Forget fancy-pants calculus.
The most important math is the stuff you learned in fourth grade.
How do you know if an income property (rental property) is a good investment?
In this article, I’m going to share three formulas I use when I’m analyzing rental properties.
Keep a copy of this article as a free PDF so that you can refer to these formulas later, when you’re looking at your own deals. You can download this for free here:
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Formula #1: The One Percent Rule
Start with The One Percent Rule: Does the monthly rent equal one percent of the purchase price or more?
- A $100,000 property should rent for at least $1,000 per month
- A $200,000 property should rent for at least $2,000 per month
- A $300,000 property should rent for at least $3,000 per month
If the property meets (or almost meets) the One Percent Rule, it merits further consideration.
Otherwise, ignore the property and move on.
Note: When I say “purchase price,” I’m referring to total acquisition cost, which includes upfront repairs to make it rent-ready.
You might buy a $245,000 home that needs $100,000 in immediate repairs, which is why it doesn’t make sense to only count the sales price of the home.
Should All Properties Get Measured by the Same Yardstick?
Some investors believe that One Percent is too lenient. These investors shoot for the “Two Percent Rule,” which means they collect $2,000 per month in gross rent for every $100,000 of house.
Those types of properties tend to exist in high-risk neighborhoods. There’s a tradeoff between risk and reward.
Properties are classified as Class A, B, C, or “War Zone”:
- Class A: High-quality-tenants; safe neighborhoods; low turnover and vacancy.
- Class B: Mid-quality-tenants; moderate neighborhoods; some turnover and vacancy.
- Class C: Low-quality-tenants; crime-plagued neighborhoods; high turnover and vacancy.
- War Zone: Terrifying.
Class A properties should meet the one percent rule. Class C properties should meet the Two Percent Rule. Avoid War Zones unless you’re a seasoned professional.
Example:
Excellentville is a stable neighborhood with high rental demand. Most tenants have high incomes, stables jobs and perfect credit. Many are saving for their own home, or choose to rent so their career/romance opportunities can remain flexible.
The tenant risk is lower, so your returns will also be lower. Look for the One Percent Rule here.
CrapTown, in contrast, holds a high crime rate. Most tenants have bad credit and bankruptcies; many bounce from job-to-job every few months. Many houses are vandalized and robbed.
The tenant risk is higher, so your returns should also be higher. Demand at least the Two Percent Rule in these areas.
Why Use the One Percent Rule?
Where did the One Percent Rule come from? Why do we use it?
- If a property grosses 1 percent of its value per month,
- And if there are 12 months per year,
- Then the property grosses 12 percent of its value per year.
(I hope you follow me so far.)
Now, let’s introduce another concept called the 50% Rule-of-Thumb. This concept says that 50% of your gross revenue will get consumed by operating overhead, such as taxes, insurance, utilities, management, maintenance, repairs, vacancies, turnover costs, pest control, administration, etc. This is a generalized rule, intended for a back-of-the-envelope calculation.
You won’t literally pay 50% every calendar year; you’ll enjoy years in which your repair bills are $0. But you’ll also experience years in which you spend $50,000 replacing the roof, windows, gutters, siding, appliances, deck and flooring. As a long-term annualized average, the 50% rule-of-thumb is the typical standard among investors.
So:
- If a property grosses 12 percent of its value per year,
- And approximately half of this consumed by operating overhead,
- Then the property nets 6 percent of its value per year.
Still with me? Good. Okay, final step:
There are two ways that investments create returns:
- Appreciation
- Cash flow
Stocks, for example, create returns by rising in value (appreciation) and paying a dividend to its shareholders (cash flow).
Real estate follows the same lead: it creates returns by rising in value (appreciation) and creating an income stream (cash flow).
We’ve established that if the house meets the One Percent Rule, the net operating income will be approximately 6 percent. We also know, historically, that real estate typically rises at the level of inflation, around 3 percent.
So:
- If we generate 6 percent returns via cash flow,
- And we create 3 percent returns via appreciation,
- Then we enjoy total return of 9 percent.
There’s one more piece of data you must consider.
The U.S. stock market historically returns 9 percent over a long-term average (1871 – 2015). Over the past 30 years (1985 – 2015), the market returned 11 percent. Keeping this in mind:
- If a property meets the One Percent Rule, it holds a strong chance of matching or beating an investment in a broad market index fund.
- If a property doesn’t meet the One Percent Rule, ask yourself: why wouldn’t you just put that money into an index fund, instead?
A few disclaimers:
- This is a quick back-of-the-envelope calculation. If you want to drill down into the real meat of an investment, calculate the Cap Rate (which I explain below).
- There are other reasons why you’d invest in real estate over an index fund; even if total returns are comparable, real estate cash flow might be stronger than stock dividend yield, which matters if your goal is passive income. Real estate also offers tax benefits. Real estate also gives you the opportunity to use leverage, which may introduce additional benefits (as well as additional risk); we discuss that in more detail below.
- The One Percent Rule’s strongest intention is to force you to consider whether or not a property is worth your time. Index funds are easier and more liquid; don’t stray from those unless you find a property that gives you a good reason to invest your money elsewhere.
Formula #2: The Cap Rate
If a house passes the One Percent Test, I look at a measure called the capitalization rate, or “cap rate.”
The cap rate measures your cash flow, relative to property value. Cap rate equals annual net operating income divided by the acquisition price.
“Uh, what?” – Don’t worry, that sounds like gibberish to me, too (and I wrote it!) Let’s walk through an example.
Let’s say that you’re looking at an investment property that you could rent for $1,200 per month. First, let’s calculate the potential rent at full occupancy. This is the best-case-scenario.
Then we subtract a reasonable vacancy estimate. This gives us our “Effective Gross Rent.”
- Potential Gross Rent: $1,200 per month, or $14,400 per year
- Less Vacancies: ($720 per year) at a 5 percent vacancy rate
- Effective Gross Rent: $13,680 per year
Next, we’ll add any other income sources that are associated with the property, such as pet fees or coin-operated laundry income. Let’s say that this comes to $500 per year. We’ll add this to the Effective Gross Rent, and we now have a new yardstick: the Gross Operating Income.
- Effective Gross Rent: $13,680 per year
- Plus Other Income: $500 per year
- Gross Operating Income: $14,180
Next, we’ll subtract the operating overhead. These are the expenses associated with running the property, such as utilities, water, trash, repairs, management and maintenance. It doesn’t include the principal and interest on your mortgage (I’ll explain why below), but it does include insurance and property taxes.
For the sake of example, let’s say these expenses come to $6,180 per year.
- Gross Operating Income: $14,180
- Less operating overhead: ($6,180 per year)
- Net operating income (NOI): $8,000 per year
Congrats, you know your net operating income, also known as “NOI.”
To find the cap rate, divide $8,000 (your NOI) by the total acquisition price of the house. Let’s assume your house cost $200,000, including closing costs and upfront repairs.
$8,000 / $200,000 = 0.04
Multiply your answer by 100 to convert it into a percentage. The $8,000 in cash flow you’re receiving translates to a 4 percent cash flow return on your property value.
Meh. Yawn.
I’m not excited about that.
Let’s change one variable: Let’s assume you bought the house for only $100,000.
$8,000/$100,000 = 0.08, or 8 percent.
Much better! At that rate, you’re getting cash flow that exceeds most high-dividend stocks. Assuming the property value keeps pace with inflation (around 3 percent annually), your total return is around 11 percent per year, two-thirds of which come in the form of cash flow.
Properties with an excellent cap rate also meet the One Percent Rule.
Take another look at the example above:
If you buy a house for $200,000 and collect $1,200 monthly rent, you won’t meet the One Percent Rule. But if you buy it for $100,000 and collect $1,200 monthly rent, you exceed the One Percent Rule. Winner!
If It’s Not Worth Owning in Cash, It’s Not Worth Owning
Notice that we’re calculating “net operating income,” not “net revenue.” This sounds like an inconsequential distinction, but it carries a crucial implication: We subtract operating expenses, but not debt servicing or equity-building expenses.
That last sentence is so important that I’ll repeat it again:
Operating Overhead is the cost of running and maintaining the property. It’s NOT the cost of financing the property.
Net Operating Income is the money leftover after you’ve paid operating overhead. Don’t confuse this with your cash flow (after paying the mortgage); these are not the same.
“You mean, I should exclude the mortgage from this calculation?”
Not exactly.
Mortgages consist of four parts: Principal, Interest, Taxes and Insurance. These are collectively called PITI.
When you calculate NOI, you subtract the cost of T&I (taxes and insurance), because they’re part of your operating overhead. This is a permanent cost associated with homeownership. Death and taxes, right?
You don’t subtract the cost of P&I (principal and interest), because these build equity and service debt, respectively. These are not operating expenses; these are temporary financing and equity-building expenses.
“Okay, I understand not subtracting for principal repayments. But why wouldn’t you subtract the interest?”
We’re trying to evaluate the asset itself — the property — not the attractiveness of the loan.
#1: Let’s use an extreme example, for the sake of illustration: All properties will look terrible with a 99% interest rate. Many properties will look awesome with a 0% interest rate. We want to judge the property itself, not the strength of the financing.
#2: The ultimate goal is to own the properties free-and-clear. (Even if you’re a debt-hungry, no-money-down advocate, you’ll want to pass your properties to your children and grandchildren free-and-clear). You’ll need to ask yourself: Is this property WORTH owning in cash?
