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Where Did it Go? The 1% Rule!!

The 1% rule. There are various 1% rules. As a matter of fact, going through the blogs on AR just this evening, I spotted a blog discussing a different 1% rule. The one I'm talking about involves investment property. SIMPLY PUT - the monthly rent is equal to at least 1% of the purchase price of the property. BASIC EXAMPLE - you buy a home for $100,000 and the monthly rent is $1000.

I would like to think that this was the dominant rule in Real Estate Investing prior to the latest boom (likely driven by historically low interest rates). More specifically, it was the dominant rule when purchasing Rental properties for investment purposes. If you bought a home, duplex or fourplex following the 1% rule, you were likely to make a good amount of money - over A BIT OF TIME. IE, your returns weren't spectacular in the short term.

In the last 5-6 years, we've seen some drastic things occur, however. The Phoenix market appreciated on the order of 50% in one year. Same for Vegas. California - goodness - California appreciated by so many percentage points that I can't even count that high!!! ;) Similar things occurred on the East Coast in Florida, DC, NY/NJ and Boston.

WHY buy and hold a property for many years when you could make HUNDREDS OF THOUSANDS of dollars in a few short years? Did this signal a paradigm shift for Real Estate Investors? Maybe not for the traditional, conservative real estate investor. But this phenomenon DID introduce a gaggle of new, relatively inexperienced investors who were buying up 2^nd, 3^rd and 4^th homes like nobody's business. Alas, interest rates have risen. Many of the booming locations where newbie investors were purchasing have become extreme buyer's markets. I don't know of too many places predicted to appreciate 50% in '07.

Back to the 1% Rule. I still don't think it works on the coasts (0.25% Rule for Cali?). Arizona/Vegas (can we coin a 0.5% rule for these states)? Maybe only in the outskirts and even then we are talking exception rather than the rule. Midwest/Texas - I think the ratios can and are being achieved with some regularity.

Without massive booms in Real Estate prices, will the 1% rule make a strong comeback? Did it ever really leave; or did it just choose to hibernate for a few years? I welcome your comments and discussion!

Posted by Kaushik Sirkar on 12/06/2006 10:55 PM

Comments (26)

real estate investing, rental property, investment property

26 Comments on Where Did it Go? The 1% Rule!!

DEC

2006

IMHO, this is an old formula.

The "1% rule" is just another way of saying that real estate investors like properties that generate positive cashflow. If you're in the ballpark of that 1%, generally speaking (depending on expenses, taxes, interest rates, vacancies, etc.) you stand a decent chance of getting into a positive cashflow investment.

When you can't find any 1% deals (CA, FL, etc.) what does that mean? Simply that the ratio of price to rent has gone up. This is one (but not the only) signal that a market is overvalued.

Does that mean you should't invest there? Or that the 1% rule doesn't hold? No. What it does mean, however, is that in order for these investments to yield a decent rate of return the market will have to continue to appreciate at double digit rates. If you think this is likely then go ahead and buy. If you don't think it's likely then hold on to your money; either wait for the correction or invest in another region.

I don't think that the 1% rule is an old formula. It doesn't go out of style. Inflation lifts both property prices and rent prices, and if things remain in parity then they move along at roughly the same rate. When one races ahead of the other (1% gets either too hard to find or too easy to find) then you can expect a correction at some point.

This is one of the ideas behind EquityScout.com. Before you make an investment (or recommend one, if you're a real estate agent) you should have an idea of what rate of property appreciation you'll need to expect in order to have the investment yield an acceptable rate of return. If you run the numbers and are satisfied with the result then you can invest with confidence.

Just my opinion...

DEC

2006

Rent prices are lagging and wages aren't supporting increases. The 1% rule will change or property values will drop.

I'm betting on the latter

Here, in College Station, Texas the 1% rule is alive and well! The only exception is duplexes, which are receiving horrible returns. Three reasons for that; investors came in and swept them up like they were candy and the prices appreciated drastically in a short period of time (they are about to depreciate now), the second reason is that duplexes are overbuilt and vacancy rates are high, and the third reason is that their popularity with students whose parents are investing in our market is high. No matter what you advise these parents they will push for a duplex. Single family currently I'm getting 1% or better on everything. I've recently sold several homes 135-155 to investors and rentals are all 1500-1600 a month.

