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: Many people who read Afford Anything (mistakenly) think that Atlanta is an awesome place to invest. But you must realize that 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.
Atlanta isn’t a one-size-fits-all market. I can’t paint such a massive metro area with one giant brush.
Sure, there are some pockets of metro Atlanta — like east of Panthersville, Georgia — where I can buy a foreclosed home for $21,000. But there are other areas in Atlanta where a 1000-sq.-ft. condo sells for $450,000. Location, location, location.
If I only looked at my own backyard, my quest to meet the One Percent Rule would be a lot harder. I put that in bold because this is a crucial lesson. Almost everyone who emails me, looking for permission to be the “exception” to the One Percent Rule, cites the reasoning that there’s nothing in their backyard that meets that requirement. Well, guess what: There’s nothing in my own backyard that fits the One Percent Rule, either. That’s why I expanded my search outward, in bigger and bigger concentric rings, until I found neighborhoods that have properties that fit this rule.
(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.