The 1% rule is common advice for cash flow rental properties.
It states that the monthly rent should be AT LEAST 1% of the purchase price of the property.
- $80k home, you’ll want $800+ in monthly rent
- $100k home, you’ll want $1000+ in monthly rent
- $120k home, you’ll want $1200+ in monthly rent
I’m going to tell you something counter-intuitive.
Your rental shouldn’t exceed the 1% rule either.
Why the 1% Rule Exists
You want to make sure your property cash flows. But keep in mind, the ultimate goal is to maximize your total return.
Every month you will collect the rent and pay expenses. The expenses include things you pay every month: mortgage, taxes, insurance, property management. It also includes putting aside money for things that happen frequently, but not every month: minor repairs, tenant turnover. And even expensive items that come up once a decade: new roof, HVAC, water heater, and bathroom remodeling. The latter 3 can easily be sorted by a single company such as the highly recommended plumbers in Port St. Lucie. Getting a new roof installed can’t be sorted by a plumbing-type service, unfortunately they can’t do everything. You would need to look into a seperate tiling/roofing service the likes of a roofing Colorado Springs company would offer.
If you have money left over after all those actual and projected expenses, you have cash flow!
Ok back to the 1% rule… it is a quick way to determine if the property is going to cash flow.
But how much cash flow? That is a more complex calculation with a ton of variables:
- How much tenant turnover is there in the neighborhood?
- What interest rate is your mortgage?
- What are the property taxes in the area?
- How much life is left on the major expenses like the roof?
Obviously it will be good to dig into those questions and calculate with more accuracy if you are thinking about purchasing the property.
But at first glance, is the rental even capable of cash flow? Just use the 1% rule.
If the monthly rent is 1% of the purchase price, you can keep investigating. But make sure the rent isn’t much more than that!
Wait… Isn’t More Rent Good?
Yes, absolutely. But what are you giving up to get more rent?
For this analysis we are considering properties that are at market price or just below.
If you put in the work to find an incredible deal, like sending out mailers that say “I want to buy your ugly house” or going to foreclosure auctions as seen on sites like Auction.com, that changes things. You are trading your effort for a lower purchase price. In that case you should exceed the 1% rule. Some people might even want 2% to make it worthwhile.
I am currently purchasing properties through turnkey providers – they do the purchase and rehab, then sell the finished product to an investor. They might claim the property is worth more than the purchase price, but it really isn’t. If they could sell it for more, they would. Maybe they price it 5% lower to sell it quickly, but that is still pretty much market price.
So if the purchase price is fairly fixed (when you pay someone else to do the work and take on the risk of rehab), that leaves rent as the variable to look for in the 1% rule.
This is where people get in trouble. There are three reasons this can be an issue:
1. Expenses Aren’t Always What They Seem
Let’s look at a snapshot of a city right now. Here are some ballpark numbers you can get in Memphis:
- A neighborhood
- $120k price
- $1100 rent
- 0.92% ratio
- B+ neighborhood
- $100k price
- $1000 rent
- 1% ratio
- B- neighborhood
- $80k price
- $875 rent
- 1.1% ratio
- C neighborhood
- $60k price
- $800 rent
- 1.3% ratio
The quick 1% rule analysis shows ratios improve on cheaper properties. What do you think? Go with the best ratio?
What would actually happen if you owned all 4 of those properties for the next 15 to 20 years? Would the cash flow match that pattern? Keep in mind the cash flow is rent minus expenses…
I bet there would be a tightening effect when you consider actual expenses.
Worse neighborhoods are going to have more vacancies. The tenant moves around every year and doesn’t treat the property as well.
Better neighborhoods? You are more likely to get a tenant for multiple years, who treat the property well, leading to minimal repairs.
The quick 1% rule is misleading even for cash flow.
2. Appreciation Potential
You’ll often hear from cash flow investors that appreciation is the “icing on the cake”. Meaning it isn’t the main reason they invest.
I don’t quite agree. You need cash flow to keep the investment sustainable, but the biggest part of the return over the 15 or 20 years you own the rental? Without a doubt, appreciation. Especially if you understand the power of smart leverage.
Let’s not chase appreciation in a stupid Miami high-rise condo sort of way, but let’s keep it in mind as a cash flow investor.
We just looked at the numbers today for different classes of neighborhoods in a city like Memphis. Would you expect different appreciation potential for a C property and an A property?
I would, mainly due to the selling options. With class C properties, often the tenant can’t qualify to buy a home. They are stuck renting without a choice. If you sell, it likely will have to be to another investor, so the properties are less liquid. As you get into nicer neighborhoods, you’ll find tenants who can to qualify for a mortgage, and the potential to sell to an owner-occupant.
More interesting – what if the city and time isn’t held constant?
Let’s look at some potential numbers for a city like Dallas 4 years ago:
- A neighborhood
- $140k price
- $1200 rent
- 0.86% ratio
- B+ neighborhood
- $120k price
- $1100 rent
- 0.92% ratio
- B- neighborhood
- $100k price
- $1000 rent
- 1% ratio
- C neighborhood
- $80k price
- $875 rent
- 1.1% ratio
The deals in Memphis would have been better too. The A class properties might have been around $100k with a $1000 rent, right at the 1% ratio.
So the A property in Memphis would be the same as the B- property in Dallas. Same cash flow numbers, which one do you think has greater appreciation potential?
When prices are down, you have the option to chase appreciation while still getting cash flow.
Where we are right now in the real estate cycle? In Dallas you might get a C or C- property at the 1% rule. Not something I’m interested in.
More: How to Visualize the Real Estate Cycle
3. Your Mental Health
I hope you aren’t approaching rental property investing as a get rich quick scheme.
If you can make over a 20% return a year (like I think you can), you will eventually have a pile of money, but it is going to take a decade or two.
The biggest predictor of success in rental property investing is how long you hold the properties.
What is it going to take to keep you in the game that long?
Fewer headaches. Pay a property manager and let them do most the work.
But also keep in mind the neighborhood and class of property play a role. If you try to beat the 1% ratio by sacrificing in this area, expect to deal with more ish.
Don’t try to be a superhero, you might burn out. Trade a little bit on the ratios to improve your mental health and stay in the game.
Your Rental Shouldn’t Exceed the 1% Rule!
Does it make sense to sacrifice on cash flow to gain in other areas?
With the strategy of paying close to market rate and waiting for 1-2 decades, do you agree your rental shouldn’t exceed the 1% rule?
How about each of the individual points. Do you agree:
- Expenses aren’t always what they seem
- Greater appreciation potential can be smartly chased
- Your mental health is worth supporting
I’m into turnkeys too and I have the same philosophy. It does sound sexy however to have 10 paid off properties… but not at a price point if 20k each. You can bet that the turnover costs will be high.
I’m in escrow now, for another one which I’ll pay for in cash. It took a while to get there, but I like the feeling of a free and clear property to add to my leveraged ones.
I’d like to probably get one more and then start de leveraging. I’m at #4.
Awesome! I think it is smart to have some free-and-clear, while fully leveraging the others. People who do the extra mortgage payments on all their properties are going about it the wrong way. Save up a lump to either pay off 1 property completely, or like you did, get another one.
Personally I’m not trying to live off cash flow any time soon, just reinvesting it. So for me it makes sense to be fully leveraged (in conservative properties). I have a couple decade timeline, and over that time, leverage plus moderate-appreciation is the greatest part of the return. Are you hoping to live off the cash flow soon?
I’m older, so yeah, that’s the game plan to have them or most of them paid off in 5 years. It won’t be a huge portfolio, but certainly enough to have me work 1/3 of the time to have my monthly expenses covered.
When I started this a few years ago, I was thinking of 30 units or so with about half of them leveraged. As time went on however, I realized that managing that much even with property management in place could still be a headache.
I think with 5-6 paid off properties can give me my current standard of living, and having them in different markets/locations will help mitigate the risk of vacancies/expenses/local economic factors.
This remains in theory however, but I think it may work.
That is awesome! I love that real estate investing can be adjusted for any person’s age, goals, amount of effort, and even money.
Isn’t it wild that just 5-6 paid off properties can get you the cash flow you need? That is such a small number and can be attained by most people, especially if they start early.
I’m sure my plan will adjust as I get a larger portfolio. Right now I have 2 properties in different cities with different property managers. I don’t want to keep doing that for every property, so hopefully I can interface with less people and discuss a larger % of my properties all at once.