1% rule and positive cash flow are not possible in today's Florida market, at least in the Tampa area. Looking at three rentals I've encountered recently, we're running about 1/4%. In those cases, the landlords are owners who are waiting for the market to improve before selling. Having such a large inventory of homes for sale had added to the rental pool as well.

The flipping of property and the great number of people enticed to buy property because of run away increases in value has just about wiped out the 1% rule.

History shows that when interest rates drop below 7% on home mortgages house prices begin to take off. Mainly because the payments become affordable by many more people and it is easy to get a house into a positive cash flow for rentals.

And to the opposite end of that when interest rates get about 11% homes stop appreciating and actually begin to depreciate.

We are not leveling out a long run in a low interest rate market. Prices have to adjust and thinking has to adjust. Just a short 6 or 7 years ago anyone here would have been delighted to have a 7% mortgage. Now many homeowners think that even with poor credit they deserve an interest rate below 6%.

The market has a short memory. We as professionalts need to remember the cycles and help clients take advantage of what is going on. Many mortgage products lend themselves well to the sales cycle right now. But they must be used with caution and with understanding.

Why not just base the rate of appreciation on the histrorical average of 4.5%. Yes there will be times when it will be flat or possibly negative, but if it is a buy and hold, then that rate will likely be the average during the time you hold it.

People need to stop "chasing" the market. The 1% Rule is a fairly good basis for researching properties, but with strategic financing, you may not need it, but that is a different discussion.

For investors, buy and hold should be treated as such and use averages like investors in the stock market. Flipping is a different story.

I"m fairly new to investment property, just checked out Equity Scout and it looks like a great tool - I'm sending to a client now. Thanks!

We've been a buyers' market since 2001 which is just now changing to balanced-and the 1% rule still doesn't apply here. Rents have stayed relatively stable because new construction includes new apartments as well as new single family. And I think that other markets have seen the same in oversupply-because at the low interest rate environment, those who CAN buy, do buy. I think it's market specific, and if you spot a market like ours with rising property values and break even on rental rates, it's a great pick. I tell investors to expect negative cash flow in years 1 and 2, breakeven in year 3, positive cash flow 4 and beyond. And that's realistic no matter what the market is doing.

1% doesn't work in the MD/DC/VA market. A friend just purchased a $770,000 property and the market for rent is $2,400.

The only rule that really works is MARKET.

The 1% rule still works in some areas but is getting harder to find. Interest rates did not however go up THAT much. There are still good rates to be found. Well under 7%. I think "flippers" have made a negative impact on the marketplace inflating prices along the way. I think the market will have to have a correction.

In the past few years Investors have been willing to leverage with little regard for their monthly return, counting on appreciation to make their money. That's changed.

You won't find anything in Naperville with the 1% rule... Maybe .33 to .66 depending where you are..... in the neigboring towns you'll do a little better, but they may not be as easy to rent, or enjoy the same appreciation.

We have an interesting new dynamic coming into the picture and that's the apartment complex sell-off. Everybody is going condo, with no new complexes being built. I know of 5 major complexes that are in the process of, or are done with the conversion. I just heard about another from one of the city councilmen.

In the development where my son lives he pays about 850 (cheap around here) a month for rent (1 bedroom) and they are now selling those same units for $140,000 (he'll be moving)

YOUR COMMENTARY IS GENERALLY ACCURATE. i WOULD ADD THAT IN OUR MARKET WHICH IS RESORT. wE FIND MANY FOLKS WHO BUY A BETTING ON THE APPRECIATION FACTOR OVER 3 TO 5 YEARS. aS LONG AS THE INCOME COVERS THE MAJORITY OF THE EXPENSE THEY ARE PALYERS. bUT LET THE MARKET SHOW A LAG WHERE THEIR SEASONAL RENTALS DROP AND YOU WOULD THINK THAT THEY WERE ON THE TITANTIC. bUT THOSE WHO BEHAVE IN SUCH A MANNER ARE GENERALLY, NEW MONEY WITH NO EXPERIENCE.

Lenn: you commented: 1% doesn't work in the MD/DC/VA market. A friend just purchased a $770,000 property and the market for rent is $2,400...The only rule that really works is MARKET.

