The 1% Rule - A quick hack to analyzing Real Estate
Article written and published by PM3 grad Mayu Thavarajah.
Let me start with saying, I didn't make the 1% rule. I am just a consumer of knowledge that picked this up from the real estate titans of the world. The principle behind the 1% Rule, is that if a property can be rented for 1% of the total purchase price, that property will cash flow for you (in most circumstances). This rule is meant to be a quick hack to allow you to analyze properties on the go and a rule of thumb that you can use to determine if a property is cash flowing.
So what is cash flow and why does it matter?
Cash flow is the total rents from the property less total cash outflow. Note, this isn’t your actual ‘expenses’ since there is a principal component of your mortgage, but it is the total dollars leaving your bank account. If a property rents out for $1000 a month, and has $999 in cash flow outflow, you would cash flow $1 a month.
Cash flow is what will allow the average Joe investor to build a scalable investment portfolio. Try buying 20 properties with each one being cash flow negative $100 - $200 a month. For the average person, that simply is not an option.
I use the 1% rule religiously when analyzing my own properties so I've included a quick case study below.
Case Study:
I purchased a property in Windsor with my capital partner late last year. Purchase price was $170K and it was a BRRR investment which meant I was able to pull out and return all of my partners initial investment (shoot me a message if you want more information on that) resulting in infinite returns for the both of us.
When analyzing that property I used the 1% rule to quickly determine if the property would cash flow in its current condition.
Through my experience, research and discussions with my power team, I knew I would be able to clear $1,700 a month in rent on that property as is, and about $1850 - $1900 if I renovated it. Therefore, 1% rule met since $1,700 / $170,000 = 1%. My cash outflow at this purchase price would be $560 mortgage payment, $200 a month in property taxes, approximately $100 a month for insurance and another $100 for property management. This left a significant amount of cash flow to allow for the the capex, repairs and vacancy allowance plus a bit of cash flow for my pockets.
Here is a quick snippet of what those numbers would look like:
So now that I knew the property would cash flow, you move on to analyzing other parts of the deal since the 1% is a rule of thumb but not a decision maker on your real estate investing.
Limitations of applying the 1% Rule:
Properties can be under rented
The previous landlord may have never increased rents, they may have opted to rent out the home to a family member or they may just not know what current market rents are. This means when you look at the current rent roll it might not meet the 1% rule currently, while in actuality the future potential based on current market rents would meet this rule.
The property could have deferred expenses
If I purchased the $170K property and spent $20-30K replacing the roof, electrical and furnace is my purchase price still $170K or is it $190-$200K? I would argue it is closer to $190K. That changes the result of the 1% rule.
Landlords misrepresent all the time
It is unfortunate but ultimately a seller is trying to get top dollar for their asset. If it is a property valued based on rent roll often they are motivated to have a temporary tenant that is willing to pay a larger amount on a month to month basis, utilize the space illegally to ensure a higher rent (i.e. boarding rooms in cities that do not permit this) or use non conforming units that can be shut down by the city at any time. All of the above would significantly skew the results of the 1% rule.
The 1% rule does not consider appreciation
If you have two properties that both meet the 1% rule which property is better? Do you assume they are both equal - not quite.
There is definitely value in real estate that is in a better neighborhood or in a better town/city itself. This factor is ultimately ignored in considering the application of the 1% rule.
To take the other end of the spectrum, a property with an A+ tenant quality is worth much more than a D+ tenant quality even if the A+ tenant quality results in a 0.8% rather than a 1%.
Market Costs
Different markets have different costs so you have to adjust your 1% rule to the market you are analyzing. This makes it difficult when you are comparing properties across multiple markets.
For example some parts of New Brunswick charge a double property tax if you do not live in the home yourself. Waterloo student rental licensing fees could significantly impact the ability to utilize the 1% rule. In some markets, utility expenses are commonly paid by the landlord, while in others it is paid by the tenant. All of the above significantly impacts your ability to analyze a property solely based on the 1% rule.
Reality:
The reality is if you are in a larger metropolitan area (like myself) you likely need to look outside of your city to find properties that meet this rule. This is why I now do a lot of my investing in secondary markets.
In addition, if you read this the entire way through I'll take it you are pretty interested in real estate! I put out some more content on Instagram so feel free to connect with me there @mayu.thava or shoot me a message/connect on LinkedIn!
If you are interested in more background on this topic, check out his video below: