The 1% Rule: Compare Apples to Apples

Real estate can be a tricky, complicated business. Even seasoned investors can find themselves overwhelmed by the influx of potential strategies. So when they’re offered one simple rule to cure all their real estate woes, they obviously jump on it.

According to the 1% rule, your property’s rent should be equal or be greater than 1% of the purchase price. If you can do that, logic says you’ll make good returns.

But investors shouldn’t stop their research there. Your property might follow the 1% rule, but if it doesn’t meet other measures as well, you may be making a costly mistake.

Property Taxes

The 1% rule says that if you buy a property for $100,000, you should expect to charge $1,000 in rent a month. But what if you’re looking at properties in two different markets?

To truly find the best property, you need to research property taxes. Let’s pretend that you’re looking into two properties: one in Pennsylvania and one in Alabama. The Pennsylvania home brings in a 1.2% return and Alabama’s is only a 0.95% return. Pennsylvania obviously seems like the better investment, right?

Wrong. In this scenario, Pennsylvania’s property tax is almost quadruple Alabama’s. In fact, whatever extra cash flow you get from the Pennsylvania property may be eaten up in property taxes.

Population Growth

When demand rises, appreciation does too, so don’t overlook population growth. It’s all about entering the market at the right time. Sure, your new property might easily hit the 1% mark, but if you lose 5% of the population each year, you should know the demand for your rentals will eventually decrease as well. Then vacancy can eat up your cash flow and drop your returns.

Demographics

Research property classes. Ask yourself if you really know the difference between B, C, and D neighborhoods. There’s a good chance you’re buying in a D or F neighborhood when crime rates are three and four times the national average. At that point, the 1% rule doesn’t matter as much. You might surpass the 1% rule, but eventually vacancies will kick your returns to the curb. Besides, fewer people in lower-class neighborhoods have the credit to get a loan, so your only exit strategy is another investor.

Property Management

Balance expertise with good prices. Good cash flow, after all, isn’t worth much if you’re spending it all on property management.

Look at fees. Property managers tend to charge the first month’s rent for placing a tenant, but another management company might only charge 65% of the first month’s rent.

It’s all about asking property managers the right questions and getting all the relevant data. Research some of the following fees:

  • Renewals
  • Lease-up costs
  • Turn costs
  • Monthly management fees
  • Renovations
  • Markups on maintenance

To make your life easier, choose to own more properties in fewer cities. That way, you can use one property management company for all your properties and avoid some major headaches down the road.

Final Thoughts

Ultimately, the 1% rule isn’t bad. It can act as a great starting point when you’re trying to determine return on investment in a given market. But alone, it can only tell you so much about your property’s overall likelihood of success.

Think of it as an ingredient in a recipe, not the entire meal. To really get the most from the 1% rule, consider other factors too, like property taxes, population growth, demographics, and property management. When you do that, it’ll be easier to focus on net cash flow and the other numbers that actually matter more.

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