Rules of thumb are a nice shortcut to make a the bulk of a decision quickly and simply.
To know whether or not something as complex as a rental property is worth the risk involves a LOT of factors. This is both the time a rule of thumb is useful and to be viewed with caution.
You may or may not have heard of the 1% rule before but it’s fairlly simple and fairly common, but onoy among real estate investors. The 1% rule states that for a purchase to be considered, the rental rate (per month) of the property should be equal to or greater than 1% of the puchase price. Stay with me! That may feel complicated but it’s really not. Lets look at an example then review it again:
Purchase Price: $200,000
Rental Income: $2,000 (per month)
Rule: 1% achieved!
So this property meets the 1% rule right on the nose. This is rare. More often than not the rule is broken by a price that is too high relative to the rental rate. Where I live in Arizona, rental rates are rarely equal to 1% of the purchase price. A home selling for about $350,000 would likely only rent for about $1800-$2400 per month. This is more like a 0.5-0.7% rule.
So why does this rule “work” at all? Aren’t there a ton of factors to consider like location, how hot the market is, interest rates, property management, the condition of the home, how many bedrooms and bathrooms there are, what the mortgage on the property costs, utilities, THE RENTERS! Yes, those are all big considerations. The 1% attempts to encompass all of that at least as a first checkpoint. It’s easy enough math to do in your head and helps you to know the property is definitely worth considering.
Our home for another example, is worth somewhere between $325,000-$350,000. (Not in it’s current state because I have about 4 projects started and not yet finished. Chaos. Tools and material and bits and pieces EVERYWHERE.) So for it to meet the 1% rule, it would need to rent for somewhere in the realm of $3,250-3,500 per month.
If you’re like me, this prompts a number of questions, all based around the one most important one: Is this enough to make me a profit? Here are the questions that flow through my mind. What is the mortgage payment? Who pays for utilities? How much are taxes again? How much should we set aside for incidentals? Etc… Because renting for over $3k/mo really feels like a lot. That alone is double our monthly mortgage payment! But depending on those other factors, it may not be as profitable as it seems. I would expect the bulk of the utilities to be taken over by any would-be renters. But something like pool care or landscaping should be handled by the landlord, in this case, me! I don’t want the yard, trees, and pool to get neglected by a renter trying to save a few bucks and end up becoming my problem anyway. So that is about $200/mo off the top.
Let’s keep going with this example and talk through some of the numbers:
1% Rule Monthly Rental (gross): $3,250
Landscaping and pool maintenance: -$200/mo
Remaining rent: $3,050
What else is a factor? How about insurance. The average homeowners insurance is around $830/ year but ours is higher at this time. Let’s call it $1100. Apparently landlord insurance is 15-20% more than insurance for your primary residence, so lets forecast $1,320. $1,320/12= $110 per month.
Remaining rent: $2,940
I would never want to personally manage a rental unless the renter was a family member, so we need to factor in the costs of property management too. I have heard a range of costs to factor for PM. Anything between $125/month to 6% of gross rent. 6% of $3,250 would be $195. Lets continue with our conservative figures and call it $200/month.
Remaining rent: $2,740
Mortgage costs are likely the biggest single costs for any property. Unless it’s paid off! But our house isn’t, and as far as I understand, the intent of the 1% rule is to encompass the costs of financing through a mortgage. We currently have a 15-year mortgage so our payment is higher than average. We chose this so we would be force to essentially make an extra principle payment and thereby get out of debt sooner. This is probably even less common in rental real estate because so much of the concern is around cash flow. Cash flow meaning: as much difference between income and costs as possible. If this number is high, odds are you will be making money and more able to keep the property. We could refinance our 15 year mortgage to a 30-year mortgage and massively increase the cash flow. By now we have paid off almost 1/3 of the total balance, so the remaining $127k or so would make for a minuscule monthly mortgage payment. (For the sake of the conversation, a $127,000 mortgage financed for 30 years at a 3.91% interest rate would be $600/mo). As tempting as massive cash flow is, I continue to factor my own financial projections as conservatively as possible. For us to be able to move and rent this house, we would need to be living somewhere else, which means we would have bought another place. The monthly cash flow from this home on a 30-year mortgage would be great, but the crazy cash flow once paid off would be amazing. So let’s do the math with our current mortgage payment. It’s about $1500/mo.
