The Creative Investor - Rent Values - Debunking The 1% Rule Once and for All

The 1% rule appears to have evolved from a simple guideline to a real estate law. People are sticking to it and relying on it too much. The 1% rule states: “A property should rent (monthly) for 1% or more of the purchase price”. In other words if a property sells for $100,000 then the monthly rent should be $1,000. Or, if a property rents

for $1000, it should sell for $100,000. Let’s talk about what the 1% rule is and is not, and what it can and can not accomplish.

1% Rule takes into consideration:

Gross Scheduled Income

Price

………. That’s it. Nothing else. Nada.

1% Rule does NOT take into consideration:

Down payment

Amortization

Loan Rate

Market conditions (comparables, vacancy, etc)

Expenses

Mismanagement

Deferred Maintenance

Varying management Styles

Vacancy

Cash Flow

Etc….

Case In Point:
Even when there are many similarities, the 1% rule has some problems. Let’s compare 2 homes that are exactly the same in every way and right next door to each other. Incidentally the cap rate is the same on both also.

Example #1: SFR. Price $100,000 Gross Rents $1,000 per month, expenses $250 per month.
Down Payment $40,000
Interest only loan: 4%
Amortization N/A
Yearly Cash Flow: $5,000

Example #2: SFR. Price $100,000 Gross Rents $1,000 per month, expenses $250 per month.
Down Payment $0
Interest only loan: 80/20 loan at a 9% blended rate
Amortization 25 years
Yearly Cash Flow: -$1070 (Yes…that is Negative)

….now try comparing a 3% vacancy rate to a 15% vacancy rate in another area. A soft market to a hot market. Fully professionally managed vs a do-it-all handyman owner. Taxes of .3% to 2%. Fluctuating regional insurance rates. The 1% rule is only the very tip of the iceberg when it comes to financial analysis.

So Where Did It Come From:
You may have heard the term “Gross Rents Multiplier”. The “1% Rule” is derived from the same equation This is simply a ratio reflected by the price divided by the rent (you can use monthly or yearly…I’ll use yearly in my examples).

Price / Rent = GRM

Manipulate it algebraically and it can look like this:

GRM / Price = Rent Or GRM X Rent = Price

Using slightly different terminology from the definition above, “A GRM of 100 or less should be sought after when buying a rental property”. (100/12 = 8.3 if you’re using monthly rents). That is the exactly what the 1% rule states, after a slight algebraic manipulation. One of many problems is that a GRM of 70 may be normal in Ohio or 120 in Southern California.

So What Is It Good For? :
Every investor needs a method for coming up with a ballpark figure of value so that they can separate the real deals from the FMV properties. After all….if you don’t know what things are worth, how will you ever spot the deal when it does come along? You shouldn’t do a detailed cash flow analysis of every single property that comes onto your radar, as it much more time consuming. The “1% rule” is just ONE type of “quick and dirty back of an envelope” calculation, and probably the easiest.. It’s a method some investors use to crunch numbers in 5 seconds or less to see if a deal may be worth more exploration. You are a fool if your number crunching never goes beyond that. You need one quick and dirty method of analyzing properties AND another in-depth method for analyzing properties.

The 1% Rule May Not Be For You:
In some areas the 1% rule is very reflexive of FMV regarding both prices and rents. This may or may not be true in your area. You need to find your own “1% rule” so to speak. New York City is not Ohio. They are very different markets. The 1% rule may be dead on for a certain investor in Ohio and way off in New York. The New York investor may need a GRM of 71 (or we could call it the 1.4% rule). In my area, I look primarily at 2/1 rental units that are in the same area, similar values, and similar sizes. I often think in terms of “price per unit”. When something jumps out at me, I look at it more closely. This is where my analysis begins….not ends.

So Where Do I Go From Here? :
1. Learn your market. If you’re looking at 2/1’s to 3/2 homes around 1500 sq. feet in a given area, get to the point where you can drive by a house, and predict within a few grand what the asking price, selling price, and rental price of that house will be. This is what Dolf de Roos teaches when he says “look at 100 properties, make 10 offers, and buy 1” After 100 properties you’ll know the values and spot the 10 deals and bag the one.

2. Find out what numbers are reflexive them: Start crunching numbers. You may get a feel for numerical values in terms of price per sq. foot, GRM, or have your own “1% rule” (eg. 1.5%)

3. Use them! Suddenly you’ll be able to accurately estimate value in a few seconds. Keep in mind, prices, values, and rents may drastically change as you cross the tracks, the river, go east, etc. If they do, just do the same thing there.

There is power in knowledge. Soon you will get to the point where you know the value of the home better than the realtor, the loan officer, the appraiser, and the homeowner. It can be frustrating, but it empowers you and you’re on your way to being the first one to snatch up the great deals that do come along.