Real estate doesn't need to follow the 1% rule to provide an acceptable investment return. Discussing exceptions and a word of caution.
Many direct real estate investors like to use the 1% rule for screening properties for possible purchase for rental income. The idea is that if the monthly rent is not 1% of the price of the property, it isn't a good deal.
- So if a property costs $100,000, you'd want to be able to charge at least $1,000/month in rent.
- For a $200,000 property, $2,000/month.
- For a $1M property, $10K/month etc.
Like anything, this strategy/rule of thumb has its strength and weaknesses. The main strength is that it is quick and easy to calculate in your head as a basic screen. The main problem is that a property with a higher percentage isn't necessarily going to provide a higher return than a property with a lower percentage. Let's take a look at what it really means.
Following the 1% Rule for Real Estate
Let's say you buy a $100K rental property that rents for $1,000 a month. In order to keep things simple, let's say you buy it Dave Ramsey Style, i.e. all cash.
Another reasonable rule of thumb, sometimes called the 45% rule or the 55% rule, is that 45% of rent will go toward the non-mortgage expenses including insurance, taxes, repairs, vacancy, maintenance and management.
So this property has a gross rent of $12,000 per year and a profit of $6,600, i.e. it has a Capitalization Rate of 6.6.
If the property also appreciates at a reasonable 3% per year, the overall return should be 9.6%, not counting the benefits of depreciation.
Since you can depreciate the property over 27.5 years, and let's say the land is worth $30K and the building is worth $70K, and $70k/27.5 = $2,545. So of that $6,600 you made, $2,545 is not taxed. It may or may not be taxed later. But if you have a 42% marginal tax rate like I do, that depreciation could be worth as much as an extra $2,545*42% = $1,069, basically another 1.1% on the return. So 10.7%. Leverage could potentially add more return to the investment, but many investors would consider 10.7% a reasonable return on their investment.
In the real world, where most purchased rental property is leveraged, following the 1% rule can help you ensure your property has positive cash flow. If you leverage the whole thing (i.e. 0% down) at 5% for 30 years, your payments will be $6,500 per year. So that first year you take in $12,000 in rent, you pay out $5,400 in non-mortgage expenses, and you pay out $6,500 in mortgage expenses. That leaves you with $100 in cash flow (totally sheltered by depreciation), $3,000 in appreciation, and a mortgage paydown of about $1,475. You ended up making over $4,500 despite not putting anything down!
More realistically, you'll put perhaps 30% of the value of the property down. Now your mortgage expenses are $4,554, your mortgage paydown in that first year is $1,033, and your cash flow is $12,000 – $5,400 – $4,554 = $2,046, all of which is depreciated. With $3,000 in appreciation plus $2,046 in cash plus $1,033 paid off the mortgage, your rate of return is just over 20% on your $30,000 down payment. Not a bad investment, right?
Not Following the 1% Rule for Real Estate
So what happens if you don't follow the 1% rule? Because it turns out in many areas of the country (usually the high cost of living areas) you simply cannot find a property for sale that meets these criteria. For example, let's take a 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 will rent for. This two bedroom property rents for $5,809/month ($69,708/year) and is worth $2,324,798. It doesn't pass the 1% rule. 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 put down to be cash-flow positive? How much would it have to appreciate to provide you a 10 percent return? Let's take a look.
Total rent is $69,708/year. Following the 45%/55% “rule”, after paying all of your non-mortgage expenses you will have $38,339 that could go toward your mortgage. How large of a mortgage at 5% could that pay on a 30-year fixed? About $585,000. That would mean you would need to put down $2,324,798 – $585,000 = $1,739,798, about 75%. Now, will you really have $31,368 in non-mortgage expenses? Maybe not.
Let's say you've done a really, really great job selecting and managing a property and can cut those in half. How much larger can your mortgage be now and still be cash flow positive? You could now get an $830,000 mortgage. You would still need to put down $2,324,798 – $830,000 = $1,494,798 or 64% of the value.
If you only put 30% down, again following the usual 45%/55% rule, you would need to feed this property to the tune of over $67,000 per year ($5,600 per month.)
What kind of appreciation would you need to see in order to have a 10% return on your investment if you put 30% down? Let's look at each component in turn:
- Your investment is $2,324,798 * 30% = $697,439.
- Your cash flow was a negative $67,000.
- The mortgage was paid down by $24,000.
- Since there was no income from the property, there is no income to depreciate.
- You need to make $697,439*10% = $69,744 in order to get a 10% return. Instead, you lost $24,000-$67,000 = -$43,000.
- $43,000 + $69,744 = $112,744 in appreciation in order to get a 10% return. $112,744/$2,324,798 = 4.8%.
Is that impossible? Absolutely not. In fact, in San Francisco over the last 20 years, appreciation has averaged 5.3%. At 5.3% appreciation, our property had a first-year return on investment of 11.5%.
So my point is that a property need not follow the 1% rule in order to provide an acceptable investment return, but the lower the rent to price ratio, the more appreciation you will need to hit a given rate of return. In addition, the more skilled you are at buying real estate for less than it is worth and managing it well, the better your returns at a given rent to price ratio.
Be careful assuming past rates of appreciation will continue. Even the mighty San Francisco real estate market lost 27% in 2008-2011. It would be really painful to be feeding a property to the tune of $67,000 per year AND watching it fall in value by $200K+ a year.
What do you think? If you buy individual properties, do you use the 1% rule as a screen? Why or why not? Do you think it is safe to count on appreciation in some markets for the lion's share of your investment return? Comment below!