If a property isn’t worth owning in cash, it’s not worth owning. If it doesn’t yield at least a 7-9 percent total return (which means it needs a Cap Rate of at least 5%), you’re better off searching for a different properties that does.
First evaluate the property, then find good financing. Don’t conflate the two.
Quick Cap Rate Hack
Here’s another quick, back-of-the-envelope way to eliminate properties based on cap rate:
Multiply the cost of the property by 0.05. This is your yardstick. [You can create a yardstick with any measure. If you only want 7% Cap Rate properties, for example, multiply the cost of the house by .07.]
Then:
Step 1: Add the monthly operating costs.
Step 2: Subtract that figure from the monthly rent.
Step 3: Multiply the result by 11.5, which assumes two weeks per year of vacancy. (Multiply by 11, or even 10, if the property is in a high-vacancy area). Compare this to your yardstick.
If Step 3’s number is bigger than the yardstick, pursue the property. If not, drop it.
Here’s a hypothetical example:
Property: $125,000
Yardstick: $6,250 (= $125,000 x 0.05)
Step 1: $100 insurance + $200 taxes + $50 maintenance + $100 management + $100 miscellaneous = $550
Step 2: $1000 monthly rent – $550 expenses = $450 monthly net income
Step 3: $450 x 11.5 = $5,175 per year NOI
The number in Step 3 doesn’t measure up to the yardstick; therefore this property might not be the best use of time and money.
(Notice also that a $125,000 house, renting for $1,000 per month, doesn’t meet the One Percent Rule.)
Don’t Drink the Kool-Aid.
Formula #3: The Cash-on-Cash Return
There’s one more formula that you’ll need to know, but I want you to be ultra-cautious about the way in which you use this. This is one type of return in which you may want to limit your upside.
The formula is called cash-on-cash return. It’s calculated as your cash flow divided by cash-out-of-pocket.
Let’s look at an example:
I buy a house with a $20,000 downpayment. After paying all the bills (including financing), I’m left with $3,000 per year.
$3,000 / $20,000 = 0.15, or 15 percent! Holy moly!
That’s … almost too good to be true!
This formula illustrates why real estate is so powerful: it’s one of the safest ways to leverage your dollars. A minor investment can yield 15% – 25+% cash-on-cash returns (or more). And, admittedly, leveraging into real estate (which is a relatively stable asset) is safer than leveraging into stocks or small businesses.
These are also the reasons why real estate attracts a bunch of debt-loving weirdos.
No other type of investment gives the average Mom and Pop Investor access to this much leverage. As as result, real estate attracts people who espouse a more-is-better attitude towards debt.
“If my downpayment is zero, my returns are … infinity!!!!!! Wheeee!”
Don’t be a debt-loving weirdo.
Take the cash-on-cash formula with a gigantic grain of salt. (Heck, take it with a whole damn salt shaker.) When used indiscriminately, cash-on-cash-return is a dangerous equation. It rewards people who take out the biggest possible mortgage, without contextualizing its results relative to risk. You don’t want to fool yourself into ignoring the inherent risks that come from six-figure debt.
“Yeah, I have zero equity and $872,490 in debt. One vacancy, coupled with a large repair bill, could wipe me out. I’d destroy my credit, lose my life savings and move into Cousin Joe’s basement.
“But I’ve been an investor for four months and I haven’t hit rock-bottom yet!
“And my cash-on-cash returns are quadruple-digit!!”
There are experienced investors. And there are over-leveraged investors. But there are no experienced, over-leveraged investors.
Eventually, the debt-loving, over-leveraged weirdos get wiped out of the game.
If you use the cash-on-cash-return formula, decide on an optimal range. You don’t want your returns to be too high.
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I occasionally hang out at real estate investor meetups. One afternoon, a new guy walked into the room. He was in his mid-20’s, and he had just bought his first investment property.
“I only put down $600 of my own money!,” he boasted.
“Why’d you put down that much?,” another guy replied.
Ughhh. *Forehead slap.*
Don’t start a pissing contest about who made the smallest downpayment. “Mine is smaller than yours!”
Nobody wants to see that.
Don’t drink the cash-on-cash Kool-Aid.
If you use the cash-on-cash-return formula, set strict parameters. Pick an optimal range, and recognize that some returns are waaayy too high. The higher your leverage, the higher your risk of default. This is one formula in which you can have too much of a good thing.
The Bottom Line
Of all these formulas, the One Percent Rule is the easiest and most intuitive.
Cap rate is the most comprehensive.
Cash-on-cash is great if it’s used wisely.
Use them all. Your success (or failure) as a real estate investor happens before you buy.
Note: This article was updated in 2015 & 2016 to address FAQ’s.
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Those are awesome tests. I especially like the one percent rule of thumb. I’m not in the market to do any rental stuff but if I did, I would for sure use this post.
Real estate investing is very tricky indeed, but you did a fabulous job of demonstrating what to look for as far as ROI, and it was easy to understand. I like the real life examples, they really brought your point home.
This is a fantastic write-up! I love reading about other’s investment strategies.
I’ve only seen cap-rate applied to commercial/multi-family properties but it makes a fine rule of thumb in this case too. However, I think strictly speaking, cap-rate doesn’t include your mortgage payments but it does include all of your other operating costs (including management, even if you do it yourself). This makes it easier to have an “apples to apples” comparison of properties while taking stuff like mortgage rates and credit scores out of the equation.
Another rule of thumb you have probably heard of is the 50% rule: in long-term studies of residential real estate, they found that expenses approach 50% over a long time horizon. Many will say that if you can make $100/mo after the 50% and your mortgage, then it’s a good deal. Personally, I’m skeptical of this rule but many investors swear by it.
I’m looking forward to more posts like this!
@DollarDisciple — Thanks!
I’m 100% skeptical of the 50% Rule (haha — that’s my weak attempt at a nerdy real estate joke). 🙂
The reason I’m so skeptical is because rental income and operating expenses are “independent variables” — you can adjust one without affecting the other. Here’s a post I wrote about why I’m dubious of that rule — http://affordanything.com/2011/10/24/how-i-make-70-per-hour-working-from-home/
That being said, it’s a good rule for the sake of first-pass, back-of-the-envelope calculations. It doesn’t carry as much heft as actually calculating the operating costs (and therefore the Cap Rate), but it’s handy for rule-of-thumb purposes.
Haha, love the real estate humor! 🙂
You make an excellent point in that linked article. And I completely agree that rent and expenses are not correlated. They increase (or decrease) independently for different reasons. But they do have one common factor: inflation.
I think the 50% rule was established for apartment complexes anyway. I like to think of it as a *really* conservative rule of thumb. Though, I don’t really use it either 🙂
Great job on the write up. I use the same 3 metrics when deciding if a home is a good investment. Do you use any other metrics beside the three listed?
To breakdown my 1st rental property.
1 percent rule: I get 3%
Cap rate: 14.36%
Cash on Cash return: This number is over 1000% Why? I bought for 30k (price+repairs) the appraisal came back high so I took out 33k. So technically I got paid 3k to do this deal. At this point I do not have any of my own cash invested in property 1
With the 33k in hand I bough property two for 30k (purchase + repairs).. the cycle goes on and on and on..
@YFS — Wow, congratulations on that Cap Rate!! That’s impressive!!
Among these three metrics, the One Percent Rule is my favorite, since it’s so easy to do in my head. The minute I hear the stats on a property, I know if it’s a good deal or not. If some says, “this will cost $50K (purchase plus repairs) and will rent for $1,000,” I’m like, “Cool, let’s dig deeper!”
I’m looking at a house now that’s on the market for $30K, and needs probably another $20-$30K in repairs, and it’ll rent for about $700 – $800. I’m feeling ambivalent. It’s an alright deal … not awful, but not great.
The property you’re buying is gonna pass your 1% rule. Is there any possible appreciation? That might make the deal a really good one in the long run.
In the area I invest the most I will pay for a property + repairs is 30k. I typically get 800-1000 depending on how many bedrooms the place has. I am to get section 8 tenants so of course the more bedrooms the better. I’m currently in the process of buying a place for 16.5k and it will only require 7k in repairs with the estimate rent being 850.
I expect this property to appraise and allow me to pull 33k out. Meaning another cash on cash victory. Then on to the next deal.
@YFS — I haven’t ventured into Section 8 territory yet. Many people love Section 8 because the government guarantees the majority of the rent payment. That said, there’s also the risk that a tenant may potentially damage the space. Some investors love Section 8 properties; others steer clear.
I have heard similar stories about section 8 tenants trashing your property. I did a bit of digging and found two interesting things
1 – The damage is mainly due to wear and tear from the tenants being in the property longer than say someone with a 9-5 job. This extra time causes more
2 – The selection criteria for someone to get on section 8 is actually pretty tight. Section 8 tenants may actually be better tenants than non section 8 in a few ways.
If a section 8 tenant causes issues you (as a landlord) can report them and have them removed from section 8. So it does not benefit them to screw you as it screws them in the long run.
I tried my hand in real estate but did not apply the 1 percent rule and had to walk away from the deal. My main thing right now is the stock market and peer to peer lending.
I do plan to get back into real estate though.
Great article!
Dale
Thanks Dale!
Those are excellent points, and in the intervening time since my original writing, I’m warmed up to the notion of Section 8 tenants, in part because I’ve met many other real estate investors who have success with renting their properties to Section 8 tenants.