I like this. We have a B+ neighborhood property that is around 0.5%. It wasn’t intended to be rental property, but life happens. We have no trouble getting high quality tenants and they tend to stay for a long time.
We also have a 1.25% property in C neighborhood. While the inside of it was great, the outside needed extensive repairs. The tenants are a little more difficult.
As you go lower in rent, you tend to get lower-income people. It’s a trade-off and it seems like the markets are priced efficiently when I look at things. I’m not usually seeing a unicorn of a 1.25% in an A neighborhood that’s in tremendous condition.
Glad to hear the rule applies to your area. In fact, that is an extremely steep ratio drop from C to B+. I suppose things are always more extreme on the coasts.
I agree completely – it is a trade-off. You can’t have everything in life, nor can you have everything in your rental property!
Nice post title, Brian! Made me want to read more.
I agree that PMs are the way to go. They will save your sanity (unless you like getting down in the trenches). I’ve done both, and it makes me appreciate my PMs even more.
And, I’d certainly want 2 properties over just 1 with more cash flow (all other things equal).
I’m looking forward to the next cycle!
I also want 2 properties rather than 1 with more cash flow, which is a big part of my refi / reinvestment strategy. It is the opposite of people who try to pay off the mortgage early.
Agree with you on this. I was listening to a personal finance podcast where the guy who is a real estate investing newbie talk about the great returns on his property. Mainly he was talking about the numbers and cashflow. It was a cheap $50k property with a section 8 tenant…he owned it for a few months. Yea, the numbers might look good in the beginning but it’s a long term investment. And you are absolutely right…I don’t like it when people downplay appreciation. It’s probably not a good idea to buy a cash flow negative property hoping for appreciation but it doesn’t mean you shouldn’t care about it at all.
Glad to hear someone agrees with me on this! As much as cashflow rules, it isn’t everything!
Of course … I’m not sure how things play out with a $50k property and section 8 tenant. Maybe the first 5 years go well and return the initial investment on cashflow alone. But it might be more risky putting all your chips into cashflow rather than spreading them among the other components of return.
This is severely embarrassing, but I’m at 23 rental units right now and I’ve never thought from this perspective. Thanks for taking the time to write this out! All my properties were purchased right around the 1.0% zone, and they are all in the same market, and I looked for [generally] the same class of property. I was also searching for something 1.0%+ but now that I see 2.0% could have been devastating (if I’d found it), I’m glad I didn’t.
I’m selling two duplexes right now (under contract) because I’m getting 0.65% for them and I bought them for 1.0%!
Seems like I’m following your advice without realizing it.
No embarrassment necessary! It is kind of a counter-intuitive idea.
Did looking at the 1% mark allow you to get a better class of property than the 2% ones? It would be interesting to look back a the lower-cost areas that you could have had higher cashflow to see how the appreciation would have been different.
Congrats on selling the duplexes after a huge gain – are you doing a 1031 exchange into more properties? Or just paying taxes on the profit?
Did looking at the 1% mark allow you to get a better class of property than the 2% ones?
*Yes, it certainly did. I don’t think I would have seen nearly the appreciation on the 2% ones. Probably less than half. Most of my gains are unrealized, though.
Congrats on selling the duplexes after a huge gain –
*Thank you! It is bittersweet. I want to hold everything forever, but property taxes and insurance are going up (due to values growing) and rents aren’t!
…are you doing a 1031 exchange into more properties? Or just paying taxes on the profit?
*I had planned on doing a 1031 exchange, because the tax savings are tremendous. I even looked into spinning them into vacation rentals that I could utilize, because Section 1031 allows you to still use them personally the greater of 15 days or 10% of rented days to arms-length non-family folks… but ultimately I opted to just recapitalize and pay off some private lenders.
The websites mashvisor.com and rented.com looked pretty interesting, but my instinct is to “know” the markets a bit better than just using web-data.
I love unrealized gains! Think of it as wealth over spending money.
I like the metric! My ratio for a property I want to sell is .32%. It’s in San Francisco, and the ratio might actually be lower than that give and I haven’t found a new tenant yet.
