Readers Ask: What If I Can’t Hit One Percent?

rental house one percent rule

Many of my readers are rental property investors (or aspiring investors). But not all of them live in “cheap locations.”

Several readers have asked what how to invest if they live in a place¬†where houses don’t meet the One Percent Rule.

Let’s answer this question by featuring Brian and Kristin, a couple in Arlington, Virginia, who wrote to me asking:

“My question is about your 1 percent rule for rental housing. What do you think about that rule when applied to the high-cost area where we live?

“The cost for a tear down where we would like to own rental properties is $400,000 – $500,000. Rents are all over the board and vary widely by proximity to metro/restaurants/schools. Generally you find $2,500 – $4,500 for a 3-4 bedroom house. The low end is suitable for college kids/roommate living and the high end is for families with kids.

“We … are currently in the hunt for (rental) houses in the $400,000 – $550,000 range. All of the houses will need work, (ranging) from … new cabinets to full-on additions.

“(We expect) to have a 3-4 bedroom house that’s worth $650,000 – $750,000 (after renovations) that we rent for $3,200 – $4,000. We may not make much on rental income, but we would be growing a nest egg in the value of the resale of the house down the road — be it 5-10 years down the road.

“We’re curious on your thoughts.”

Dear Brian and Kristin –

I crunched the numbers at the low end of the range — $3,200/mo gross income on a house valued at $650,000. I assume you net 70 percent of the monthly income after expenses (although that’s a generous assumption — the industry rule-of-thumb is that you’d net 50 percent).

You’ll net $2,240/mo, or $26,880 a year. Your cap rate is 26,880/650,000 = 0.041, or 4.1 percent. So right off the bat, I’d say that you should make sure your interest rate on the loan is lower than 4 percent.

(Ideally you want a big spread between your interest rate and your cap rate, because you’re taking on a risk. Investors call this spread a “risk premium,” a fancy way of saying that they get paid for the risk they carry).

Historically, homes nationwide have appreciated at a long-term annualized average of about 6-7 percent, which makes them a comparable (though slightly worse) choice than stocks for the long-run.

But Arlington, VA has appreciated at an annual rate of 3.9 percent since 1990, according to Neighborhood Scout.

So, again, you want to make sure your interest rate is substantially lower than the returns you’ll be getting. It looks like the return you’ll get is about 4 percent, based on historic long-term appreciation in your area. That means your interest rate should be around 2 percent.

What if you can’t get a teeny-tiny interest rate? Here are two options:

#1: Dedicate a significant amount of time scouting out the best deals. You just need one super-undervalued property to make your personal numbers substantially better than the general average. You can beat the average in rental properties if you buy the right house.

#2: Look outside of Arlington. Imagine a bunch of concentric circles on a map, with your hometown as the epicenter. If there’s nothing that meets the One Percent Rule in your hometown, expand your search to the next ring. Then the next one. And then the next one.

I lived in Boulder, Colorado for 8 years. I never found anything in Boulder that meets the One Percent Rule. But when I expand outward to a small city called Broomfield, Colo., I can find plenty of rentals that meet the One Percent Rule.

Also: When I talk about “metro Atlanta,” I’m referring to a place that has a population of 5.2 million people. That’s eight times more populous than Vermont. It’s a bigger population than the entire state of Colorado.

I can’t paint a massive metro area with one giant brush. Sure, there are some pockets — like east of Panthersville — where I can buy a foreclosed home for $21,000. But there are other areas in Atlanta where a 1,500-sq.-ft. condo sells for $355,000. Location, location, location.

If I only looked in neighborhoods where I’m willing to live, my quest to meet the One Percent Rule would be a lot harder. (It took me a year of fruitless searches to figure this out. Here’s the ah-ha story that I wrote when I did. Learn from my mistake; you’ll save time.)

By expanding outward, I can find better deals — and so can you. Keep looking. Don’t give up.

Good luck.

Cheers,
Paula





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20 Responses to “Readers Ask: What If I Can’t Hit One Percent?”