My advice to anyone who wants to pursue Section 8 renting is the following:
Make it your niche. If you’re a beginner real estate investor (e.g. fewer than 5 properties), you’re best served by focusing on just one niche and one strategy, as outlined in this post. Master that niche, dominate it, and learn everything that you can. Expand into other niches only after you’ve freed up enough time and mental space to dominate two spheres of the real estate world.
The engineer in me likes this type of post…great How To tips. …and I agree with leverage in the real estate market being less risky than the stock market for one other reason: the chance of having your risk “called” because of a couple bad days are nearly nonexistent in the real estate arena. In stocks, because they’re revalued so often, the chance your leverage turns against you is much, much greater.
@AverageJoe — I figured this post would appeal to engineers, accountants and all other math-types.
You know, it’s funny. I never liked math as a child. I never, ever (EVER) would have imagined myself writing a math-centric article like this one.
But the more I invest, the more I realize that many people make decisions based on speculation. “Oh, I think the price will go up.” “Oh, I think that’s a good deal.” There needs to be a standard, a metric, to evaluate houses — and math / formulas are a good one.
And I agree — leveraging stocks is RISKY business!! You (as an individual) have zero control over the stock price, and leverage can really accelerate your loss.
The fact the real estate is just a pure “numbers game” is one reason I was attracted to it in the first place. Of course, I’m an engineer too… 🙂
I love that I can run all the numbers and pretty much know exactly how much money I’m going to make before I even buy the property!
The one percent rule is a nice, simple way to begin the decision making process. Takes the emotion out of the equation.
Engineer here! At work while we’re coding we like to discuss real estate (we’re pretty hardcore…) and the 100x Rule and its variants (50x, 75x) and some of the things we talk about. We get into heated battles about how to predict maintenance and what to do about HOA (if a condo is poorly run? HOA will increase and eat directly into CoC return). Also beware the special HOA assessments!
Nice article!
@PKamp3 — LOL! It sounds like I’d love your workplace (well, besides the engineering part!)
Wonderful Article. I love the break down process.
Just a thought on the cap rate where I am buying the property for 100% cash. If I had a $100,000 in cash, I’d leverage it by buying 5 properties worth $100,000 each with $20,000 down payment on each property.
Now, I could collect rent as long as I wanted to on these 5 properties or if the prices went up in a few years, I could sell them for a profit. Say for example, after 5 years of ownership, real estate market jumps and all 5 properties are now worth $115,000 each … That’s a $75,000 profit on capital gains alone. The rent you pocketed in these 5 years is ON TOP of the capital gains. This could result into well over a 100% return altogether in just a few years time.
There ain’t no game like real estate in town.
Thanks Paula for the wonderful article.
This was a great and useful post. Could you provide a post on how to protect yourself from legal liability? My family is looking at purchasing a rental, but is concerned about getting sued if something goes wrong. It’s not clear if the property itself needs to be held in a LLC. Thanks if you can address this soon.
@Carol —
(1) Assuming that you don’t have a Due on Sale Clause within your mortgage, file a quick-claim deed which transfers the property into an LLC.
(2) Use a separate entity for the property management. (Or outsource this, for ultimate protection!)
(3) Finally, buy an “umbrella policy” to insure against claims — this policy is cheap (often less than $10 per month for $1 million in coverage).
Thanks for the response. Can I ask what amount of coverage you get for $10 or less per month? I imagine there is regional variation.
@Carol – It’s an umbrella insurance against liability, and it’s cheap because it’s a last-case, worst-case scenario insurance.
Is the umbrella policy inder your llc? Or is it personal?
Thanks,
Andréa
Andrea –
The policy should be purchased by whomever is listed as the owner of the property.
“(2) Use a separate entity for the property management. (Or outsource this, for ultimate protection!)” – do you mean another LLC?
This is a nice article or information. I like this.Your one percant rule is a very good rule and also the real estate strategy is very nice..Your post is really a very nice post.
I would not call it the 1% “rule” but more like the 1% suggestion. 3 years ago in Atlanta it was close to impossible to make that 1%. Now its more like the 1.2-1.3% or even higher. It’s a guideline and just a quick check but it really has no mathematical backing.
@Luis – It’s a “rule of thumb.” Rules of thumb are just meant to be general guidelines.
The formula explained to evaluate a property’s income potential was an excellent way to select some property. I was just passing by this article and it has suddenly helped me in home purchasing. These rules of thumb are now my bookmark as for every property I will definitely calculate my margin like this. Thanks a lot!
Great post! I would love to know if you think this applies to places like Seattle, where the cost of real estate is much higher. I could see this definitely working in some parts of the country, but does this also apply to high cost areas? How would you adjust for that? Or does this article imply that you would not invest in this kind of area? Is this about finding the miracle deal? I have been told many times that the miracle deal does not actually exist.
We bought a duplex for 575,000 which we get 3500/month for between both units. And I always thought that was pretty good until I read this article! It’s in a highly desirable area and it is rented to stable professionals with perfect credit. On the other hand, my parents own a house in a very sketchy neighborhood in Arkansas that is maybe worth $50,000 which they rent for $500/month. They always have problems with that house.
Thanks again for a great new perspective on gauging these investments!
Sam-
I agree with you.
I have a similar property. We paid 350k for a duplex that rents for $2500 a month combined. It’s in a FANTASTIC area and we also never have problems renting to professionals with perfect credit. We have thus far have never had a vacancy and our current tenants have been there for nearly three years. I don’t really see how you can apply the 1% rule equally to Class A, B, and C properties. Yes I have less reward (debatable) but I also have less risk. This rents all day long to great tenants who don’t trash the place. Since no one trashes it and it’s so popular, we spend minimal time screening because everyone is great, and since I never have a vacancy (new tenants move in two days after the previous tenants leave), my .07% may well yield as good a ROI and ultimately as high a cap rate as the 1% rule property mentioned on this website that remained vacant for months. Ultimately it’s about cap rate and ROI , not the 1% rule. There are many models out there that work. I think for people starting out the 1% rule is very safe, especially in marginal areas. But it’s not the only way to be a successful investor.
Love the website and love Ms. Pant’s amazing success.
Where is everyone getting these figures from and which cities are you buying property. In Canada you need 20% downpayment for rental properties. So can someone please xplain how they getting to buy houeses with 20-30k downpayment. That would mean the house purchased is 150k
which i have never seen a home like this.
When I look for rental properties i look in major cities like toronto, and close to the downtown core.
I purchases a rental property with cap rate of 5.15%
cash on cash return of 25.7%
the 1% rule really doesnt make any sense to me and dont expect to be buying houses close to major city downtown cores and expect 1% rule to work out
@Manny — Then look for houses away from downtown cores. Go where the good deals are.
There are no such deals in Canada. And the fantastic deals in the US are getting harder to come by as the market improves.
Even to be cash flow positive in Canada you’ll need a suite in a regular home and you need to Airbnb or VRBO it furnished to get anywhere close to 1% – which is def not passive income. Straight rentals just won’t get you to 1% return in any market in any area of Canada I’m aware of, not to mention the down payment you’ll need and the LOC on this is much higher here.
Your examples just don’t work for Canadians and Canadians cannot generally borrow to invest in rental properties in the US, most would need to use a HELOC and pay cash, and never mind that the Canadian dollar is now about 35% less than the US dollar or the fact that the taxation of US property is a disincentive AND you can’t do DIY yourself.
I believe that Australians are in the same boat.
Where does that leave Canadians? Not being able to follow your example but still being able to have a fairly good long-term return with strategic purchases. And appreciation is going to be the saviour in some high-priced markets… but that is a waiting game and not certain.
I own 8 units, 6 rented furnished and 1 unfurnished. I couldn’t retire on the income despite the fact that the value is over 2 million, but we do live rent free and pay about 1/3 of our expenses with the net income. They will pay themselves off over time and hopefully appreciate so the leverage is valuable.
In Canada if you had $150,000 to invest you might be better off with dividend investing or Couch Potato for better short-term returns.
I’d encourage you to check the assumption that “There are no such deals in Canada. ”
Really …. there are no deals ANYWHERE in the ENTIRE nation??
Are you sure?
You might be right. As I repeat on this blog many times, my information is specifically U.S.-based. But if you really want to be a rental investor, spend dozens of hours (as I do) searching for deals. Look at foreclosures. Go to auctions on the courthouse steps. Look in rural areas.
Deals don’t come to you. You need to go to them.
And it definitely depends where you are looking In The U. S. I just looked at MLS listings locally and found a great duplex that would rent for $1400 listed for $71000 in a local Cleveland suburb. (some of us binge readers read the comments, too!) 🙂
Thanks @Hotdog! Yes, I LOVE the Midwest and the South (among many other parts of the U.S.) for some of the great deals that people can find. 🙂
This statement simply is not true. There are lots of opportunities in Canada for these types of buildings.
Take a look at Brantford, Simcoe and rural cities on outskirts of urban sprawl. You will find the commuters and retired people that sold off their high priced homes to use that equity as part of their retirement moving into a newer house for less money.
I recently purchased a 4 unit townhome for $250,000. This investment will bring in $2800 in rent / month. Has an NOI of $27180.00 and a cap rate of nearly 11%
Does the cap rate method take into account the expense of a monthly mortgage payment? In addition to monthly maintenance and utilities, would you include your mortgage payment as an expense? Or are these strategies for investors who are purchasing properties with 100% cash? I want to make sure I could calculate an accurate ROI if I were to take out a mortgage loan with 20% down.
