When I first began looking into real estate investing, I spent a lot of time trying to figure out what criteria I would use in selecting which property to buy. I have built many Excel spreadsheets with mind-numbing calculations and data, all geared to finding that perfect investment property.
The biggest question is always this--how to determine if a rental property is a good investment. Having now purchased four rental properties over two years, I've developed a much easier way to evaluate whether a property will generate positive cash flow or not. I call it the 1 percent solution, and it works like this--
Will the property generate monthly gross rent equal to at least 1 percent of the total cost of the property?
How the 1% Solution Works
The total cost of the property includes four things: (1) purchase price of the property; (2) fix-up costs; (3) financing costs; and (4) carrying costs from the time of purchase until the first tenant moves in. Of course, this requires making a reasonable estimate of what the rent will be and the cost to fix up the properties. With enough experience and research, I’ve found that these estimates can be made with good accuracy.
On estimated rent, for example, I usually estimate within a range of $100 and calculate the 1 percent using the mid-range of this estimate. Because my investment properties are all in the same area, I've got a very good idea of how much rental income a given property will generate.
A Case Study
Let’s look at an example based on the last single-family home I bought. The home was a HUD Foreclosure. It was a small three-bedroom, one-bath home in a good school district. Here are the numbers--
Purchase Price: $42,000 Rehab & Other Costs: $25,800 Total Investment: $67,800 Rent: $895 Monthly Mortgage Payment: $403.69 (P&I) Taxes: $156.00 Insurance: $33.00 Estimated Repairs: $66.58 per month Estimated Annual Vacancy $74.55 Total Monthly Outflows: $733.82
Monthly Positive Cash Flow: $161.18
I few things to note about these numbers. First, we include the rehab and financing costs in the total. This is particularly important where, as here, there were significant repair costs. This is common with HUD foreclosures.
Second, always include estimates for repairs and vacancies. Both are a reality for landlords. We estimate vacancy as one month’s rent, although we look to reduce this by offering long-term leases of 2 or 3 years. Whatever your methodology for making this estimate, be sure to include these costs in your analysis.
In this example, our rent is actually higher than 1%. It comes in at 1.32%. Why?
The main reason is that we bought an older home in an older neighborhood, and the home needs substantial repairs. In my experience, these types of homes generate higher rents compared to the cost. On the downside, they tend not to appreciate as quickly as newer properties in newer neighborhoods.
In this example, we have a positive cash flow of over $160. In addition, the tenant is effectively paying the mortgage each month, reducing the mortgage balance. And finally, we benefit from the appreciation of the property value of time. The result is a profitable property that will generate income for years to come.
Things to Consider
As you evaluate real estate investments using this rule of thumb, there are several things to keep in mind.
First, we've purchased successful properties that fall below the 1% rule, although not by much. The point is that this is a guideline. Just because a property meets this rule doesn't mean it's a good investment. Likewise, a property that falls below 1% doesn't mean it's a bad investment. If it falls significantly below 1%, however, it's a good bet that you should pass on the investment.
Second, be sure to include all monthly expenses in your calculations. One expense not included in the above analysis is Homeowner's Associate fees (HOA). We tend to avoid properties with HOA fees. But if you are considering such a property, be sure to include the expense in your calculations.
Finally, in many areas of the U.S., finding a property that meets the 1 percent rule is next to impossible. I invest in the mid-west, and given the high rate of foreclosures, have been able to find properties that generate rents at or near 1 percent of the total cost. I am able to finance nearly 100% of the total cost on a 30-year fixed-rate mortgage that enables me to generate positive cash flow immediately, even after factoring in an allowance for repairs and vacancy.
I live in Northern Virginia, an area of very expensive real estate. It’s impossible to find a single-family home that can be rented for 1% of the cost. The result is that I don’t invest in this area. Many certainly do, but they rely more on increasing property values for their returns. They are also forced to invest more cash in each property.
I’d be interested in hearing if anybody else uses this or another guide to evaluate potential real estate investments. But I’ve found the 1% solution to be a great way to make profitable real estate investments.