When analyzing a potential real estate investment property, it becomes oh so easy to over-complicate the process. I often feel like the most important thing to do while searching is to find the right property in the right neighborhood. My personal philosophy is that it’s always better to buy the ugliest house in a good neighborhood than to purchase the best looking property in a crummy location.
Don’t Waste Time
With that said, a lot of investors waste a lot of time running the numbers. Some folks will run calculations all day long, until they’re blue in the face, and still not know what to do! We’ve all been bit by analysis paralysis at some point, and most newbie investors make the mistake of focusing too much energy on the math.
Don’t worry about the math. Dedicate your time to finding an awesome property in a desirable location.
Quite frankly, the math behind analyzing a deal is extremely simple. The most important thing to do is not overlook any hidden fees or expenses. So, it’s always important to do your due diligence and err on the side of caution (use conservative numbers). If the property still cash flows reasonably well, you’re good to go!
The 1% Rule
Here’s a rule-of-thumb that is extremely useful (and will save you a lot of time) to use when analyzing a property — the 1% Rule.
The 1% Rule states that the gross monthly income of the property must be at a minimum, 1% of the purchase price.
Let’s illustrate with an example property from Dallas.
The gross rent is $1550/month. The purchase price is $155,000. This property exactly meets the 1% Rule.
Dallas is a good example to use because the property taxes and insurance are typically higher than what you’ll find in most other markets. In other words, if the numbers work in Dallas (Texas), they should definitely work in a cheaper location. This example also allocates 6% of gross monthly rent to vacancy and maintenance reserves. Property management fees are 8%. Pretty conservative numbers all around. HOA dues are also included and accounted for.
As you can see, since the property meets the 1% Rule, it cash flows. This isn’t always guaranteed, but I’ve found this to typically hold true. My own personal rule-of-thumb is that if the property fails the 1% Rule, I immediately cross it off my list. There’s no need to waste any more time on such a property, because in today’s market, it’s easy to locate properties that do meet the 1% Rule.
Exceeding the 1% Rule
When I look at the numbers for a property, and I see that the gross monthly rent exceeds the 1% Rule, I immediately get excited. This is usually a good indicator that the property under consideration has a lot of cash flow potential.
Let’s use an example from Indianapolis.
The gross rent is $1075/month. The purchase price is $92,000. This property exceeds the 1% Rule (1.17%).
Wow, a cash-on-cash return of close to 20%! That’s something to get excited about. Assuming the property is located in a fabulous neighborhood, this is the type of deal I would jump on.
Note: Indianapolis is a market that has lower property taxes and insurance than Texas. Comparing the two directly would be like comparing apples to oranges. There are different reasons (not numbers specific) for investing in each one.
But let’s revisit the same Dallas property and revise the rent to match the 1.17% ratio found In Indy.
Gross monthly rent adjusted to $1811.14. The purchase price remains the same as before, $155,000.
For a market like Dallas, 13.08% cash-on-cash is a very solid return. Again, I would pounce on this deal!
The 2% Rule
Once upon a time (2009-2012), it was possible to locate very desirable single family homes in good neighborhoods that would cash flow so tremendously that they would meet the 2% Rule! That’s right… 2%!!! These days, it’s next to impossible to locate such deals. The rebound in housing prices across the nation have made these deals a thing of the past.
However, if you are daring enough to venture outside of the good neighborhoods, chances are reasonable that you’ll still be able to locate properties that meet the 2% rule. Generally, these properties are priced around $25,000 to $50,000. In many cases, the 2% Rule is achieved because these cheap houses are actually duplexes. If each side rents for $500/month, you can see how it’s possible.
Sub $50,000 properties are what you are most likely looking at though. The odds of finding $100,000 properties that rent for $2000/month are not very good. If you scale up further, the odds of finding $200,000 properties that rent for $4000/month are zero… Yeah, those don’t exist. Rents don’t scale with purchase price as most everyone in the Bay Area, New York, L.A., Seattle, Boston, etc. know.
Let’s analyze a 2% Rule deal.
This is a duplex. Each side is a 3/1. The gross rent is $1000/month. The purchase price is $50,000. This property meets the 2% Rule.
With duplexes, the owner typically has to pay for utilities (unless individually metered) and landscaping. However, even with all these extra expenses added in, a property that meets the 2% Rule will still cash flow fantastically. In this example, the cash-on-cash return is an outrageous 31.91%! Honestly, I’ve never ever come across such a deal. The only properties I’ve located that cash flow this well are in areas I would be hesitant to invest in. But maybe you’re a pro and can locate them.. if you do, you’ve just found yourself a cash flowing gem!
Failing the 1% Rule
As I mentioned above, if a property fails to meet the 1% Rule, I won’t even consider it. I don’t like taking risks… Yes, I don’t mind taking on a lot of debt (I want to get to 10 loans), but I consider it low risk if each property meets or exceeds the 1% Rule since they will cash flow reasonably well. In the first example (Dallas), even if you had to reduce the monthly rent by $200/month, you would still break even. And this is with maintenance + vacancy reserves already factored in. See, I told you I’m conservative.
Let’s look at a property in the Bay Area. Well, you can pick any property because they will all fail the 1% Rule these days…
The above property is a real example of the cash flow returns in the Bay Area today. For a conventional downpayment of 25%, the property will not cash flow! Unless you’re buying for appreciation (which should not be considered investing since it’s more like speculation), you really have no business sinking money into this non-investment. You’ll be out-of-pocket $250 each month!
This property fails the 1% rule since the rent to purchase price ratio is only 0.67%. This is a big reason why so many Bay Area investors (and other investors who live in expensive areas) choose to invest their capital elsewhere.
The math behind real estate investing is very easy and straightforward. You can use the 1% Rule to save yourself a lot of time. This rule will help you quickly filter out properties that are bad investments, since you’ll know right off the bat their cash flow potential without having to dig deeply into any real analysis.
If the property meets or exceeds the 1% Rule, you can then go on to crunch the numbers.
If the property fails the 1% Rule (and you’re not buying for appreciation potential), discard it and move on to the next one.
Math made simple. Happy investing!