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.
45% Rule
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.
Cap Rate
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.
Appreciation
If the property also appreciates at a reasonable 3% per year, the overall return should be 9.6%, not counting the benefits of depreciation.
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.
Leverage
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.
The Dahle Family social distancing in a yurt in the Wyoming Wilderness in late Winter.
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!
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 27 hours of content, and it gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course! You can also sign up to receive our free “Real Estate Opportunities” newsletter and be the first to hear about specific deals, special discounts, and everything real estate.
Featured Real Estate Partners
Totally agree with your warning to be careful about assuming past rates of appreciation will continue. I bought a coastal investment property 8 years ago and made a big assumption that the historically large appreciation rates would continue. Well it hasn’t even been close. We’re now in the process of selling it as it no longer serves our long term goals of simplicity and being debt free/financially free.
Great Post. I’d like the know who wrote the post?
WCI wrote the post. If it’s a guest post, he mentions the author (and financial relationship) right at the beginning of the post.
Agree, it’s a great post. Love the simplified, easy to understand breakdown of the numbers.
In a place like SF, where many many people rent long-term, if the ROI wasn’t good enough for investors, they would flee and prices would drop. So, it obviously works for most of them. But the real-estate market being inefficient, some people don’t do well if they bought at too high a price. Also the barrier to entry into the market is higher d/t higher purchase prices.
You can see how SF landlords are assuming a very high rate of appreciation in order to have the same returns as someone in another state where a property that follows the 1% rule can be purchased. If they get it, they do fine (especially with leverage.) But if they don’t….
I did. More about me here: https://www.whitecoatinvestor.com/about/
On this blog, Monday and Friday posts are new and written by me. Tuesday posts are also written by me, but are recycled from something published years ago. Wednesday posts are guest posts. Thursday posts are the show notes from my weekly podcast, written by my assistant. Saturday posts are WCI Network posts, written by the bloggers behind The Physician on FIRE, Passive Income MD, and The Physician Philosopher blogs.
I think even the 1% rule is too “expensive” … here in Central Maine, most of our properties adhere to the 2% rule. (And this is not low income property which is the case with following the 2% rule in many areas). But boy oh boy, just about EVERYTHING has to go right to come out ahead accepting the 1% rule. I really think I’d sooner stick with a bond fund or CD vs. a property that falls under that rule. I don’t know everything but this is after a 10 year period of investing in SFH’s and multi’s in Central Maine and publishing a book about it.
Interesting to see your comment juxtaposed next to one from San Francisco arguing just the opposite.
It’s just a rule of thumb. The higher your cap rate, the less appreciation you need to get the same return. If a property has a low rate of appreciation, or even depreciating, it needs to be providing a lot of income to make up for it.
Overriding all of the rules is the fundamental principle that “all real estate is local”. As other comments have noted, wide local variations pretty much eviscerate the rule. However, the analysis provides good examples of evaluating real estate.
Also, the article does not reflect some of the [hopefully temporary] COVID19 impacts on the mortgage sector. Unsure where you now [or even before] you can get 100% LTV investor loans. Worse still if the loans are jumbo.
Another, unanticipated effect of shelter in place has been the recognition that much work can be done remotely, often more efficiently. This has significant consequences for very high costs areas, as companies and workers realize that workers can buy better housing at <50% of [e.g. NYC/SF] costs, work remotely, and still be within @ one hour of the company office for occasional, in-person meetings. One SF broker told me of multiple clients who were looking in SF, looking an hour of more out. So prospects for appreciation in high cost areas may now be far riskier than previously. Coincidentally, that reinforces some of the old rules emphasizing cash flow, including the 1% rule, however locally modified.
This article is useless for anyone who lives in New England and each coast. Where do you live Idaho?
@Sam Gagilardi – The 1% rule is pretty widely known, even if often not applicable in a particular location. Since the author included an example in SF, a pretty expensive city, and showed all the calculations for a beginner to think about, and showed the different ways a “less than 1%” strategy Could/May work — then I’m wondering what more you would have wanted to make the article “useful”. I’d love it if your next comment could help improve my knowledge.
Also pretty obvious WCI lives in Utah…
Sorry to waste your time. But I think I’d live in Idaho before I ever lived on one of the coasts again (and I’ve lived on both.)