  1. alana
    11. Dec, 2012 at 8:00 am #

    yes, bring on the real estate stories. As someone who really wants to get into leasing properties, I always find myself looking forward to your next real estate post so I can run numbers of my own. Real estate is your plan for wealth generation and financial freedom so it’s all related in your view of universal personal finance. Dont hold back on us, keep them coming!

  2. Little House
    11. Dec, 2012 at 9:59 am #

    I just checked out the one-percent rule and that’s a great way to determine if a house is worth the trouble. In my area, I’d have to search 15 – 20 miles outside of where I live. Not a problem if I was serious about buying a rental property. I’m still on the fence. Ha, ha, ha! ;)

  3. Sustainable Life Blog
    11. Dec, 2012 at 10:53 am #

    Really enjoying the real-estate stuff paula. I’d like to get into it sometime, but am waiting until I have a bit of extra cash.

  4. PK
    11. Dec, 2012 at 10:59 am #

    I’m down for more real estate posts – but as you know, I love the pictures you bring (even the rotten bathroom floor pictures).

    Here’s another hint: you can buy near family or close friends who don’t live near you, and perhaps hire them in case of an emergency at the property where you need someone on site (or have them help you get a cheap and reliable management firm.)

    Not ideal, but better than overpaying…

  5. vmongo
    11. Dec, 2012 at 1:37 pm #

    I just read your other post “Here’s the ah-ha story” (left a post there, but figured this post is more current to comment on) and am curious about the financing of your income properties. You had indicated a 10% down purchase. How are you qualifying for an investment property with only 10% down? In California lenders will only lend on an investment property if you have at least a 25% down payment. Am I missing something?

  6. Mrs. Pop @ Planting Our Pennies
    11. Dec, 2012 at 8:02 pm #

    Just curious where your 70% assumption comes from?

    We run a bit lower than that currently by the time you add in taxes, insurance, and allowances for maintenance and occupancy rates.

    • Afford Anything
      13. Dec, 2012 at 5:48 pm #

      @Mrs. Pop — The rule of thumb for apartments is that 50 percent of gross income goes toward paying operating expenses. But apartment complexes need hire a full-time staff, maintain a parking lot, landscape, pay commercial property taxes rather than a residential rate, buy commercial insurance rather than a residential rate, pay higher legal, bookkeeping and accounting fees and and sometimes also pay for the residents’ water.

      Based on that, I make the assumption that a single-family home will see 30 percent of its gross revenue go toward expenses (management, repairs, maintenance, insurance and taxes). It’s a 20 percent discount over the apartment-complex rule of thumb.

  7. Katie
    11. Dec, 2012 at 8:16 pm #

    Hmm, great advice. I live in Chicago and we would definitely need to either score a stellar deal or search in areas we wouldn’t consider living to meet the 1% rule. My husband and I have talked about starting with purchasing rental properties by finding 2 or 3 flat (very common here) that we would “owner occupy” and also use as an investment property. How would you approach the 1% rule in the case of a property that will serve as our residence and our investment?

    • Afford Anything
      12. Dec, 2012 at 2:10 am #

      @Katie — I’d estimate the “fair market value” of the section that you’re occupying. For example, let’s say you have a 2-bedroom. You live in one of the bedrooms and you rent out the other bedroom for $700 a month. Assuming the two bedrooms are roughly the same size/quality, the “fair market value” of your own bedroom is also about $700, so the whole unit is $1400.

  8. elb
    13. Dec, 2012 at 3:07 pm #

    Another nice way to get started in high-cost areas is to owner-occupy for your first few properties.

  9. Blair@LifeDollarsandSense
    17. Dec, 2012 at 8:40 pm #

    I always look forward to your real-estate posts! I have been researching and learning as much as I can on real-estate now since I don’t have the funds yet. At first I felt that I was forced to invest where I live, but the more I read the more I realize that I don’t have to constrict myself (im 24 and i know im going to move and not settle in one place yet). I know that I do and will live in places that don’t make sense to invest. So I am actually learning about investing in other states in a very “hand off’ manner and what that actually entails.

