Rent Values - Debunking The 1% Rule Once and for All

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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:

  • Gross Scheduled Income


  • Price


  • ………. That’s it. Nothing else. Nada.




  • 1% Rule does NOT take into consideration:

  • Down payment


  • Amortization


  • Loan Rate


  • Market conditions (comparables, vacancy, etc)


  • Expenses


  • Mismanagement


  • Deferred Maintenance


  • Varying management Styles


  • Vacancy


  • Cash Flow


  • Etc….




  • 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 = Rent Or 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.

    Comments(16)

    • lansinginvestor11th March, 2004

      Great article!

    • lorien11th March, 2004

      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" wink

      becki

    • director3813th March, 2004

      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.

      • hibby7613th March, 2004 Reply

        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.

      • DealerJo14th March, 2004 Reply

        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.

        • CREIPAP14th March, 2004 Reply

          That's correct DealerJo. Many investors use rental properties for tax shelter and not for cash flow. Here in NY, properties get for about 20X GRM. Well, we should probably move somewhere South and inland to enjoy CREI.

        • hibby7614th March, 2004 Reply

          "he cant really speak of a national cash flow formula. No one can."




          I get the feeling that you read it fast and missed the point of my article. I was saying JUST THAT! Many people try to apply the "1% rule" to all properties, in all circumstances, in all areas.



          That's exactly what I"m pointing out. The numbers that I tossed out in the article were purely hypothetical and demonstrative. I'm not suggesting that those are the target numbers if you live in those areas, but rather you need to FIND OUT what the target numbers are. My point was that you need to learn your market intimitly well and then figure out what formulas work in your area, be it cap, cash flow per unit, GRM, price per unit, sq. feet, etc.

      • Wayne-NC21st March, 2004 Reply

        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.

      • director3814th March, 2004 Reply

        Ah yes - very good. Glad we expounded on that a bit. Thanks!

    • turtlepw15th March, 2004

      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.

      • CREIPAP15th March, 2004 Reply

        For the begining, tha's the creative move. I am looking some properties there myself. Good luck!

      • Wayne-NC21st March, 2004 Reply

        OK, sink incredible sums of money into the downpayment. Question, where did that cash come from and what is the loss of income that it once produced? Does that turn the cash flow positive after you net out that loss of income expense?

        • turtlepw22nd March, 2004 Reply

          First of all, I wasn't advocating "sinking incredible sums" into downpayments, otherwise I would have worded it differently. I would have said something like, "putting in a healthy downpayment is a safe and wise strategy for RE investment", or some BS like that.



          Where did that cash come from?

          If you are a whale, and have lots of ca$h just sitting around, and want to protect it from taxes, it might make sense. I am not a whale, and even if I was, I don't think it is a very good strategy. Better returns on your money are out there.



          Basically, in the second part, you are asking about the "opportunity cost" of "sinking incredible sums" into a downpayment.

          You could be doing other stuff with that cash, rather than sticking it in a illiquid investment like RE. Alls it takes is a dip in the market, and you're stuck holding the bag for a while.



          Putting as little in upfront as possible is best. However, as you go towards 100% financing, the cost of that borrowing goes up, and it becomes increasingly difficult to make the property cashflow positively.


      • cdpapoulias24th March, 2004 Reply

        You are soooo correct about the DC RE market!!



        Baltimore, where I work (live in Silver Spring) can be a great value, but I haven't personally invested any RE money in this area yet.

    • woodsrim18th March, 2004

      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

      • hibby7622nd March, 2004 Reply

        In my area there aren't any great comparable rentals nearby. Lots of other rentals though. I'll talk to the people that call up looking for an apartment and chat with them about the market, the other apts that they've looked at, what they're expecting to pay, etc. It's not a perfect method, but I can get inside the minds of the prospective tenants and get a feel for what the rents can and should be.



        I also get quarterly reports on the market from a real estate brokerage that lets me know statistically what the market is doing....usually this supports what I've found out on my own.

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