you cut 30%? Let’s look at the individual components one by one:
- Your investment is $ 2,324,798 * 30% = $ 697,439.
- Her cash flow was negative $ 67,000.
- The mortgage was repaid for $ 24,000.
- Since there was no income from the property, there is no income that needs to be written off.
- You need to earn $ 697,439 * 10% = $ 69,744 to get a 10% return. Instead, you lost $ 24,000 to $ 67,000 = $ 43,000.
- $ 43,000 + $ 69,744 = $ 112,744 appreciation to get a 10% return. $ 112,744 / $ 2,324,798 = 4.8%.
Is that impossible? Absolutely not. In San Francisco, the average value over the past 20 years has increased by 5.3%. With an increase in value of 5.3%, our property achieved a return on investment of 11.5% in the first year.
So my point is that a property doesn’t have to follow the 1% rule to get an acceptable return on investment. The lower the rent-to-price ratio, the more appreciation you need to gain in order to achieve a given rate of return. The better able you are to buy and manage property well for less than value, the better your returns will be given a given rent-to-price ratio.
Be careful assuming that the appreciation rates will continue in the past. Even the powerful San Francisco real estate market lost 27% in 2008-2011. It would be really painful to feed a property worth $ 67,000 a year AND watch its value drop by $ 200,000 + a year.
What do you think? Do you use the 1% rule as a screen when buying individual properties? Why or why not? Do you think it safe to expect the lion’s share of your investment return to appreciate in some markets? Comment below!