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.


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