The question is: why would your friend think this is a good investment? You're friend is going to be paying between $4,500 and $5,000 a month in mortgage payments alone. Add insurance, expenses, allowances for vacancies, taxes, etc the total cost of the property will be somewhere in the neighborhood of $7,000 - $8,000 per month. He/she is going to be four or five grand in the hole every month.

This would be a good investment if your friend expects the market to continue to skyrocket. However, if the market appreciates at historic averages - 4 or 5 percent per year, this investment will lose a tremendous amount of money. If the market corrects, meaning it actually drops (a real possiblity) the risks are even greater.

I'm not saying this is a bad deal. Your friend might know something about the local market that I don't. But the important thing to realize is that in order for this investment to work out the market must continue to rocket at 15 to 20 percent rates of annual appreciation. Anything less than that and your friend is going to lose a lot on this deal.

Regards,

Christopher Smith

EquityScout.com

Note: In this example: $770,000 purchase price. Total expenses (principal+interest, tax, fees, insurance, etc) estimated at between $7,000 and $8,000...which happens to be about 1% of the purchase price. Coincidence?

The rule isn't dead...

Thanks for the post. I'll put it in my collection of 'mental thumbnails' to spit out in a pinch.

Doesn't work here any more. Investors need to understand that "tenants" can buy for the same or less right now - so why would they pay rent based on the 1% "rule"?

It doesn't work here in Southern California now either, unless there is a whopping downpayment. Lots of investment properties on the market and sitting there for many months (duplexes and larger). Rents are creeping up but certainly not enough, even with the drop off in prices in some areas.

I think the 1% "rule" was more of an observation at one time - and as interest rates and payments changed, so did that dynamic.

I remember when 1% applied here in Honolulu, but I'm getting senile.

Chris Tesch - I have looked into buying investment properties in BCS myself. But mostly looked at duplexes and fourplexes and they just didn't do it for me there.

Chris Smith - You really appear to know your stuff! Thanks for your insights.

Tony and Suzanne Marriott - What are you guys noticing on the fringes of the phoenix metro? I have seen some REALLY discounted spec homes in pinal county that are probably at about the %0.8 rule - anything approaching that in your neck of the woods or up north?

All - thanks for your thoughts and comments!!!

Kaushik, you might want to consider single family homes. A&M is getting many associate professors, we get military families in with regularity and people who are coming for their upper levels and planning on staying only 2 years. Many times the military, or their work is paying for their housing. Like I said, we've done many single family homes here in just the last year and all were rented out rather quickly. The appreciation is climbing here and you get the 1% rule, a great combo I think!!!

Note to Chris Tesch: According to statistics at Global Insight - a good, objective source - College Station is the most undervalued market in the country. Never recovered from the oil-fueled collapse in the '80s that cratered Houston, Dallas, and parts of Louisiana. I invest in Houston - getting up to College Station has been on my to-do list.

DEC

2006

The 1% rule will come back if the new congress starts messing with capital gains.

1% rule from what I have seen here in the Tourist town of Branson Mo. Is a little bit out of line again we have had sucha increase in value and the market is holding on at the present. I will keep this bookmarked and check back later when the market changes a little.

DEC

2006

My goal is positive cash flow with 20% down. That takes into consideration the cost of money and expenses. Add in Principal reduction for an ROI of 6% or better and you have a winner. In our small Air Force town where rentals almost always work, I can find a good return in 25% of our listings. I recommend buys based on 'Investment' not 'Speculation'. If your 20% can earn a 6% ROI, not counting appreciation thats a good Investment. I don't recommend a buy based on what I think the value will be later, I leave speculation to the stock market guys.

BTW the 1% rule is a great way to decide which investments are worth taking a closer look at.

DEC

2006

Ah the Negative cashflow vs. future apreciation paradigm. I would have to agree that it does appear something will need to happen with the way investment homes are treated in rental terms. Either the rents will need to go up to at least support the current mortgage levels, or the prices will drop. I believe that prices will be eventually drivin up to were they need to be for rents in the next couple of years, seeing as how it is likely that a the populus as a whole would let a large scale price recession happen. My $.02

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