Rent Values - Debunking The 1% Rule Once and for All
The 1% rule appears to have evolved from a simple guideline to a real estate law. People are sticking to it and relying on it too much. The 1% rule states: “A property should rent (monthly) for 1% or more of the purchase price”. In other words if a property sells for $100,000 then the monthly rent should be $1,000. Or, if a property rents for $1000, it should sell for $100,000. Let’s talk about what the 1% rule is and is not, and what it can and can not accomplish.
1% Rule takes into consideration:
1% Rule does NOT take into consideration:
Case In Point:
Even when there are many similarities, the 1% rule has some problems. Let’s compare 2 homes that are exactly the same in every way and right next door to each other. Incidentally the cap rate is the same on both also.
Example #1: SFR. Price $100,000 Gross Rents $1,000 per month, expenses $250 per month.
Down Payment $40,000
Interest only loan: 4%
Amortization N/A
Yearly Cash Flow: $5,000
Example #2: SFR. Price $100,000 Gross Rents $1,000 per month, expenses $250 per month.
Down Payment $0
Interest only loan: 80/20 loan at a 9% blended rate
Amortization 25 years
Yearly Cash Flow: -$1070 (Yes…that is Negative)
….now try comparing a 3% vacancy rate to a 15% vacancy rate in another area. A soft market to a hot market. Fully professionally managed vs a do-it-all handyman owner. Taxes of .3% to 2%. Fluctuating regional insurance rates. The 1% rule is only the very tip of the iceberg when it comes to financial analysis.
So Where Did It Come From:
You may have heard the term “Gross Rents Multiplier”. The “1% Rule” is derived from the same equation This is simply a ratio reflected by the price divided by the rent (you can use monthly or yearly…I’ll use yearly in my examples).
Price / Rent = GRM
Manipulate it algebraically and it can look like this:
GRM / Price = RentOr GRM X Rent = Price
Using slightly different terminology from the definition above, “A GRM of 100 or less should be sought after when buying a rental property”. (100/12 = 8.3 if you’re using monthly rents). That is the exactly what the 1% rule states, after a slight algebraic manipulation. One of many problems is that a GRM of 70 may be normal in Ohio or 120 in Southern California.
So What Is It Good For? :
Every investor needs a method for coming up with a ballpark figure of value so that they can separate the real deals from the FMV properties. After all….if you don’t know what things are worth, how will you ever spot the deal when it does come along? You shouldn’t do a detailed cash flow analysis of every single property that comes onto your radar, as it much more time consuming. The “1% rule” is just ONE type of “quick and dirty back of an envelope” calculation, and probably the easiest.. It’s a method some investors use to crunch numbers in 5 seconds or less to see if a deal may be worth more exploration. You are a fool if your number crunching never goes beyond that. You need one quick and dirty method of analyzing properties AND another in-depth method for analyzing properties.
The 1% Rule May Not Be For You:
In some areas the 1% rule is very reflexive of FMV regarding both prices and rents. This may or may not be true in your area. You need to find your own “1% rule” so to speak. New York City is not Ohio. They are very different markets. The 1% rule may be dead on for a certain investor in Ohio and way off in New York. The New York investor may need a GRM of 71 (or we could call it the 1.4% rule). In my area, I look primarily at 2/1 rental units that are in the same area, similar values, and similar sizes. I often think in terms of “price per unit”. When something jumps out at me, I look at it more closely. This is where my analysis begins….not ends.
So Where Do I Go From Here? :
1. Learn your market. If you’re looking at 2/1’s to 3/2 homes around 1500 sq. feet in a given area, get to the point where you can drive by a house, and predict within a few grand what the asking price, selling price, and rental price of that house will be. This is what Dolf de Roos teaches when he says “look at 100 properties, make 10 offers, and buy 1” After 100 properties you’ll know the values and spot the 10 deals and bag the one.
2. Find out what numbers are reflexive them: Start crunching numbers. You may get a feel for numerical values in terms of price per sq. foot, GRM, or have your own “1% rule” (eg. 1.5%)
3. Use them! Suddenly you’ll be able to accurately estimate value in a few seconds. Keep in mind, prices, values, and rents may drastically change as you cross the tracks, the river, go east, etc. If they do, just do the same thing there.
