February 28, 2016

Does The 1% Rental Rule Really Make Any Sense?

I'm not sure the 1% rule for rentals makes any sense.

If you aren't familiar with it, the 1% rule for rentals says simply that your rent for a rental property investment should be 1% or more of the purchase price.  So for example if the property costs $100,000 then you'd want a monthly rent of $1000 or more to pass this rule.

I have a few problems with the rule.   Mostly its applied too broadly and the exact costs differ too much for the 1% rule to really be useful.     I also don't know the origins or logic of the rule so I don't know how we could modify it to individual situations or to evolve over the years.

First big flaw I think the 1% rule has is that it is applied equally across the nation even though situations vary a lot.    For example, the property taxes and insurance rates are going to vary across the country but this is never accounted for in the 1% rule.   Here's an example of a couple houses to illustrate :

Texas :
Price $100,000
Rent : $1200
Tax : $2400
Insurance : ~$600
Tax and insurance = $3200 or 3.2%

Northwest :
Price : $100,000
Rent: $900
Tax : $1200
Insurance : ~$300
Tax and insurance = $1500 or 1.5%

The taxes and insurance alone are a $1700 annual difference or 1.7% of the purchase price.

I estimated the insurance rate for that Texas house.    But I think thats a fairly good guess.

Interest rates in 1980 were around 10%.    Today they are around 4%.   (see history of mortgage rates) If you finance the property with 25% down and a $75,000 loan then you would have been  paying $7500 a year in interest in the 80's and only $4000 a year now.   Thats a $3500 annual difference in interest you'd be paying from then to now.   Thats pretty huge.

Second, the 1% rule has been around for decades but hasn't evolved with the changes in the interest rate environment.   Interest used to be a lot higher in the past than it is today.  If it made sense to buy a house as a rental under the 1% rule in the 80's when interest was higher then it should make more sense to buy such a house today.

A house in Texas in the 80's could have had $7500 in interest costs and $3000 in tax and insurance costs for $10,500 total costs.   You'd almost have to hit the 1% rule then just to over your basic carrying costs.   You'd be a "success" with the 1% rule if you took a mere $1500 net a year.   If the house above with its $1200 rent was bought in the 80's then its net would be just $3900 after interest, tax and insurance.

Buying today in the Northwest by comparison you'd have $1500 in tax and insurance and just $3500 in interest and that $900 in rent would give you $10,800 gross for a net $5,800.   Yet this Northwest house at 0.9% rent / purchase is a failure.

If you combine the difference in interest, tax and insurance and buy in different locations in the 80's versus now then you could get :

Northwest house today :   Rent is 0.9% and nets $5800
Texas house in the 80's :  Rent is 1.2% and nets $3900

Yet the 1% rule has not changed and would have been applied the same in the 80's in Texas as it is today in the Northwest.

Third thing the 1% rule fails at is accounting for any other costs.    What if your rental has a HOA fee and it requires you to pay the water, garbage and heat?    Where does that money come in versus a property with no HOA where the tenant pays all utilities?     I have a single family home where I pay no utilities so those costs for me are $0.   My dad has a four plex where he has to pay water, garbage and (until recently) he had to pay the heat and its not in a warm region.   My dads bills for utilities would have been running easily $300-400 a month for that property or $75-100 per tenant.  My dad changed the heat setup a few years ago so he no longer pays those utilities.    But the 1% rule would treat these properties the same and doesn't consider the different utility costs.


No comments:

Post a Comment

I'm starting to get too many spam messages in the comments so I'm turning on moderation. Please be patient and wait for your comment to be approved. Note it may take up to a few days for approval, thanks. I've also had to remove anonymous posting of comments to cut down on spam and pure stupidity.

Blog Widget by LinkWithin