    • Afford Anything
      20. Dec, 2012 at 6:28 pm #

      @Blair – You’re absolutely right; you don’t need to restrict yourself. Plenty of successful investors have houses in that are hundreds of miles from where they live. (In fact, investing groups based in New York, D.C. and Boston are starting to pour money — remotely — into Atlanta real estate. It’s actually a little annoying for those of us living in Atlanta, because now we have to compete with these New York investors, who generally have more money than we do!)

      My one piece of advice: Visit the place you invest. You’ll learn a lot about the location once you see it in person. But don’t feel restricted to only places that are close to where you live. Would you rather be able to drive by your rental house … or would you rather deposit a bigger check every month? :-)

  10. Johnny C
    25. Jan, 2013 at 2:24 pm #

    Dear Paula,

    First of all I just discovered and absolutely love your website and perspective on life!… not in that order.

    I’m wondering if you can help me understand the 1 percent rule as it applies to this simple situation.

    I thought about purchasing a $400,000 home in an affluent community with extremly highly sought after schools and I thought the math worked out well enough until I applied the 1% rule.

    It is common for families to rent in this town until they can find the house they would like to purchase, and a 2 bedroom like the one I wanted to purchase typically rents for $2700, though you can find them for $2500.

    When I pondered the deal in the following manner I thought it was attractive: List Price = $400,000; I put 20% down, therefore mortgage amount = $320,000; assuming 3.433% (perhaps this is my error: I assumed a rate for a primary residence, rather than for a rental) my monthly mortgage payments + property taxes + insurance = $1892. Even if I were to figure some vacancy and repairs (this place was just upgraded, so I felt repairs were a long way off) I would think a rent on the lowside, of $2500, would be more than enough to have some positive cash flow, or at least to break even.

    Yet the 1% rule would advise that if I can’t get $3200, I should walk away. I don’t doubt the 1% rule; rather I want help in understanding why this deal is not solid.

    Thanks,
    John

  11. Shannon
    05. Feb, 2013 at 10:21 am #

    I think people just need information. Banks made buying a house scary. Why buy a house when you can have it taken from you in a hot minute. Not litteraly but you know what i mean. Just a couple intrest points will send you overbudget. I thank you for this information. Even if your not buying right now its good to have in your back pocket.

    • Afford Anything
      05. Feb, 2013 at 3:59 pm #

      @Shannon — Get a fixed-rate mortgage. Your interest rate and monthly payments will never rise, which means you won’t go overbudget. Many people will adjustable-rate mortgages regretted their choice when their payments skyrocketed.

  12. Ray Douglas
    10. Mar, 2013 at 9:41 pm #

    Hi, I have only been in the Real Estate business for a couple of years in Ca. I like your 1% rule good info and advice.I like a lot of people want to be an investor.Thanks again.

  13. Kyle
    01. Jun, 2014 at 2:44 pm #

    Paula,

    You mentioned in the post that “Historically, homes nationwide have appreciated at a long-term annualized average of about 6-7 percent, which makes them a comparable (though slightly worse) choice than stocks for the long-run.”

    So how does one decide to even bother getting into real estate rather than just putting all their money into the stock market? Is it just about monthly cashflow when talking about real estate? If I had $100,000 to invest, why wouldn’t I just put it in the stock market for a more long term gain?

    Thanks!

    • Afford Anything
      01. Jun, 2014 at 3:11 pm #

      Great question.

      You earn money from real estate in two ways:
      1) Cash Flow
      2) Appreciation

      As a rental property owner, your primary motivation is Cash Flow. If you receive any Appreciation, it’s “icing on the cake” — a bonus, rather than the main course.

      If you follow the One Percent Rule, your Cash Flow will be 6 to 9 percent, making the house a fantastic “dividend payment” source. If the property then appreciates by another 6 percent, you’ll end up with a 12 to 15 percent total return. Read more about that here, in the “one percent rule” subsection.

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