Rental Numbers For Different Areas
Recently I have been looking at rental properties in different areas of Columbus, Ohio. I have been using the "1% rule" and a variety of other numbers, GRM, DCR, NOI, etc.
A quick evaluation with the "1%" rule has provided much information, but also generated many questions.
In some of the nicer sections of town the numbers look terrible. One example is a property located in arguably the nicest section of town. The total rent for the unit is $3650 and the listing price is $525,000. The one percent rule would place the value of the property at $365,500.
I don't think the owner is far off from their estimation of the market value of the propery. Nevertheless, there is no way that this property will get a DCR anywhere near 1.25. A DCR somewhere near .8 is more likely.
My question is this. Who would buy or own such a property? Isn't this a certain loser? Properties in nicer neighborhoods tend to result in a lower DCR, but can a property in a nice neighborhood with a low DCR still be a good investment?
[ Edited by curtbixel on Date 04/29/2004 ]
Generally, you would use the 1% rule (of thumb) as an indicator of positive cash flow from rental use. If the list price is $525K, then by the 1% rule of thumb, this property needs to generate at least $5250 in monthly rental income to produce a positive cash flow.
If the market rents for the area are lower, then this property may not be worth considering as an acquisition to your rental portfolio.
The 1% rule is just a quick screening device and does not replace a detailed cash flow analysis. With market rents at $3650 there is no guaratee that this property will cash flow if priced at $365K.
A high income medical practice in desparate need of a tax shelter might buy this property with the expectation of profit from future appreciation.
A reliable rule of thumb is that cash flow increases as purchase price decreases. When property values are increasing, higher priced properties appreciate faster than lower priced properties. You have to decide whether you want cash flow, appreciation, or a mix.
How do you all determine what the rental rates are for a particular area?
Dave,
Thank you for your reply. As I am still learning about the real estate market, I have another question for you. I have heard from other sources that more expensive properties appreciate faster. My understanding of economics tells me that this can't be sustainable.
If the prices of houses in the rich section of town go up faster than the houses in the poor section, eventually, the rich section will be so expensive that less people will want to buy them. This would drive prices down. Meanwhile, in the slower appreciating poor section of town, the houses will become more desirable because of their price. The increased demand in this section of town would drive their prices up.
Can it really be true that more expensive areas appreciate faster than cheaper areas?
Curt,
There is the law of supply and demand.
If the nicer neighborhoods become overpriced (unaffordable), while the less desirable neighborhoods don't improve (neighborhood in decline), some builder/developer will come in and fill the need with new properties priced to sell to the target demographic.
The very high priced homes will become more exclusive and the wealthier buyer who craves status and status symbols will still drive the market appreciation for those properties. The appreciation rate may slow down,
So the properties in the rich neighborhood will eventually experience a decline or at least a stagnation until the other areas catch up.
The poor area, on the other hand, may either experience a higher rate of appreciation, or more likely, the neighborhood just gets worse and worse and worse, and the property values will not increase.
The developers, seeing a nitch in the market, may, if interest rates cooperate, decide to build properties appealing to those who can no longer afford the houses in the rich section.
Either that, or someone comes along with the whole gentrification thing and buys up the houses at a big discount, improve the area to make it more attractive and sells the houses for a big profit.
One very important point is that high rates of appreciation are not indefinitely sustainable.
Am I getting it?
Don't forget there are other factors that keep a rich neighborhood appreciating because of demand.
Trends in development do not mimic the style of the older yet affluent neighborhoods, it is economically impossible to build a neighborhood that in price sits between the ghetto and the rich neighborhood yet has bigger houses or sits on more land then the rich neighborhood. There ends up being a compromise because of costs. Everything costs way more now then it did then, especially land.
Secondly the reputation of the neighborhood in the community and don't forget one of the biggest factors, the school system associated with the rich neighborhood, very much a factor.
The 1% rule is good but the Proforma-nator is a better tool at weather you are going to have positive cash flow.
Go to MyTCI,
click on My Tools,
and then choose Proformanator.