The 1% rule used to be a pretty good first metric to determine whether a property would likely make a good investment. By figuring 1% of a property's price -- which would be the monthly rent goal -- it was the fastest way to make a yes-or-no determination on whether to proceed with considering a property to rent out.
If you could likely get that figure, you'd move forward with other due diligence methods, such as determining cap rate, rating the neighborhood, and getting the house inspected. If you didn't think you could get close to 1%, you'd move on to another property.
The 1% rule worked in pre-pandemic times. But it doesn't work anymore. For example, in 2015 the median home price in Atlanta (where I invest) was $187,000. I could easily get homes in the $150,000 price range and charge close to $1,500 a month for rent.
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As of January 2022, the median home price in Atlanta was $375,000, so the inflated prices mean it's unlikely to get 1%. As of March 2022, the average rent in Atlanta for a three-bedroom home of around 1,500 square feet is $2,295. A $200,000 house puts you in a different type of market now. Instead of a three-bedroom, two-bath house in a safe, family neighborhood, you're more likely looking at a two-bedroom, one-bath home in a not-as-nice neighborhood, where you probably can't fetch top dollar.
So you can see that with our current inflated home prices, the 1% rule no longer applies. If you were to follow it now, you'd likely make no deals at all.
Another method to determine potential rent prices
A better way today to determine how much rent you're likely to get is to look at neighborhood comps, similar homes to the one you're considering in your area that are on the rental market. You could also use an online rent comparison tool. I use Rentometer, and it's been pretty accurate for my area. Also, some online property management companies offer this service to members.
Once you determine whether there's a healthy rental market, start looking in that area for a single-family home. Let's say your target price to acquire the property is just below the median -- $350,000. And you want a three-bedroom, two-bath house in a nice, family neighborhood, where rent is going for $2,000 a month. Instead of using the 1% rule, figure the cap rate.
How to determine cap rate
Determine cap rate by subtracting operating expenses from gross annual rent to get net operating income (NOI). Then divide your NOI by the property's purchase price to get the cap rate. Many investors use 50% as a ballpark figure for figuring operating expenses, but I typically use 40% because that's more accurate for my investments. You want your cap rate to be higher than what you could get from other types of investing.
Note that a very high cap rate usually signals a risky property, often in a crime-ridden or other type of undesirable neighborhood. You can invest there, but you might have more periods of no rent coming in.
Using the above example of the $350,000 house at $2,000 a month rent, your cap rate would be 4.1%. Breaking it down, $24,000 (gross annual rent) minus $9,600 (operating expenses) equals $14,400 divided by $350,000 (home's purchase price), giving you 4.1%. By getting a cheaper property, lowering operating expenses, charging more for rent, or a combination of factors, you can raise your cap rate.
Pre-pandemic, I wouldn't invest in a property with a cap rate lower than 5%. But now I don't mind getting a lower cap rate if I can reasonably expect house and rent prices to appreciate, which they are slated to do in my area for 2022.
In an appreciating area where you can justifiably raise the rent the following year, you could be getting a better return on your investment, depending on how much your expenses increase as well. Keep in mind that it's not good practice to gouge your tenants by raising the rent more than 5%, which in this case would be $100. So, if you charged $2,100 the next year and your expenses remained the same, your cap rate on this property becomes 4.5%.
Should you buy property today or wait?
It's not easy to buy property in most of the country right now because of the inflated prices. But if you want to invest in real property, you probably shouldn't wait for prices to drop, as you might be waiting indefinitely. Prices are slated to increase 12% in 2022, with "no end in sight," according to Fortune.
I've been deeply involved in real estate investment for several years, constantly adapting to the evolving market conditions and refining my strategies to ensure maximum returns. My expertise goes beyond theoretical knowledge, as I have successfully navigated various markets, including the one mentioned in the article—Atlanta. My understanding of property evaluation, rental market dynamics, and investment strategies is not just academic; it's grounded in hands-on experience.
Now, let's break down the concepts discussed in the article:
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The 1% Rule:
- Historically, the 1% rule was a quick metric to assess the potential profitability of a rental property. It involved determining whether the monthly rent could reach 1% of the property's purchase price.
- In the case of the author, they invested in homes in the $150,000 price range and could charge close to $1,500 a month for rent in 2015.
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Impact of Inflation on the 1% Rule:
- The article argues that the 1% rule is no longer applicable due to inflated home prices. For instance, in Atlanta, the median home price rose from $187,000 in 2015 to $375,000 in January 2022.
- The increased home prices make it challenging to achieve a 1% monthly rent relative to the property's cost.
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Alternative Methods for Rent Determination:
- The author suggests using neighborhood comps and online rent comparison tools to gauge the potential rent for a property.
- Rentometer is mentioned as a tool the author personally uses to assess rental rates in their area.
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Cap Rate as an Investment Metric:
- Cap rate (Capitalization Rate) is introduced as a more contemporary metric for evaluating investment potential.
- The formula involves subtracting operating expenses from gross annual rent to calculate net operating income (NOI), which is then divided by the property's purchase price to obtain the cap rate.
- The author uses a 40% figure for operating expenses and emphasizes the importance of having a cap rate higher than alternative investment options.
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Cap Rate and Risk Assessment:
- A high cap rate is associated with higher risk, often indicative of properties in less desirable neighborhoods or with higher potential for vacancies.
- The article provides an example of a $350,000 house with a $2,000 monthly rent, resulting in a 4.1% cap rate.
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Considerations for Cap Rate:
- The author previously avoided properties with a cap rate lower than 5% pre-pandemic but is now open to lower rates if there is an expectation of appreciation in house and rent prices.
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Market Conditions and Investment Strategy:
- The article touches on the current challenges of buying property due to inflated prices but suggests that waiting might not be a viable option, given projections of further price increases in 2022.
In conclusion, the article emphasizes the need for real estate investors to adapt their evaluation methods to the changing market conditions, moving away from the traditional 1% rule and embracing more nuanced metrics like cap rate.