Thanks!
Great question, John.
Anytime you’re calculating the return on a property, you should always — intentionally — remove the principal + interest portion of the mortgage payment, but include the taxes + insurance portion.
Why? Because you want to make an apples-to-apples standardized comparison of how the properties perform, regardless of the financing structure that you establish. Your first tasks is to evaluate each property on its own merits, to see if it’s viable. Once you find the property that gives you the best returns, you then look for the best financing arrangement possible.
Taxes and insurance are part of the operational expense, so you include those in your Cap Rate calculation. But debt servicing is the second step, and it’s unrelated to the underlying performance of the house itself.
As a non-cash buyer (20%) I run my calculations with the cost of interest included in all properties. I do this across the board a marginally higher rate that is currently being offered by banks and brokers.
I find this allows me some wiggle room for errors that may have been made in the evaluation or surprises that show up in the early stages.
I don’t use this as part of my CAP Rate calculation. I use it in the total profit calculations. I am an Excel guy so have created a spreadsheet laying out the profit / loss for all my searches. Typically this gives me a more dynamic view of what to expect.
Similar to your strategy, I run the calculations with varying rents, non payments and best case scenarios.
This is the reason I like multi-unit dwelling for first time non-cash investors. There is more diversity and less risk. It is highly unlikely you will have 3-4 units all not paying at the same time.
Love your blog – I have been glued to it for the past week. Thanks for all the sharing.
Thank you so much for writing this article! 🙂 I’m gathering knowledge to buy my first rental property, and some websites really confused me, but you’ve made the math really easy for a beginner to grasp. (Why can’t other investor writers explain things in conversational, plain English?) I’ll be using your tips in my journey, for sure.
Great article and I like the simplicity. Do you still recommend the same equations for cities such as NYC or Boston? The housing market is very expensive…you can not buy a 2 bed condo for less than $400k, but the rent for that same place is only $2k a month. Should you not invest then, even though the prices are going up at least 10% in some areas?
@Ellie — Yes, I recommend ONLY buying a rental property that meets the 1 Percent Rule, regardless of where you’re investing. Buy-and-hold investors buy for cash flow, not for appreciation. Appreciation is icing on the cake (and a hedge against inflation), but it’s not the purpose of the investment.
If you’re negatively-geared on an investment property, meaning that you’ll pay out-of-pocket for the operating costs, you’re stuck. You’re necessarily limited in how many properties you can buy, you’re tied to a job that you may not want because you need to pay the bills for the property, and you hold significant risk of losing the property in the event of a vacancy or major repair. If your property produces strong cash flow, which can only come from a 1 Percent Rule property (or better), you’ll have better protection from all of those downsides, and you can reinvest the cash flow into growing your real estate empire.
okay – many thanks!
Great blog post… Very interesting 1% theory. In the UK, it’s practically impossible to achieve that kind of yield now as property prices are off the charts.
But it’s certainly an adaptable rule of thumb.
Hello,
these rules applied to Europe (i.e. France and Swiss) don’t work,
in Switzerland for exemple an apartment of 500 000 CHF is rented @ 1600 CHF, far from the 5000 CHF you suppose.
… any other calculation available?
@Lorenzo — I’d recommend investing ONLY in areas where the One Percent Rule works. My knowledge and experience is entirely U.S.-based, so I cannot comment on Europe — I simply have no investment experience on that side of the ocean. However, I know that in the U.S., there are some cities/areas/neighborhoods where it’s almost impossible to find a One Percent property, and other cities/neighborhoods where it’s much easier. If you’re in a location where there aren’t One Percent properties, look elsewhere. Yes, this means you’ll need to invest the upfront time into learning a new area, but that upfront investment of time and research will yield dividends that pay off in the long-term.
I am curious…why the 1% rule? Aren’t cap rate and ROI really what matters? If a 1% rule property stays vacant for six months, wouldn’t you be better off with a property that rents like crazy, has great tenants, and doesn’t involve evictions? How can this apply equally to Class A,B, and C properties?
Congrats on your awesome success! Love the website!
The 1% Rule is a minimum. On a Class B property, I’d want 1.5%, and on a Class C property, I’d want 2% or more. The 1% Rule is the lowest threshold I’d consider.
Why this rule? First and foremost, you look at listings for hundreds/thousands of properties before you buy one. You can’t crunch the cap rate on every single one of those properties, and you certainly can’t trust the cap rates that the listing agent claims. You need a way to sift through those listings, eliminating the worst performers right off-the-bat. The 1% rule allows you to do this. Then you can perform due diligence on the properties that pass this test.
Secondly, 1% per month = 12% per year in gross revenue. Using the 50% rule of thumb, half of that gets gobbled up by operating overhead, leaving you with a 6% net return — analogous to holding stocks with a 6% dividend yield. Add this to property value gains (let’s call it 3%, the rate of inflation), and you’re yielding a total return of 9% annually. That’s in-line with the long-term annualized return of the U.S. broad market index.
Phrased another way: If you’re getting worse returns than 8-9% overall, why not just go into an index fund? It’s less work + more liquidity. Adhering to the 1% rule is a first-pass-test to screen properties that have a low likelihood of creating the returns that you need.
Thanks for laying it all out. You didn’t mention it here, but one cost that I always put into my cap rate (and other) calculations on investment property is vacancy. When you look at investment returns long-term (e.g., what it will make over a year, three years, etc.), vacancy becomes a cost. I have seen you account for vacancy in your projections of your own properties, but I think it can be handy for cap rates too. This is particularly true if you are comparing multiple properties and have a good sense of the market. Not all properties will have a similar vacancy rate. I’ve been investing in real estate for about 10 years and when I go to look at a potential property, I try estimate what vacancy will be. An APOD from previous managers/owners can be helpful, but not always trustworthy. I almost always start at 10% and go up from there, just to be safe. (I’ve got some properties that have had 0% for years, but it’s not something you want to count on). Some high-risk properties here (Albuquerque) can have vacancy rates of 25% or more. There’s good money to be made on those, but a lot more time/effort/management has to go into it. So, if you are evaluating properties in the same neighborhood in the same condition, it doesn’t matter whether you add in vacancy as a cost. But if you are looking at diverse properties, it’s a must. Something that looks like a great deal (1.5-2% rent to cost) might actually be a bad investment once you have deal with high vacancy (which means more cleaning, advertising, unpaid rent, etc.).
Yes, I completely agree!
I didn’t go into detail about everything that gets piled into the expense category (since there are so many items to list), but expenses should include:
– Property tax
– Homeowner’s insurance
– Umbrella liability insurance
– Any other insurances (e.g. flood insurance)
– Vacancy
– Management (even if you manage it yourself, run the calculations as if you don’t — so you can later step away and the equation doesn’t change)
– Repairs (rule-of-thumb: 1 percent of purchase price annually.)
– Maintenance (pest control, gutter cleaning, lawn care, etc.)
– Advertising (depending on the neighborhood, paid ads might be effective)
– Cleaning and turnover-related costs
– Unpaid rent and collection-related / eviction-related fees
– Landlord-paid utilities and services (trash, water, sewer, and if applicable, electric, gas, internet, security)
The list can be quite extensive. 🙂
I’ve seen that my properties in high-risk areas (House #2 and House #5) tend to have the highest vacancy rates but lower turnover. In other words — it’s harder to find a tenant, but once you find one, those tenants stay for awhile. My properties in low-risk areas (Houses #1, #3 and #4) have low vacancy and are much easier to fill, but tend to experience high turnover, since many of these are rented by young professionals who get job opportunities out-of-state, enroll in grad school, get married, buy their own house, etc.
Great post on how to work the numbers on a deal!
Like all things, I think many people get confused with the terminology. It irks me when experienced investors use it to explain things to non-experienced ones. No wonder people get confused!
Enjoying the blog, thanks for sharing! 🙂
@MobileHomeGurl — Yes, I hesitated to use the term “Net Operating Income,” because it sounds technical and confusing, and I worried that it might scare away the beginners. But I also want to teach readers the difference between Operating Income and other types of income (such as equity income). So my approach is to use the correct terminology, and also spend a few paragraphs explaining these terms. It bothers me when I read articles that simply reference “NOI” or “PITI” without explaining what those terms mean. 🙂
Hey Paula! I LOVE your blog and I am so fired up to buy a rental property (I’m hoping to be able to get one next year). I’ve struggled my entire adult life with work and feeling restless and aimless. You’ve inspired me and helped me find direction with where I want to take my life!
Please forgive me if my question is really basic, but how do you know what the rent is going to be in order to calculate the one percent? How do you decide what a house is worth? What if you overshoot or grossly under charge? Thanks so much, you have inspired me!
Melissa
Hi Melissa! I’m SUPER happy to hear that this blog has made such a positive impact on you!! Rock on!!
To determine the rent: I pretend (inside my head) that I’m a renter who wants to live in a particular neighborhood, and then I’ll search online for rental properties in that area. I’ll check Craigslist, PadMapper, Zillow, Trulia and Postlets, narrowing the search based on the number of bedrooms and the type of property (example: high-rise condo vs. single-family home). I don’t actually make any viewing appointments, since I want to respect the other landlords’ time, but if anyone is hosting an “Open House,” I’ll swing by to check out the condition and size.
