Whether you’re new to real estate investing or a seasoned pro, chances are you’ve heard of or even used the 1% rule to evaluate a potential real estate investment property.
The 1% rule is a general rule of thumb in which the property’s monthly rent should equal or greater than 1% of the purchase price. For example, if a duplex is listed for sale for $300,000, it would need to generate monthly rent of $3000 or more in order to cash flow. And if the duplex needs repairs, then the cost of those corrections should be added to the sales price and the rent equal to or greater than 1% of the new total.
That’s the theory anyway. And while it’s a great measure from a 30,000-foot, birds-eye view, it has several limitations which may cause you to either end up in a bad deal or miss a good one in its entirety.
Well, there are several things this rule doesn’t take into account:
- Lack of or Missing Inventory – The fact is, in the Twin Cities metro these properties are hard to find. And the few that meet this threshold may be inexpensive to one or more of the other items on this list. Having analyzed literally thousands of properties in my decades as a real estate investor, I can tell you there have been many that have cash flowed with rents lower than 1% of the purchase price.
- Neighborhood – In a city with higher property values overall, the handful of duplexes and rental properties that meet the 1% threshold are most likely found in neighborhoods with a large population of renters rather than homeowners, high turnover, and perhaps even higher rates of unemployment or crime.
- Expenses – In the thousands of properties I’ve analyzed, there have been hundreds and hundreds that cash flowed and violated the 1% rule – some because of low expenses and some because the property’s expenses were just too high. For example, high taxes or utility bills can result in a negative cash flow. Conversely, if the tenants pay 100% of the expenses, the property may be a gold mine because it has so little overhead.
- Interest rates – The historically low-interest rates we’ve experienced the last several years have made monthly payments lower, which resulted in investors being able to pay more for a duplex than they could at higher rates. Higher interest rates, on the other hand, will result in higher mortgage payments, which will result in buyers being more price-restricted. In a market with not enough housing supply regardless of type, scarcity may mean prices remain high.
- Condition –A property that meets the 1% rule may have a great deal of deferred maintenance. If the needed repairs are necessary for the long-term condition of the building, but won’t result in more revenue, it may not be a good investment due to the cash outlay on the immediate horizon. An example of this might be a roof with cupped shingles. It may not be leaking, but it is clear replacement is imminent. Since the roof is currently waterproof, the seller may not be willing to make price concessions to keep buyer acquisition costs within the confines of the 1% rule.
- Appreciation – While I never counsel a client to buy on appreciation, it is a financial bonus for all real estate investments. If a property violates the 1% rule but is in a rapidly gentrifying neighborhood, or an area where a new or existing employer is expanding and bringing jobs, a duplex may be a worthwhile investment due to forecasts of increasing demand for the area, increasing rents, and as a result, rising prices.
There is more than one factor to consider when purchasing an investment property. And while the 1% may be a worthwhile quick measure, it does have its limitations.
As always, it is important to look at the whole picture before you buy. If you’re looking in the Twin Cities, give me a call. There are deals out there. You just have to know where and how to look.