Remaining rent: $1,240
We’re still in a strong position with well over $1,000 left every month. I’m sure there are regular expenses I have overlooked, so as one more category we will add: “small thing(s) Brendan overlooked” for another $150/month.
Remaining rent: $1,090
One of the most opinionated factors to consider remains: capital expenditures. If you want to sound like a guru, use industry terms like “cap ex”. These are the occasional repairs and costs that pop up as part of normal property ownership. Our AC unit is older than I am. It’s bound to go soon. Our plumbing system is made from cast iron (thanks 1970’s construction trends) and is slowly rotting away to nothing. It will need to be replaced in the next 5-10 years. (This hurts even to type in this hypothetical scenario!) Our roof is less than 10 years old but already is missing a few shingles and needs repairs…now! Shoot I need to call a roofer! Our pool is surrounded with “cool deck” which is chipping, cracking, and coming apart. It likely needs refinishing in the next 5 years. The list goes on. These are all expenses we sort of can expect, but don’t have a way to predict perfectly. And there are still others that are lurking and will pop up when we least expect them. For all of these unfortunate but common realities, we need to budget for capital expenditures. How much? Well we basically have to list out the items we know about and how long we think they will last and divide their replacement cost by that amount of time. Then we know how much to factor in between now and then. Confused? Don’t worry, here’s a handy chart!
| Item | Total Cost | Lifespan (yrs) | Cost/Year | Cost/Mo |
| AC unit | $4,000 | 5 | $800 | $67 |
| Plumbing system | $10,000 | 7 | $1430 | $119 |
| Roof | $400 | 1 | $400 | $33 |
| Pool deck | $4,000 | 5 | $800 | $67 |
| Water heater/etc.. | $500 | 5 | $100 | $8 |
| Total | $18,900 | $3530 | $294 |
All of those costs and timelines are “best guess”. Since I work full time in construction, I feel a little more confident in my estimates, but it’s best to ask pro’s what their normal range of cost would be. Overall the cost is going to be at least $294/month, and it’s probably wise to factor more. This is all of the known and foreseen expenses. EVERYTHING ELSE is not factored in. I would want at least $200-300/mo for incidentals. Again, on the conservative side, we will total this as $294+$300= $600/month
Remaining rent: $490
The next factor that we might often overlook through sheer optimism and lack of experience is vacancy. I never considered this until recent years and the repeated advising of people wiser and more experienced than me! There is virtually no way you will have 100% rental rates. Even if your rental market is hot, really hot, hotter than the sun, you will need some downtime to clean up, repair, or fix anything that’s broken between tenants. A typical factor to consider for vacancy is 10% The average has been closer to 7% nationwide and it varies depending on your area and your particular property. If we lean on the conservative side and plan for 10% vacancy, that means for about 1 month per year we will be getting zero rental income. So one of those sweet $3,250 payments is gone! Poof! If we plan on that and divide $3,250/12 months= $271 per month. Even though this isn’t a “cost”, it’s revenue that is gone and needs to be planned for.
Remaining rent: $219
Wow, how far the mighty have fallen! When you first look at the rental rates by way of the 1% rule it seems like you are absolutely guaranteed to make a ton of money! Yet, after factoring in all of the expenses and forethought needed to actually remain profitable over time, we would only be making $219/month. Now don’t get me wrong. I would love to clear $219 every month after covering every conceivable expense!
But here’s the rub: I’ve NEVER found a property that meets the 1% rule! There are a lot of people who take real estate investing much more seriously than I do and are constantly shopping. Odds are, whatever 1% rule deals that exist are snapped up and purchased before I ever stumble across them. However, the point still stands. These properties are not easy to find and often require the sweat equity and/or cash on your part to take them up to that level of rent. In fact in the market where we live I think this is almost mandatory to get anywhere close to the 1% rule.
The implication I am trying to make here is that just because you found a property that “cash flows” over and above the cost of the mortgage doesn’t make it a profitable investment. If the mortgage payment is $1500 and rent is $1900, you aren’t necessarily making $400/month. Remember to think about all the other costs that come along with owning physical property. As the old saying goes, “You make your money when you buy it”. (Implying that if you buy real estate cheaply enough, the rest of the math works out.)
Do you have any rental real estate?
Do you know someone with a rental?
What do you or they consider when buying a rental property?
Have you heard any horror stories around rental properties? (I feel like everyone knows someone who got burned and now vows never to do anything with real estate again!)
What do you think about real estate investing?
Abacus Fitness and Money 