Just for kicks, I’ll also check websites like RentOMeter.com, but you should take their recommendations with a grain of salt. If the rent you see on RentoMeter is aligned with that you’re finding independently (when you’re researching online), then cool — they’ve corroborated what you already know. If the results you find on RentoMeter are drastically different, through, give priority to the prices that you’ve found firsthand by searching online.
My pricing philosophy is to compete on quality, rather than price. If I start undercutting the other houses in the area, then I’m starting a chain reaction that will cause the whole neighborhood to fall in price. (Plus, I’m depriving money from my own bank account). Instead, I’ll price my units at the same rate as everyone else, but offer a nicer place to live: fresh paint, updated cabinets and countertops, new windows, professional cleaning before move-in. The tenants get a higher-quality space at the same price.
Simple math goes a long way, thanks for the bottom line.
Just found your site and love it! Using the formula, our recent purchase doesn’t seem to cut it. We put 25% down on a $160K home and it’ll rent for $1075. Do you mean that the house should rent at $1600 or do we use our 25% ($40K+other acq. costs) to calculate? In that case, it would meet the 1% rule.
I’m wondering if the acquisition cost is the downpayment + closing costs..basically all the out of pocket costs it took to get the home vs. the total price of the home? It seems like it would make more sense to use out of pocket expenses vs the price of the home to calculate the cash on cash return.
Also, why isn’t the principal payment added to the NOI? What is considered a good NOI? Using your formula, our investment property has a NOI of 1.25% and a cash on cash of 4.6%. If we add the equity gained due to the principal payments, the NOI is 2.5% and cash on cash is 9.6%
Oh..that’s relly very cool incoming property.
Loved it.!
Love your blog! Just discovered it today when I was looking into the feasibility of AirBnB and have been perusing your articles since then. The section in this post about the cap rate was particularly useful for me.
Thank you John!
Hi Paula,
The 1% rule is a great method to weed out properties that provide little or no hope of generating income. So, what is a time-efficient way to seach for such properties? In my area, (Westchester County, NY) properties emply the .05% rule unless you look at big apartment buildings. I am OK with going outside my area. A time efficient screening/seach process would be a great help. Thanks! John R.
Hi Paula,
The One Percent Rule is great way to keep from wasting time on properties that won’t yield positive cash flow. Do you have any ideas on a time-efficient to finding/screening properties that meet the One Percent Rule?
Where I currently live (Westchester County, NY) the .05% seems to apply unless you are looking at large apartment buildings. An efficient way to find properties that meet the One Percent rule would be helpful. Thanks! John R.
John,
Great question. I’d recommend one of two strategies:
1) Imagine concentric circles, with your home in the epicenter. Start systematically looking at properties each “ring” of concentric circles, until you reach the ring that offers a selection of properties that meet the one percent rule. Remember that these homes aren’t always going to be the first listings that leap out at you — many neighborhoods offer 1% Rule properties in the form of foreclosures, short sales, auctions and other deals that aren’t advertised.
2) Choose a specific area/neighborhood that you’ll specialize in. For example, you might decide that Philadelphia, Pittsburgh, Cleveland, Cincinnati, Columbus, Dayton, or various rural communities/towns in Vermont, New Hampshire, Maine or upstate NY might become your area of specialty. Then concentrate all of your investment properties in that specific area. This carries a few benefits: 1) the more you’re an expert in a given geographic area, the better able you’ll be to spot deals when they emerge; 2) you’ll develop a team of contractors, realtors, etc., who are localized in one area; 3) you’ll become well-versed in area specifics like turnover patterns, specific local laws, etc.
The “concentric circles” method is ideal for people who want to invest close to home, but can’t find anything in their immediate neighborhood. I often talk to investors in places like Charlotte or Charleston or Atlanta who say, “there’s nothing here!”, but their problem is that they’re only looking at the type of places where THEY would live. They’re not asking themselves, “Where do the janitors in my community live? Where do the TSA officials and baggage handlers live? How about the Starbucks baristas and the cashiers at Target; where do they live?” If this is the case, start methodically searching in concentric circles. Start within a 5-mile radius, then expand out to 10 miles, 20 miles, 40 miles.
Sometimes, however, people genuinely live 50+ miles from the nearest One Percent Rule neighborhoods, and that’s when I recommend choosing a particular city/town and specializing in that area, accepting the knowledge that it’s not in your backyard. There are serious benefits to investing in a city/town that’s too far for you to drive to on a whim, as this forces you to develop the systems and processes necessary to make this a passive enterprise.
Hi Paula,
Thank you kindly for your detailed response. I am particulary intriqued by your last sentence i.e., “There are serious benefits to investing in a city/town that’s too far for you to drive to on a whim, as this forces you to develop the systems and processes necessary to make this a passive enterprise.” Besides Zillo and Trulia, which websites would you recommend that give accurate and timely data on rents, and sales prices on properties not close to one’s home to start sceening potential acquisitions. Thanks! John R.
I trying to get a handle on calculating the cap rate.
Most sites, including yours and investopedia
http://www.investopedia.com/terms/c/capitalizationrate.asp
say to calculate it using the value of the property.
Then most sites, including yours, give examples using *purchase* price.
If you are paying full price, then that is relevant by coincidence.
Or if you are calculating Cash-on-Cash and paying all cash.
Otherwise, I don’t see what the purchase price has to do with anything.
You even emphasize the point by changing the purchase price, without changing the value, and say that changes the Cap Rate.
Am I missing something?
Can you clarify?
Thanks!
@Brad —
If you purchase a home for $200,000, and it needs $0 in repair to get it rent-ready, and there are no wild extenuating circumstances around the purchase (like some foreclosure fire-sale that allowed you to buy the home for a fraction of its fair-market-value), then it’s fair to say that the value of the home is $200,000.
If you buy a home for $200,000 and it needs another $75,000 in immediate repairs to get it rent-ready, and you invest that $75k into repairs, then the value of the home is $275,000.
My first property, for example, cost $225,000, but I’ve invested approximately $150,000 into repairs. So I use $375,000 as the new value when I’m calculating the Cap Rate for this property.
I’m trying to find a easy way to evaluate markets around the US & maybe Canada, as well, from a rental rate vs acquisition cost standpoint. Do you know if their is a web site that integrates acquisition costs in neighborhoods with rental rates so I can do some evaluation on where is the best places to invest?
Thanks for your info above, very helpful & any thoughts you might have. Regrads, Bruce
I wish I could get a rental for 100k that rents for 1000. In Alberta the rental market is great, but pricing is high so the cash flow is a lot less than the United states I’m sure
How does the 1% rule apply to a property that will be owner occupied? Do you still apply the 1% to the total purchase price? Or do you carve out the portion of the purchase price that relates to the owner occupied portion of the property before applying the 1%?
Thank you so much for the clear articles on real estate investing. It really made things click for me.
Hi Dan –
I assume you’re referring to a multi-unit property, like a duplex/triplex/4-plex, in which you live in one unit?
In that case, just “pay yourself rent.” I don’t mean that you should literally write yourself a rent check each month. Run the calculations based on the fair-market value of the space you’re occupying. Crunch the numbers as though you’re not living there. This way, you can move out, replace yourself, and the numbers stay the same.
I’m glad the articles are helpful! If you’re not on the email list yet, I’d definitely encourage you to join. 🙂 Thanks!
I’m new to income property and have a question regarding investment. Is it better to buy 5 houses at $50k or to buy 1 house at $250k (assuming both are with 20% down and both pass 1% rule)?
Hi Peter,
That’s a great question. I could write an entire chapter in a book answering that question.
In a nutshell: there are pro’s and con’s to both approaches. If you buy 5 houses at $50k, you’ll diversify your income. If one house is vacant, you still collect rental income from the other 4 houses. There’s a low likelihood of all 5 houses being simultaneously vacant. If you only hold one house, by contrast, and that house is vacant, your income is $0.
On the other hand, 5 houses means 5 leases, 5 sets of tenants, 5 turnovers, 5 roofs, 5 lawns, 5 gutters, 5 insurance plans, 5 tax bills, 5 kitchens … you get the idea. 🙂
Personally, I’d recommend this approach: buy 5 houses at $50k each, or if you want to consolidate overhead (e.g. just one roof), buy a 4-plex or 5-plex worth $250k. This way, you’ll consolidate overhead while still diversifying income.
Awesome feedback. Thanks so much!
What would you recommend as an asset protection strategy?
Put each property into an LLC. If your state allows it, look into a series LLC. Never work on your own property. The fan that you installed for a tenant just fell he her child’s head, killing the child. Guess who is liable? You are.
“If it’s not worth owning in cash, it’s not worth owning”. Now that’s a tweetable quote. Great read btw! I would love to know your thoughts on buying for cash flow vs buying for appreciation. I’ve heard that a way to think about cash flow is that it’s a means to hold the investment for equity building and appreciation. Soooo you don’t necessarily need a great cash ROI, just a solid positive number, and then bank on the appreciation and selling to profit. What do you think? And do you have any tool suggestions to analyze property deals?
Somehow I ended up on this article after clicking Clark Howard’s link to your Airbnb experience. Thia is a great analysis that has me excited about rental real estate again. Amazing where a click or two will take you! Mahalo!
Hi there! Someone iin my Facebook group shared this site with us so I
came to give it a look. I’m definitely loving thhe information. I’m book-marking and will be tweeting this to my followers!