Would you sell? I’m very tempted. The appreciation since 2005 has been very strong.
Sam
Ya things definitely skew in SF. I think of it as more supply-and-demand pricing with a fairly fixed supply. Small changes to demand can have big results, my guess wouldn’t be any better than anyone else’s.
The cashflow markets I invest in, I think more about replacement cost. Kind of like in the stock market valuing based on PE ratios and book value. Much more numbers based and easy to understand.
I would also be tempted to book some of that profit, fearful of a dip in the market. If you do decide to keep it, you could refinance to access that cash. Yes, sounds crazy. Have you heard that quote along the lines “If you owe the bank thousands, then the bank owns you. If you owe the bank millions, then you own the bank.”
If you own 20% and the bank 80%, and the property drops 30% in value, you owe more than the house is worth. This is a problem for the bank and they are incentivized to give mortgage modifications. Meanwhile you got a pile of money you are hopefully earning a greater return on than the cost to access it (your mortgage rate).
A larger mortgage balance sounds risky, but when you think of equity as providing 0 return (if it isn’t paid off entirely), diversifying by pulling it out doesn’t sound so crazy. Obviously cash reserves and margin of safety are important.
(For someone looking to build wealth and ok with putting in some hassle to get there, I would recommend looking into a 1031 exchange into multi-family in a cashflow area. When the market does turn, it will be much more gentle there, maybe 15% peak to trough not 30%, plus you’ll be getting 3x the cashflow. Then when you feel there are killer deals in SF, you can do another 1031 exchange, probably getting 2+ properties with the same money.)
I just fear the IPOing of Airbnb and then Uber will see a multi-billion flood of demand into the SF Bay Area real estate market, causing prices to jump even further. We are cheap compared to London, NYC, HK, and Singapore. With domestic demand + international demand, SF seems like it’ got a lot of room to run.
I’m in contract now as the buyer came up to my counter. But I don’t feel good about paying the 4.5% commission. Just feels dumb. So, I may try to get out of it still! Either way.. I think things will be OK. I’l’ hire a property manager.
It feels dumb selling when you don’t need to sell. But my LTV is only about 32%, so the asset is no longer a huge performer for me.
Sam
Ya I don’t doubt SF will be in demand for a long time. I just have no idea how that maps to real estate prices on a 5 year time-horizon and doubt the experts really know either. But you’ve been monitoring SF prices for a lot longer than I have, noticing how several hundred buyers post IPO can have a big effect. Or if you are cool with a 20 year time-horizon.
That’s great that they accepted your counter offer. Commission definitely hurts but it is the price to access the equity (same with refi fees). When you think about it as an under performing asset, it can make sense to bite the bullet and move it into something that will earn a greater return.
I just wish the price to pay was Lower given the Internet has lowered all commission cost everywhere. I guess 4.5% is better than 5% or 5.5% or 6% as some people pay.
I just don’t think I can deal with holding onto the property and all the maintenance required and stuff like that for the next 20 years. If I didn’t earn online income, I would’ve held on for sure. But on one income is blowing rental income out of the water right now. It is unexpected.
Also, can you imagine having to pay $22,000 a year in property taxes for the next 20 years? It actually pisses me off. The buyers want to $20,000 credit after reading the home inspection report and receiving ridiculous estimates from a general contractor.
Hmmm. So conflicted. A decision will be made tonight I guess whether to give them the credit or partial credit.
What do you think? Sell for $2.73M on a home that was purchased for $1.52M in 2005 and simplify life? Or ride it to perhaps $4 million in 20 years based on a growth rate of 3.5% a year and give my son a leg up in what will be a much more expensive rental and probably market in th and give my son a leg up in what will be a much more expensive rental and prop market in the year 2040!
Mortgage rate is only 2.35% and the rental income is about $9000 a month if I can find a new tenant to pay the last tenant’s rent.
I need to make a decision tonight!
Thx,
Sam
Well I can give a couple more things to think about, but in the end it is a personal decision and you are the one that lives with it, so I wouldn’t recommend taking anyone’s advice.
The first thing was the 5 of 20 year timeline.
Next is imagining a few different scenarios playing out and if you’d be able to live with your decision. If you keep it and the market softens over the next 5 years, would you be ok with that risk? If you sell and were right about SF being undervalued / IPOs, would you be ok missing out? And more scenarios – what “worse case” scenario are you ok with?
