How To Employ The 1% Rule
The old school. down and dirty mechanism for coming up with a purchase price offer on a rental property was always the infamous 1% rule of thumb in real estate investing. This rule proffered that any residential rental property’s valuation was roughly worth one month’s rent roll on the property, times 100. So, for example, a property with a rent roll of $2,000 per month, regardless of the number of units, should be valued at approximately $200,000.
Unfortunately, during the run-up years to the housing balloon bursting in 2008, many investors ignored this simple rule, and started making offers far in excess of the 100 times rent corollary. And this aided in creating the foreclosure mess this country continues to slowly dig out from under.
A simple tool
The 1% rule serves as a quick and easy way to see if a rental property is overpriced, undervalued, or close to market price when searching for properties to purchase. This assumes you know the rent roll’s accuracy, vacancies, and whether market rents were being properly obtained in a timely fashion – or could be obtained based on the condition and location of the property in question.
Abandoning the 1% Rule led to investor foreclosures
So much of the foreclosure problem in the U.S. could have been prevented had investors not ascribed greater rent roll potential valuation, based on the simple hope that an investor could raise rents well above market rent for any particular area. And that includes increasing a rent roll based on basic renovation improvements to a property’s units.
Improvements such as updating a kitchen or bath, painting and landscaping were many times used as the main driving force behind attempting to obtain over-market rent on any given piece of rental property. When this failed, market rents on properties bought at inflated prices created huge negative cash flows for thousands of individual investors. When they tried to sell after 2008, they were hit with the starkness of reality: a burst housing bubble combined with negative gearing.
Avoiding a crucial mistake
So remember that a huge mistake property investors make in residential rental property locating is hoping that a particular real estate investmnet will rent out for more than market rate. It’s wishful thinking – but it should never be used to create valuations on a rental property without proper, provable justification. And justifying a market rent can be accomplished very simply by doing a basic market rent analysis based on comparable units. While time-consuming, this analysis can be done yourself by visiting like rental units currently available for lease in your target area.
When you predicate your offers on concrete market rents currently being paid in your area, then you will be much less likely to overpay on your next investment property. And you will have a much greater opportunity to turn a positive cash flow on the newly acquired piece of real estate.
No substitute for numbers crunching
This so-called 1% rule was never designed as a substitute for full numbers crunching on any prospective rental property purchase. Rather, it was considered a suitable checks and balances for a thoughtful, researched layout of all the numbers required to come up with a solid purchase offer on a property. It was a simple tool to be added to any real estate investor’s arsenal of proofs of their numbers crunching, in addition to other tools like Comparative Market Analyses – either done by your local real estate agent, or yourself – if you had prior experience running CMAs.
Ultimately, the 1% rule is a great time-saver for rental property investors. It is designed to quickly determine if a potential winning property at first sight makes sense to continue going after and make an offer on. It also aids in steering you clear of highly overpriced properties, while pointing you in the right direction towards locating positive cash flow investments.
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