August 12, 2014

The 1% Rental Investment Rule - Is it Still Valid?

The 1% rule for rental properties basically states that for a property to be a 'good' investment as a rental the rent should be at least 1% of the property cost.   For example if a property costs $100,000 then the rent should be $1,000 a month or more for the numbers to work in your favor.

I would have thought I would have written about this more than I have.   I mentioned it in a way in a post back in 2008 How to value rental property prices.   But then I referred to a 100 x rent price rule, rather than calling it the "1% rule".

I can't seem to find any detail on the origins of the 1% rule.  I don't know who came up with the rule of thumb or how they figured the 1% number.   When I search the net I see lots of references to the rule but nothing about its origins.   I remember the 1% rule being cited by my father decades ago.   That must have been in the 80's or 90's, so I know its been around a long time.  

One thing that has made me wonder if the 1% rule still holds as well is the interest rate changes over the years.   Mortgage interest rates have dropped considerably over the past couple decades.   Todays rates are significantly lower than they were just 10 or 20 years ago.    If the 1% rule was designed when typical interest on a mortgage was 7% then they assumed larger carrying costs than you'd have today.   For example if you're paying 7% interest on a $100,000 mortgage then that is $7000 a year but today you can get a rental mortgage at 4.5% so you'd pay $4,500.   Thats a $2,500 difference in cost to the owner.   With such an interest change, else equal, you could get the same end resulting profit out of a rental with 80% as much rent compared to paying that 7% rate.  

On the other hand I'm not sure if the 1% rule actually assumes you have a mortgage.  It might just be based on getting a return on capital without any consideration of carrying a mortgage.   Since I don't know the origin of the 1% rule I don't know what it assumes or how they came to the 1% figure.   Maybe they assumed you were buying the rental with cash and then just looked for a basic 8% return on your money and assumed 33% expenses.   That would end up with the 1% rule.    But they might have targeted an 8% return on the money based on relatively low appreciation of the property or maybe they thought 8% was good compared to 12% annual stock market returns.    I don't know.

Unfortunately since I can't find any detail on how the 1% rule was originally devised I can't tell if its assumptions hold up over time.   Its just a rule of thumb and should be treated as such.   As rules of thumb goes it works well enough.  What you really want to do is run all the numbers and decide if the investment is a good one or not based on the specifics.    You can't universally apply the 1% rule to all properties and expect to get the same results.


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