As a big advocate for real estate investing, I’m often asked for advice. One of the most common questions is one of the hardest to answer: how do I know if a property is good to invest in?
Obviously, there is a lot that goes into that decision, and it all depends on what you want. Still, when looking at a potential property, it’s safe to say that the number question you should be asking is this:
Will this property create the type of cash flow (now or in the future) that will help me reach my financial goals?
That’s the overarching question to keep in mind. Of course, finding out the answer is usually easier said than done.
Goals & Gaining Knowledge
For one, maybe you’re just learning how to invest in properties. You know that investing in real estate can be a great way to achieve financial freedom, and you’ve (hopefully) created some definitive passive-income goals at this point . . . but you’re not sure what the next step is. Maybe you haven’t learned how to do the full due diligence on the property.
It takes time to learn how to do this. I’ve read numerous books, like The ABCs of Real Estate Investing and The Book on Rental Property Investing, both of which would be great starting points. You could also start by taking the free Mini-Course, Zero to Freedom, hosted by my friends at SemiRetiredMD where they’ll teach you what you need to get started investing in real estate.
As I've mentioned you need to be rock solid on your goals before you can truly find real estate investments that help you achieve them. That means you need to be very clear on how much passive income you'd like to create per month and in what time frame you'd like to have it by.
For example, some people in my course, Passive Real Estate Academy, have mentioned that they'd like to create $10,000 a month in passive income within 10 years. So then we're able to reverse engineer and figure out how to make that happen.
Once you have that goal crystal clear in your mind, you can then go out and seek out the investments that will help make it a reality.
You Make Money When You Buy
You’ve probably heard the old adage when it comes to real estate: you make money when you buy. Once you’re in a poor deal, it’s hard to recover. Learning how to properly vet deals–whether investing actively or passively – is the majority of the battle.
However, it takes time to really dig deep and decide if something is the right property. You’ll get better with the due diligence with time, but suffice to say that most of the important work is done upfront.
But before we get to how you can choose the right property, it’s important to understand the concept of my two favorite words in personal finance: “cash” and “flow.”
What is Cash Flow?
“Cash flow” refers to the amount of money “flowing” through your personal finances. Cash comes into your life and cash goes out to cover expenses. Whatever’s left over is net cash flow.
Net cash flow can be positive, meaning you have extra left over after expenses, or it can be negative, meaning that your expenses are greater than your income. The latter is usually indicative of accumulating debt. Put simply, the equation is this:
Cash Flow = Income – Expenses
In real estate, we’re always looking for positive cash flow. So what does this look like for the real estate investor?
Income Versus Expenses
Here are some examples of what you can expect when investing in a property.
- Other (utilities, laundry, parking, etc)
- Property management
- Routine maintenance & repairs
- Capital expenditures (major expenses to maintain or upgrade the property, ex. roofs, HVAC, appliances, flooring
- Taxes (property, etc.)
- Accounting & legal
- Pest control
When you ask yourself whether a property will produce positive cash flow, you have to take all these things into consideration.
This usually involves doing a deep dive into the due diligence.
That involves asking the seller for something called the “rent roll.” This is essentially a list of the leases and actual rents that have been collected over the past year. It also usually indicates if there have been any concessions made to tenants (like first month free for example).
Then, to calculate expenses, you’re going to want to see all the seller’s records, including maintenance and taxes.
This all sounds well and good. But when you’re searching for properties, you might have to look at 20, 30, even 50 properties before you find a good one. The reality is that you can’t do a deep-dive into due diligence on every one of them. For many of these properties, this type of information isn’t available to you until you’re in contract for the property.
So wouldn't it be nice to be able to quickly filter out properties that don't make sense? That's where the 1% Rule comes into place.
The 1% Rule
I’ve talked about the 1% rule before (briefly), but it certainly bears repeating in more detail.
Basically, the 1% rule states that you should be looking for properties where the rent per month is greater-than-or-equal-to 1% of the purchase price of the property.
The 1% RULE is… The rental income per month should be > 1% of the Purchase Price of the Property
For example, if you’re looking to purchase a $100,000 property, you’d like to see that it is getting rent of at least 1% of the purchase price per month ($1,000 a month). As an equation, it would look like this: 100,000 x .01 = 1000.
Now let’s say it’s a property that’s $540,000. Then you’d like to see rent at $5400/month.
This is really just a quick screening tool, but it can be very useful in weeding out properties that likely won’t perform the way you want it to.
It’s like using simple bloodwork for health screening. It ultimately doesn’t tell you if someone has ischemic heart disease. But it could give you a quick idea of whether you need to take a second look and maybe consider taking a deeper dive.
What Does the 1% Rule Tell You?
It gives you a basic idea of whether the property at hand will be able to create a positive cash flow situation or not.
So Where Do You Find Out the Rents?
To calculate whether the property fits the rule, it would be best to use actual rents from the “rent roll” or on occasion the sellers will list actual rents on the listing itself.
Other times, however, you'll get a list of something called “pro forma” rents, which are projected or potential rents they could be getting. This is good, but ignore the pro forma for now.
Take a look at the actual rents. Add them up and see if it meets the 1% rule. If the actual rents aren't available, then do your own research on market rents. Some ways to do that are to use Rentometer, Zillow, and Trulia.
If it doesn’t meet the 1% rule, but it’s close (or there are other reasons to make you want to dig a bit), figure out why it doesn’t meet the 1% rule. Perhaps if you factor in construction costs, could you meet the 1% rule? Use these potential market rents to your advantage.
So, we’ve determined that the 1% rule is quite useful. But…
How Practical Is It To Find Properties That Fit?
Well, I can tell you that in coastal cities it’s near impossible in today’s market. For example, in Los Angeles, you might see a $1.5 million 3br/2ba house, at an average of 1700 sq ft. Using Rentometer and Zillow, it may average $5300/ month.
That equates to 5300/1,500,000 = .3%, which is far below the 1% rule
In other midwest cities you might find a $500,000 apartment building that nets at least $5,000 in rental income
What Do You Do If It Doesn't Meet the 1% Rule?
Well, you either move on and look for a place that matches the 1% rule, relax your standards a bit and look for places you can add value and come closer to the 1% rule, or you wait until prices go down to meet the 1%. That last one is especially hard to predict.
Ultimately, I simply use it as a basic pre-screening. I also find that as I look at multiple units versus single-family properties, I come closer to finding that 1% sweet spot.
Once you’ve taken the steps to actually find a few (dozen) potential properties, it’s just one rule of thumb that can help you quickly narrow down which ones might get you to your ultimate goal: true financial freedom.
Enjoy talking about passive income? You can continue the discussion on our Facebook Group, Passive Income Docs.