Outstanding blog and terrific style and design.
I am definitely interested in investing in the real estate market for rental income. Can anyone point me to where the pro’s meet up? I live in Whittier, California.
Love your blog! I’ve read so much, I think my head is overflowing. Now, I have a question to run by you. We currently have a 3 bed 2 bath home, which we were initially going to sell. We purchased it for 90k 6 years ago, and owe just under $80k now on it. We were approached by my mother in law, asking if she could rent it instead. (This is not a discussion whether or not to rent to family)
The thing is, we need some money for a downpayment on our new home. In the current market where we live, the house would sell for $150k (conservatively), and similar homes rent for $1500 (tenant pays utilities). My idea was to refinance the home for $120000, and take some cash out on the re-fi towards the downpayment. We’re in a high tax area ($5k annually), so profits would never be too high on a rental. We also have a 12k home improvement loan. I was thinking of renting it to her for $1300/mo.
So, doing your math:
1300×12 = 15600
15600*11.5% = 650 for 5% vacancy rate (which seems unlikely)
$14950 gross profit
No other income from property
Other fees: 150 in home maintenance x 12 =1800
Taxes =5000
Total: $6800/annually
14950-6800=8150
8150/120000 = 0.0679
It’s on the edge of what you deemed profitable. And I’m wondering if I’m missing something.
Once MIL moves out, we could easily raise the rent to $1500+, making it more profitable down the line. But I’d be just as happy having a reliable tenant like my mother in law staying there for years, paying our mortgage on the home.
What are your thoughts?! Thanks! 😀
Hi Charlotte –
(Disclaimer: per your request, I’m avoiding any discussion on renting to family.)
At $1300 per month, your house passes the One Percent Rule of thumb. The cap rate COULD be much higher (at fair market rate); you’re trading off some return in exchange for having a reliable tenant, which is a reasonable decision with regard to peace-of-mind, lower vacancy, easier management.
From a numbers perspective, this house sounds like it may be a good rental property, but before making any final decisions, I’d encourage you to take a closer look at the assumptions you’re using within your expenses. Note that you didn’t include property management, which will need to get baked into the formula when a different tenant lives there. Your repair/maintenance numbers also look low, given that you’ll have long-term capital expenditures (roof, windows, siding, gutters) which must get averaged into your annual costs.
Thank you Paula so much for your feedback! 🙂 These are all things we’ll take in to account when we crunch the numbers.
Great article! Just one correction – the historical long-term compound annual growth rate of the S&P500, including dividends but not considering inflation, is not 7 – 9%. It’s 10.4%. In the cost-benefit analysis of whether to buy real property or stocks, it’s critical to have both sides of the equation as accurate as possible.
That depends on which span of years you’re looking at. I’ve spent hours digging through multiple studies and they all cite within the 7-9% range depending on the specific year span and the sequencing of returns.
I notice that you’re citing 10.4% without naming specific years.
— Is that the 80-year span from 1920-2000? 1921-2001? 1922-2002?
— Is that the 40-year span from 1950-1990? 1951-1991? 1972-2012?
— Or is that a shorter span, like 1942-1977? How about 1943-1978? 1954-1989?
You cannot make a statement like 10.4% without giving a specific timeframe, because the sequence of returns matters. If your investments drop early within the investment, your recovery time can diminish overall returns. Similarly, if the market drops shortly before you sell, before the recovery begins, this timing can also diminish overall returns. The range of 7-9% encompasses the median returns within that wide spectrum of timeframes. Because it’s critical to be as accurate as possible. 🙂
That’s an excellent point, and shame on me for not mentioning the period, which surely matters. I actually forgot the exact relevant period – again, my bad.
I believe I’ve seen that number cited with regards to 1970 – recent years. I believe my primary source for that figure came from an earlier version of http://www.schwab.com/public/schwab/nn/articles/Q-and-A-Estimating-Long-Term-Market-Returns
But we can easily confirm the CAGR of the stock market for any period for ourselves using http://www.moneychimp.com/features/market_cagr.htm
No studies needed.
We can use a period as early as 1871, though arguably we may or may not want to narrow the years to those whose economic policies and realities were more similar to those of today. The downside to narrowing our window is that we lose years of historical data – exactly what we’re trying to study to get a sense of our anticipation for future returns.
If we use 1871 – 2015 – all available data, the CAGR of the S&P500 was 9.05%. If we use a starting point of 1926, or after the valleys and subsequent peaks of the Great Depression, we get mid-10%s and even slightly into the 11%s. Again, that may be a good dataset if we think post-Great Depression years are significantly more similar to how our current economy functions, or a bad dataset if we think the GD can easily happen again and want that historical data included.
Either way, even the high-end of 7% – 9% is too low. During no long-term period of the S&P500 that I’m aware of was the geometric return 9% or lower.
Regarding the studies you read – the most common cause for people inaccurately citing too-low statistics is not including dividends. (The most common cause for people inaccurately citing too-high statistics is using an arithmetic average instead of geometric average)
Wow. You make an excellent case. I’m impressed. 🙂
Here’s one of the most convincing sources of the 7% end of the scale — according to this NYTimes graph, the average real annual return for the S&P 500 over a 20-year time period, starting and ending at every year between 1920-2010, has a median value (after inflation) of 4.1%. Since we’re comparing this to other studies that show returns that include inflation, we can add another 3% to that number for a median return of 7.1%.
This figure includes dividends; however, it subtracts some return for taxes and fees. (I would not have subtracted those values if I had created this graph, given that taxes and fees vary widely based on the individual. I disagree with that aspect of the way in which they reported this data. Also, to properly compare apples-to-apples, this data really ought to show the returns without adjusting for inflation. I’ll acknowledge that adding 3 percent to compensate for that inflation subtraction is crude methodology.)
According to this graph, to the best of my ability to interpret it, the median of the S&P 500 for any 20-year set from 1920-2010 would be approximately 7.1% after taxes/fees (or if you adjust for the pre-tax amount, perhaps roughly around 8 percent?). Of course, “median” means that half of the returns would be worse.
You are knowledgeable and well-informed about this topic, so I’m genuinely curious to hear your thoughts on the data in this graph. How would you respond to this?
Finally, thank you for contributing to this conversation. If it’s true that the long-term returns are higher than commonly reported in most studies, then this is important information to know as we make investing choices. I appreciate you! 🙂
Thank you!! That means a lot, especially coming from you!
I also wish such articles would make it easier for us to compare apples to apples. Generally, returns are presented without inflation, taxes and fees, which make the raw returns so much easier to compare between opportunities. I suppose the article is trying to show buying power, though, and don’t want to overwhelm the reader with too many stats.
In terms of how I interpret that data, I agree with your analysis for the most part. That period (1920 – 2010) seems to have had an average annual inflation rate of about 3.1% (http://inflationdata.com/Inflation/Inflation/DecadeInflation.asp), so 4.1% becomes 7.2% after inflation. I’d add taxes next, which I’d guess people pay an average of 20% on. How amazing it would be if people realized the extraordinary power of tax-advantaged accounts, but that’s another discussion 🙂
20% from 9% yields 7.2%, so 9% is the pre-tax amount. Lastly, let’s subtract fees. About as bad as not going the tax-advantaged route is when people use high-fee instruments or worse, active management. Since this article focuses on the S&P500, we can assume the money isn’t actively managed. Yet, fees are probably non-negligible. I could be wrong, but my understanding is that the lowest-fee funds/ETFs like VOO and FUSVX have only been so low-fee in recent years. And at any point in time, I think it’s safe to assume the average investor probably doesn’t realize they can track the S&P500 for as low a fee as the cheapest instruments out there. So I’d tack on another .7% or so (or higher, historically) as the average fees people might pay to track the S&P500. That leaves us with a reverse engineered 9.7% average return over those years.
And we see that the data from the Money Chimp link earlier with the S&P CAGR calculator can be seen as consistent with our rough analysis.
By the way, I see this as a bit of worlds colliding. You are an expert in building wealth via real estate in a way that’s accessible to most, and want to teach those concepts to the masses. Though I’m no expert, I’ve always had a similar approach, except with a focus on the stock market. I’ve used this approach since I started working in 2006, and since having read how the experts (Mr Money Mustache, Go Curry Cracker, Mad Fientist, JCollins) turn it into a science, I’ve started taking it even further. I now teach this stuff as part of a training series at work (I’m an engineer, so it’s more like a User’s Group), teach interested friends one-on-one, and write articles for a Financial Independence fb group. But I’m by no means in the same league as the aforementioned experts, so I’m always trying to learn more – which is what brought me to your site 🙂
I see you as on the level as those experts, except in real estate. We’re all trying to help the masses reach financial independence – some via real estate and some via the stock market. And there are other approaches too. When these worlds collide, it helps people to broaden their toolset for achieving FI, since they all can play a powerful role.
(Maybe you’ve done this already, but along those lines I wonder if you should consider doing guest posts on each others’ sites)
Wow. You have convinced me.
Let’s take the lowest-tax, lowest-fee set of assumptions — that a person pays a 15% effective tax rate and a 0.1 percent fund fee. (I know those assumptions are far too low, and that it’s likely that the average investor pays higher taxes and fees, but just play along with this thought experiment for a moment, so we can see where it leads.) The pre-tax amount, in this scenario, would be 8.5%, which means the return before fees would be 8.6%. Again, that’s using a set of assumptions that’s too-low-to-be-likely-for-the-majority-of-cases, but this number shows us the lowest end of the likely range.