There is power in knowledge. Soon you will get to the point where you know the value of the home better than the realtor, the loan officer, the appraiser, and the homeowner. It can be frustrating, but it empowers you and you’re on your way to being the first one to snatch up the great deals that do come along.
Great article!
Wow Hibby,
Very well written and thought out.
(have to admit when i got to "So What Is It Good For? " I started humming "War"
becki
Of course the 1% rule is just the tip of the iceberg. I think however that the article is a bit misleading. Sure you can turn a negative cashflow into a positive by putting more cash down, but is that a good use of your money? One of the greatest things about RE is use of leverage and OPM. If you have to sink a bunch of your own cash to get positive cashflow, you will be more limited in the number of properties you can buy.
One thing I like to do when I calculate cashflow is to pay myself interest on the money I put down. That way you can make sure that your money is also working for you. My personal rule is that if I can't get positive cashflow with 100% financing then it's not worth it.
I agree with you. Properties should cashflow with 100% financing.
Lately I've read a lot of people in the forums lately that will say things like:
"This SFR cashflows $150 per month fully managed, but it doesn't follow the 1% rule"
OR
"Nothing in my area meets the 1% rule. Can I really invest here"
Many people are using this as the final say as to whether or not a property is worth while. There are other factors to consider, and I agree, that cashflow is the most important of all.
Let me also make a correction. Price/GRM = Rent. I had the numerator and denominator switched. Sorry.
director38,
-- " One thing I like to do when I calculate cashflow is to pay myself interest on the money I put down. That way you can make sure that your money is also working for you. My personal rule is that if I can't get positive cashflow with 100% financing then it's not worth it. " --
Great comments. You are most defiantly right. My understanding is that hibby76 speaks based on his young investor experience earned in his local market and from several RE investor's books.
Without extensive knowledge and lifelong experience tide down to key regions such as New York, Atlanta, Miami, Dallas, Los Angeles and San Francisco, he cant really speak of a national cash flow formula. No one can. I learned from my family experience that in above mentioned mega-markets, higher professional earnings are causing larger and larger down payments to be sunken in plain and simple long term tax shelters. Cash flow is therefore not as important to people who got cash to "hide" and protect. How you compete against them? You cant and therefore the 1% formula don't apply. But, if we neglect all of this, grammatically perfect, hibby's article flows fine. Keep up the good work hybby76. We enjoy your posts.
Your comment is both right and wrong. A negative cash flow can only turn positive if your personal cost of funds used for the down payment is less than the outside source of funds and is enough to cover the spread. You are completely correct in understanding the 100% financing rule. Any use of personal funds is going to have a loss of income unless it has been stored under the bed.
Good article. I had noticed that the 1% rule wasn't working here in Arlington, VA. The $400K 4/2 I live in only rents for $2200. I was trying to figure out how the landlord makes any money. The reason is that he bought a few years ago at $170K. So if he ignores the incredible amount of equity that he built up, he is still getting a good cash flow.
I have realized that in order to proceed with a buy-and-hold strategy, I will need to invest in a different market. The only way to make the properties in a market like NoVA, DC, NY, and CA cashflow positively, is to sink incredible sums into downpayments. (not very creative, eh?)
So I'm moving to Baltimore! Plenty of houses in the $60-$100K range.
hibby 76 - Job well done! I really like your presentation of the 1% Rule. It is direct, and to the point. However, I should like to add 2 additional things I do to get my Rents;
1. Walk the neighborhood, stop and ask the owners/tenants exactly what dollar amounts are being paid for the Rentals in this area - I usually try to get 4 responses before I make my decision as to what I'll charge for my rental.This takes me an average of 1 hour.
2. Crunch the numbers based on Property Mgt. Realtor Comps.
LASTLY, hibby, maybe you would be kind enough to further educate us on your method used. Thanks for your input - quite useful.
Woodsrim