I think Forrest’s comment below is excellent. Your gut will often tell you what you want to do.
People often rationalize what they “should” do over what they want deep down. A tell for that is if there are too many reasons why they made the decision. For example if you said you were going to sell because property taxes, tenant issues, good profit, 3 people you talked to said to, diversify, etc. That seems like rationalizing.
You need 1 great reason, 10 good reasons don’t cut it. If you can say you are going to sell to simplify because it’s not worth the time compared to blogging, then you have your 1 primary reason. There might still be 10 other good reasons, but someone confident about their decision knows those are secondary. These are the people who make decisions without regret.
Sam, I may be too late on this response, but I wanted to chime in with something that’s been helpful to me. (By the way, I’m a reader on Financial Samurai, though I’m not sure I’ve ever commented…)
Obviously you already know that your overall portfolio and risk tolerance should inform that decision in front of you.
For me, the key part of that equation that is dynamic is the risk tolerance. We often don’t think about the fact that we are human beings… we may have a high risk tolerance at age 20, and lower at 35. Maybe not, just depends on the person probably.
My experience is that my risk tolerance is dynamic, rather than static. While I don’t toss out my “financial plan” with mood swings, if I notice a trend line occurring, I might make big changes based on that change in risk tolerance.
Mostly the context here is: When I was single, when I was married, when I had my first child… etc.
If you are truly questioning right now, and discovering more uncertainty, you might benefit from taking some time to just listen that “inner voice” if you will… hear it out completely. You may not make your decision based on what it says, but maybe you will. Perhaps your risk tolerance has changed a bit, and the questions you are asking are a trigger or a cue that could heighten your self-awareness.
I noticed you mentioned your son… that’s why I bring this up.
If your decision is tonight, I’d just suggest trying to get 20 minutes with a coffee, candle, whatever helps you quiet your mind, and just listen to your self. Your right-brain has something to say. Just my two sense. (Cents?)
Howdy Forrest,
Thanks for sharing. Nice to hear you read my site as well. What do you think are the reasons why you’ve never commented b4? I’m always curious to know reader’s mindsets.
Onto the property, I’ve already accepted an offer that I thought I could live with after a counter ($2.75M), but now I’ve got a new counter $20,000 lower due to the inspection report ($2.75 goes down to $2.73). It’s not a huge amount based on the percentage, and the fact there are some new things the buyer needs to do. But it just feels rotten to pay the buyer’s real estate agent a $68,500 commission (2.5%, and 2.5% of my total 4.5% commission I’m paying) who is working AGAINST me. I feel like I’m getting robbed.
It feels morally wrong and I feel stupid for paying that much to what is essentially my adversary. Then of course there is about $150,000 in long term capital gains tax to pay. So spending $285,000 to sell this property seems painful, yet I long so much for less stress and simplicity, which is why I accepted the counter in the first place.
I’ve been thinking about this whole process for 2 weeks now. Now I’m looking for justification one way or another. For example, I’m looking at perma bear sites like Wolf Street and Socketsite for justification to sell. Even though those guys have been wrong for so long, they eventually will be right 🙂
To Brian, yes, my #1 overriding reason is rental income is a small portion of my overall income now that’s causing more stress than necessary. I was going to sell the house for $1.75M in 2012 if someone gave me an offer, but nobody did. Now, someone has given me an offer for $1M more. It seems like it’s time to just bite the bullet on commission, taxes, and fees and sell.
I think I’m going to counter with giving a $10,000 credit this afternoon, instead of giving them a $20,000 credit. The good thing I feel is that I’ve pushed them to their max of affordability, otherwise, they wouldn’t be asking me for all these concessions.
Sam
That’s funny you went out looking for reasons to justify what you want to do! Good luck with the counter offer!
You can find a viewpoint that justifies ANYTHING you do.
I like to generally look at the other side of why I shouldn’t want to do anything first.
RE: What do you think are the reasons why you’ve never commented b4? I’m always curious to know reader’s mindsets.
I can’t think of any particular reasons. I probably will eventually. 99.9% of blogs I read, I don’t participate in commenting, although I like reading the comments