In other words, the most-conservative-scenario would be a 1920-2010 long-term-annualized return of 8.6% before taxes/fees, which is significantly higher than 7 percent. Which means I need to edit that sentence in the article. 🙂
Thank you for raising this. You’re correct in observing that my focus around achieving financial independence is through rental property investing — specifically rentals with a cash-flow focus, selected for the purpose of producing long-term passive income.
The other bloggers in the financial independence space focus on stock investing; I refer a lot of people to JLCollinsNH’s stock series, in particular. And I credit MadFIentist with teaching me how to “hack” my H.S.A. (pay out-of-pocket, scan the receipts, and let your money compound its tax-free growth within the account, assuming your H.S.A. balance is invested in index funds.) In retrospect that tactic sounds obvious (why wouldn’t I let my money continue tax-advantaged growth for as long as possible?), and I mean that as a credit to the MadFIentist; the best ideas often seem obvious in hindsight, because the wisdom is so clear.
I disagree with you about one thing — your statement that you’re “by no means in the same league.” 🙂 You’ve clearly studied FI, absorbed and synthesized a variety of ideas, and can share this information with others in a graspable and logical manner. Have you thought about starting a blog? I think a lot of people would benefit from it. 🙂
Exactly – those bloggers have brilliant ideas that sound obvious in retrospect! They got it down to a system, which can make a tremendous difference to many people’s quality of life. That stock series, HSA “Ultimate Retirement Account”, and Roth Ladder are monumental.
And yet I see so many friends just coast along without some basic financial concepts. Perhaps they’re overwhelmed by what seems out of their league, think they can’t do it, or just are lazy. But seeing so many friends defaulting to average financial outcomes compelled me to write articles on this in the first place. If they don’t read the experts and/or think they’re in another league, maybe they’ll see how doable it is realizing that even *I* can do it 🙂
So what I’ve written has been mostly just to friends, family and the communities I’ve lived in. But your really generous words and advice may be a better approach. Instead of writing for such a limited audience, in a pathetic Google Sites free-hosted personal homepage (https://sites.google.com/a/schoenbrun.net/schoenbrun/personal/thoughts-on-finances?pli=1) and on a FI fb group I started, maybe I should consider making it more public in case it can help more people.
I still am hesitant from some sort of inferiority complex compared to you guys. But I am confident I do have thoughts and ideas to share, so I suppose I should put my thoughts in a more public, permanent and respectable-looking venue.
Thanks for the kinds words, encouragement, and of course, the wisdom you’ve taught me through your blog!
Hi Yihezkel,
With regard to comparing yourself (or blog, online reach, etc) to others, all I would suggest is this:
Don’t compare your “chapter 1” to anyone else’s “chapter 99”. We all start somewhere.
When you are ready, do a little more. Then a little more the next day. And so on. There are no overnight successes- just people who take consistent little actions that add up over time.
Like compounding interest. 🙂
Leveraging is really not a bad thing especially if the interest rate is less than the cap rate. You borrow money to make more money :)!! I didn’t quite understand the reasoning behind limiting the upside of your cash on cash calculation. I’d think that a more intuitive rule is to make sure that each property mortgage, you have 6-9 months of liquid/semi liquid cash available? I’m one of those highly leveraged weirdos with 7 figures in debt :), but I do have at least a years worth of expenses in semi liquid cash for each of my property.
This was a very clear and concise post, loved reading it. Especially the section on cash-on-cash and over-leveraging. A refreshing perspective in a world of high-risk investors. Thanks Paula.
Hi Paula,
Apologies if this info is available elsewhere, but I don’t think I’ve come across it. What source(s) do you use to estimate the rent for a particular home or unit you’re evaluating? I know Zillow has their (possibly very rough) rent estimate on any given address, but is there a better tool out there that you’d recommend to a beginner in real estate?
Also, thanks for writing a blog of such phenomenal quality! Been a reader for ~6 months now and really like reading your perspective on financial topics.
You mentioned there are two ways a rental makes money appreciation and cash flow. What about depreciation for taxes and value in relation to the amount of the principle you pay off every year. Great article.
what are your suggestion on asset protection strategy especially when one intends to invest in a developing country like ghana.
I am looking at getting 2 properties in the same condo building. Both are nearly identical 2/2s, but small at about 750 sqft (NYC). We plan to Airbnb one full time, and are trying to decide what to do with the other one, which we plan to live in.
Would you recommend airbnbing out the spare bedroom/bath, finding a roommate, or enjoying our peace and quiet? The one airbnb will cover both mortgages, but not much more. I work full time, wife runs a charity, but can work from home as needed. We plan to start out doing the flips ourself, then slowly integrate a team to handle it. We plan to leave the area within 2 years and turn them both into full time rentals / Airbnbs depending on how it plays out.
Where do you consider HOA fee for condos and townhouses etc? Is it included in the 1 percent calculation, also do you consider it towards operating overhead when calculation Cap Rate?
Thank you for sharing. Your information is really interesting, it’s the first time I know about the 1 percent rule.
Our family has owned an apartment without considering about the rule, but I think it’s safer to think about that rule before making any decision of owning other properties.
Again, thank you, it’s useful and interesting.
A great post! Have been binge reading your blog and it sounds very exciting for you 🙂 I am envious with the real estate market you are living in though! Buying foreclosed houses in cash! I live in Ottawa, Canada and I have literally never seen a foreclosed house selling for less than $100K. Heck….even under $200 k is a rare find and is usually in a run down condo building with $800 condo fees! lol
I’m trying to get into the real estate game after being inspired by family and have a substantive down payment! Problem is property prices. The cheapest most run down detached houses in not the best location sell for at least $300K. But the 1% rule really wouldn’t apply…these places can, at MOST, rent for $1500. I saw a house in an up in coming neighborhood that would have been great to update and rent….but the house was listed for $500K. I did the math and realized no way would I be able in a million years rent it for $5k a month. I figured maybe at most $2500 ? But that would just barely only cover costs (mortgage and tax). So I passed. Someone else bought it and I saw a ‘to rent’ post a week later for $2000/month. Its been 3 months and it still hasnt rented!! Which tells me I was smart to pass but also depressing because how the hell is one supposed to get into real estate rentals like this??
All that to say….in a city / market like this…what would you recommend for someone to do? the 1% rule definitely doesn’t work…. Is it impossible to get into the rental game? 🙁 Would appreciate any input you may have!
Hi Paula!
I have about $110K to use as a down payment in an investment property, but I haven’t found the perfect multifamily rental for me yet (Seattle is a tough market these days!). What should I do with the money while I look for the property? Schwab has suggested CDs since they are safe (but also low yield). I’d love to hear your thoughts on that. For a bit more context, I also have a healthy amount in emergency funds and I max out my tax-incented retirement savings, so I can dispose of the $110K entirely to create passive income.
Hi Barbara!
Congrats on building $110k to use as a downpayment! Personally, I keep my downpayment funds in a savings account (or a money-market account) rather than CD’s, since I know that I might need to tap those funds in anywhere from 2-12 months.
Let’s assume that, as compared with the interest on a savings account, I could earn an extra 1% by putting money into laddered CD’s that expire in 3 months, 6 months and 12 months. On an investment of $110,000, that extra 1% annually comes to $1,110, or about $92 per month.
While that’s real money, to be sure, it’s not such a large amount that it’s worth futzing around with. I’d rather focus my time/energy/attention on finding a great property investment.
That’s my two cents. Or perhaps, that’s my 1 percent. 🙂
Thanks for reading, Barbara!
– Paula
Thank you for writing this article. I now have terminology to use!
Currently I own 1 property free and clear and 3 single family rentals which I picked up in the past 12 month. They all pass the 1% rule and are Class B.
I’m looking for a 4th and plan on using same financing from my local bank, 5/2 15 ARM, 10% down, minimal closing costs with cross collatoralize.
At the end of the day the Total Operating Expenses + mortgage = 85% – 95% of total rent. This means that each property makes between $50.00 – $250.00 per month. Year is around $5-$6,000 total.
The properties are solid and were purchased from $85,000 – $160,000. I don’t expect much appreciation, maybe 2-3% per year.
I’m in this for the end game of owning the asset in 10-15yrs and collecting passive income.
Currently I have the options to pick up a turn key single fmaily or I can pick up one a couple different duplexes. One is Class B one is Class C.
Based on this article, the class C duplex is out of the question.
The Class B duplex (not turn key but decent enough) which would provide about an additional $100.00 per month of NOI.
In anyones experience. Have you made the jump from single family to duplex multi-family?
Is it worth an additional $100.00 per month to manage an additional set of renters and maintenance cost?
Cheers. Thanks for your contributions.
Great blog. Glad I found it, thanks for filling it with meaningful content.
I do have a question. I understand why you separate the financing from the asset when determining whether or not to make a move on a property.
What if the financing is part of the reason for buying the property though? I have a home that doesn’t quite meet the 1% rule, 140k to purchase, 1300 for rent. However the house belongs to my mother. There is about 70k left on the mortgage and she has about 60k in equity, the other 10k would be for remodeling. We agreed that I could take over the mortgage and buy her out of the rest no interest. The 70k left on the mortgage is financed at 4.2% (She refinanced not long ago).