I live in IDAHO and it has been phenomenal Geoarbitrage! I have 3 mortgages (my home and 2 investment townhomes that cashflow) that equal what my brother rents for a 2 bedroom SF apartment. This truly is the GEM State 😉
We live near Coeur d’Alene, Idaho, and it’s one of the most beautiful areas of the country and still very affordable.
There are a lot of beautiful places in Idaho. I spent a week on the Salmon River last summer. Gorgeous. I just got off the San Juan and it’s downright ugly compared to the Salmon.
[Ad hominem attack removed] the whole point of the article is NOT to treat the 1% as some inviolable rule.
No, it simply points out that in at least some high cost of living areas, rental real estate being a good investment often depends entirely on substantial property appreciation. Is that a good assumption? At least person who have already commented made that assumption and suffered as a result. If properties in HCOL areas continued to appreciate at a faster rate than inflation, they would eventually become so expensive that very few people could ever afford to buy them.
The bottom line is that rental real estate may not be a good investment in all areas of the country. That shouldn’t be offensive to anyone. It’s just math.
You can always be a landlord at a distance. Buy properties in areas where the math works out.
I’m a bit confused about your return calculation at the beginning. You said a person bought the property for $100,000, rented it out for $1,000/month. Assuming a gross margin of 55%, net is $6,600 per year. If property appreciated 3% per year, that’s an extra $100,000*3%=$3,300. So return is 9.6%. I’m able to follow all of these.
You went on and said that depreciation is $2,545 per year. So not all $6,600 is taxable. If your marginal tax rate is 42%, you save an extra $1,069 and that’s equivalent of a 1.1% return. And then you concluded that the overall return is 9.6%+1.1%=10.7%. This is where I am confused.
There’re 2 returns, before tax and after tax. The before tax return is 9.6% and that doesn’t change, in my opinion. Your tax from the rental operation, is ($6,600 – $2,545)*42% = $1,451.10. In other words, your after tax income from rental is $6,600-$1,451.1=$5,148.90. Assuming that you don’t sell the property and you keep that 3% property appreciation, your return, after tax, is therefore ($5,148.90+$3,000)/$100,000=8.14%.
So your before tax return is 9.6% and your after tax return is 8.14%, if you pay the property in cash. I don’t know where that 10.7% return comes from.
Am I thinking correctly?
You’re certainly looking at a it a different, and perhaps even better way than the way I did. I suspect I calculated an after-depreciation but before other taxes return. 🙂 But I’d have to go back through all the numbers to determine what exactly I did months ago when I wrote this.
Excellent and comprehensive post. Just a typo “your rate of return is just over 20% on your $3,000 down payment” I believe should read “$30,000 down payment”
Either that was already fixed by my content manager or you’re misreading it. Looks fine now.
Hi Jim, elementary question from a resident who has only ever rented – how is the mortgage paydown calculated in the above examples?
See the paragraph on leverage. Leverage generally increases returns, but it does so both ways, i.e. it increases risk.
But if you’re asking for “how to calculate the principal payment”, check out the excel function PPMT or a calculator on the mortgage professor site.
Awesome post! I tried to replicate this in Excel for future property analysis and I got a bit confused on the math behind the following:
*At 30% down, again following the usual 45%/55% rule, you would need to feed this property $67,000 per year – how is 67000 calculated?
*The mortgage was paid down by $24,000 – this is Principal only , correct?
Would you be so kind to elaborate? Thanks a lot!
I’m always amazed that years later people show up in the comments who actually want to redo the calculations in my posts, so over the years I’ve tried to “show my work” more and more frequently.
It’s probably been most of a year since I actually wrote this post so I don’t have some secret excel sheet showing the work. So I have to recreate it. So let’s see what we can do.
We’re talking about a property worth $2,324,798 with a 30% down payment. Looks like we’re talking about a 5% mortgage. I don’t know what term we were using, but let’s say 30 years. So the financial function you would plug into Excel would be:
=PMT(5%,30,-(2324798*70%),0) = 105,862
That’s your annual mortgage payment.
Since it only produces rent of $69,708 per year and has non-mortgage expenses of 45% * 69708 = $31,369, the cash flow is $69708 – $31369 – $105862 = -$67,523
Hope that helps.