Would this move the needle towards making the home a good value or no?
Wonderful blog and it is very inspiring. Every time I look at a property I keep the mantra in mind, “If it isn’t worth owning in cash, it isn’t worth buying”. I also keep in mind my rate of return. If I can’t get a good return on real-estate I am better off investing my hard earned money elsewhere that would be more likely for me to receive a good return.
I have been searching in my local community for several months (5+) now looking for a rental property but I have a slight issue…I would love some feedback on what I should do.
I have talked with a few real estate agents, brokers, and acquaintances that have rental properties but, low and behold, none stay true to the 1% rule, very few do.
Here in Albuquerque, NM the rental rate and the price of homes don’t match the 1% rule. The cost of homes on the East Side of town are overpriced but rent quickly. The homes on the West side of town are newer, better priced, but rent for less.
Here is a common example:
Say a home on the desirable East side is priced at $180K but rent for that 3Bed 2 Bath is only $1300-1400 a month. A home on the West side is priced at $150K for a similar 3Bed 2 Bath but will only get $1000 a month. Both homes don’t even come close to the 1% rule. Apartments on the other hand for 2bed 2 bath generally run about $800+ a month, some priced as much as home rentals.
Homes that would equate up to the 1% rule are homes that need plenty of work and are almost always foreclosures. Though the home would sell for a price that would generate a 1%, that real price would increase from numerous repairs needing to be done.
My financing would be 20-25% down. Cash purchases make better deals but that is out of the budget at the moment. I work full time and would prefer to purchase a home with minor repairs than a complete fixer upper.
“I have looked at hundreds of homes!!!!”
Overall my question is:
Are there any recommendations when it comes to purchasing rental properties in an inflated market such as the one I am in? What would be a good course of action when keeping in mind the 1% rule of thumb under this circumstance?
I want to invest in real estate but I know that buying a $130K home will not get me $1300 in monthly rent, at least not in Albuquerque. I continue to keep my eyes open for good deals.
Thank you!
Hi Christine – I’m in the same boat as you. Also in Abq! I don’t see much that is in good condition that fits the 1% rule, the closest buys are in the rougher parts of town, where I would expect more tenant issues and vacancies. Any luck?
I’m perplexed by this as well. I live in Verona, WI (suburb of Madison) and houses are flying off the market for 250k and our renting for 1800. Great college town, extremely stable employment, but the 1% rule wouldn’t get me into a property within a 100 miles of here that I’d feel safe visiting nor do I feel like dealing with that type of renter. I’m a newbie though.
Where in the world do you find properties for 100k (including acquisition costs) that gross 1k monthly rental income? Additionally, how would you be able to command more rent in more risky neighborhoods? Lower income areas will not pay more for rent.
Iowa! I live in a suburb of Des Moines and that is very doable
I love the information you have here and I have been glued to your website for hours reading.
BUT…Maybe I am blinded by California property prices but where on earth can you find a property for $30K and have a $0 down payment? I can’t buy a pile of dirt for that in San Diego! :-/
In reality, I do not think the 1% rule could EVER apply to San Diego or other expensive market real estate. Heck, I even own a property in Utah which is a less expensive market and could only get to .6% as of present time and that took 8 years to get there. What advice do you have for a market like San Diego where the 1% rule doesn’t apply and we only rely on quick appreciation and high rents?
Hi Paula, I love your podcast, blogs, and the ease by which you explain things; great article by the way. I was wondering why you have not Invested in Multifamily or have You? Would you consider partnering up on a deals as a way to Close more deals?Thank you for your time,
Sincerely,
Carlos D. Reinoso
Paula: Loved this post, its been very helpful in us penciling out a new prospective investment. We own and operate a small new 4 duplex adult 55plus community. they are free and clear so I am new at having a Mortgage on investment property. We have an opportunity to expand our complex with building 2 more triplex units. I will have to finance one of the triplex units plus pay for some infrastructure costs to the property. your article helped me stabilize my confidence in rationalizing this investment- thank you
This blog is looking great! ‘Should You Invest in This Rental Property?’ it’s gave me a list of ideas. The cash-on-cash return formula is wonderful. I’m looking forward to more posts like this! Those are excellent points.
Hi. In the One Percent Rule, when you say purchase price, you are refering to the the upfront cost(downpayment, legal fees, stamp duty fees, repair cost and et ) or the sales and purchase price of the house?
Let say i were to buy a $200,000 house, i will take 70% loan on it. Therefore my upfront cost including repair let say is $60,000 + $10,000. So if my rental is $2,000, my one percent rule is 2,000/200,000 or 2,000/70,000?
It’s the purchase price, plus any repairs. Paula has said this: “When I talk about the price of a property, I’m referring to the purchase price plus the cost of any upfront repairs necessary in order to make it rent-ready for your first tenant.”
So for example, if you buy a property for $200,000 and spend $10,000 on repairs to make it rent-ready, then the total purchase price is $210,000, which means you’d want to aim for $2,100 in monthly rent (according to the one-percent rule).
Hope that helps!
Incredible article! BTW, how would you analyze real estate investment in an IRA or Solo 401K?
completely unrealistic figures at the beginning of this article. expecting to add 1% for every $100k is impossible. every rental in so-cal would be $5000 to $10,000 per month if your figures were accurate. it costs 1 million for a 1 bedroom in a decent so-cal area. 3-5% would be more realistic. investors might earn this in the long term market but with real estate you will also have your equity in the appreciating home. on another note, people shouldn’t leverage rental properties. if you can’t buy it in cash then don’t buy it. pay $200,000 cash for a home in the south or midwest region area with low property tax. rent it out for a minimum of $1000/mo and hire a property manager at 18%. $820 x 12=$9840 gross income. let’s assume there is $2840 expenses (taxes, insurance, misc repairs). $7000 net profit. you just turned your $200,000 investment into $207,000 not including the appreciation of the home. much better than leaving in the bank and in my opinion less risk than the stock market.
First time poster here!
There is something I don’t agree with here though regarding the financing! I love financing! especially the type of mortgages where I merely have to put anything down and with long maturities.
I understand your point that being overleverage could wipe one out however it’s rare or if the cash flow makes sense.
Example:
In my country we can get 50 year mortgages, as long as, your age plus the mortgage term is not higher than 75. This means a 25 year old can have a 50 year mortgage while a 30 year old can only have a 45 year mortgage at most.
As you can guess, 50 year mortgages rock in my opinion! The cashflow they provide is ridiculous which enables you to either paydown the mortgage – but why especially if price of money is cheap, which it is nowadays – or to accumulate other properties.
My personal example, I bought 5 years ago, a few properties… these houses are made of concrete and stone and maintenance is not as adamant as US houses.
These houses met the 1% rule barely or failed by little. The houses cost about 50,000 and the rents at the time were around the 450 mark or 500$.
My mortgages on each house amounted to $120 – YES that’s $120 dolllars – while providing me 450/month.
Downpayment was 10%, so I was able to purchase 3 houses (2 for 50k and 1 for 100k).
I was paying about 450$ in mortgages and collecting 1900$ gross rent. Forward 4-5 years, and by good fortune rents on the 50k houses I can easily have them for 650$ and $1400 on the 100k house. My mortgage is still at 450$ – and each month almost all of it goes towards the principal since interest rates overhere the benchmark is negative – my interest rate for past 5 years as gone from 1.5% to currently 0.9% – out of 450/month in mortgage about 320 goes to principal which is great.
Even if rents didn’t increase I think it was a great return that made sense. I put 20k down, and was getting 1600$ in gross rents after P&I. Haven’t had any vacancy so far – houses in high demand area – nor renovations – for most part renovations here are mostly to change aesthetics that have aged and you need to ‘become’ trendy again… since everything is concrete there is no rot or drywall damages and the like.
Even then considering 400$ of costs per month, my ROI has been +72%. My investment was paid pretty much in first year 🙂
This to say, that $200 per 100k of debt would not make someone default. And repairs costs around here are pretty low – we don’t replace roofs nor siding, heck my parent’s home, their roof is 150+ years old.
It all depends on the context. I dont mind at all paying mortgage for these 50 years and have a big positive cash flow in the meantime. Which i can use it to paydown, reinvest in other stuff and wait to pay off the mortgages if I so wish or if interest rates go up …. which I doubt I will do anytime soon since interest rates are super low still and I can’t get 50 year mortgages anymore due to age – I can still get 45 years though but at 20% down since banks are more stingy now.
I live frugally so all the cashflow generated by those properties were reinvested in stock market which has been behaving handsomely …
Another good thing of keeping the mortgage payment low is due to DTI. Higher mortgage would bring me closer to my limit of 40% of DTI for debt, while in this case it still enables me to have a nice cushion in case I see a good oportunity to invest in the meantime.
Ok I stopped reading at the 1% rule … this absolutely does not work in Australia (could be different in America I’m not sure). We’re looking at investing in Adelaide which is a small capital city. A very basic house goes for around $300,000 (which is considered very cheap) and will only rent for around $250 a week. Going by your rule if we bought a $300,000 house we would have to charge $750 a week rent. We would be laughed out of the market. We are living in a nice house in an expensive area and paying $500 a week rent (which is considered high). Our house was purchased 8 years ago for $600,000. Which again is considered fairly expensive. So technically we should be paying $1,500 rent … literally THREE times what we’re paying … so I’m not sure if I’m understanding this incorrectly or if it actually is like that in the states …