Rental Properties & The 1% Rule
Calvin Ewing
Helping People Obtain Above Average Returns Backed By Real Estate - Note Buyer | Real Estate Investor |
The 1% rule is used as a simple guideline to quickly estimate whether or not a rental property will generate enough cash flow to be a worthwhile investment. The rule states that the monthly rent should be equal to or greater than 1% of the purchase price. For example, if a rental property costs $200,000, the monthly rent should be at least $2,000.
The 1% rule has a number of benefits for rental property investors, including:
.While the 1% rule can be a helpful starting point for investors, it is important to note that it does not account for all of the expenses associated with owning and operating a rental property and, in my opinion, relying on the 1% rule alone can lead new investors into making unwise investments.
These often unaccounted for expenses can include:
If these expenses are not properly considered when crunching the numbers prior to purchasing a rental property, the 1% rule can lead to investors buying properties that are not actually profitable and can instead be a financial drain or a black hole constantly sucking in more of the landlord’s money.
Vacancy
Vacancy is the percentage of time that a rental property is unoccupied. Even in the best markets, there will be some periods of vacancy. Investors should budget for at least 5-10% vacancy when calculating their expected cash flow.
Repairs and maintenance
All rental properties require repairs and maintenance over time. These expenses can range from minor repairs, such as fixing a leaky faucet, to major repairs, such as replacing the roof. Investors should budget for at least 5-10% of monthly rent for repairs and maintenance.
Capital expenditures (capex)
Capital expenditures are expenses that are incurred to improve or maintain the long-term value of a rental property. Examples of capex include replacing the HVAC system, renovating the kitchen, or adding a new deck. Investors should budget for at least 1-2% of the purchase price for capex each year.
Property Taxes
Rental property owners are responsible for paying property taxes on their rental property. Property taxes vary depending on the location of the property, but they typically range from 1-2% of the property's assessed value.
Insurance
Homeowners insurance protects landlords from financial losses in the event of damage to their rental property. It typically covers damage from fire, flood, wind, hail, and other natural disasters; Vandalism and theft; Liability for injuries to tenants or guests.
The cost of homeowners insurance will vary depending on the location of the property, the condition of the property, and the amount of coverage that the landlord chooses. However, landlords should expect to pay around 1-2% of the property's value per year in homeowners insurance premiums.
Property management fees
If you hire a property manager to manage your rental property, you will need to pay them a management fee. This fee typically ranges from 8-12% of the monthly rent.
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Financing costs
These costs include the interest on the mortgage loan, as well as any other fees associated with obtaining and maintaining the loan.
The amount of financing costs will vary depending on the terms of the loan, the credit score of the borrower, and the interest rate environment.
Conclusion
The 1% rule is a simple rule of thumb that can be used to quickly weed out bad rental property deals from potential good ones, but it is important to note that it does not account for all of the expenses associated with owning and operating a rental property.
Investors should carefully consider all of these expenses when evaluating potential investment property deals. In my experience however, a great number of rental property investors do not factor in these expenses when buying rental properties. As a result, many investors lose money over the long run.
In some markets, the appreciation of the property can make up for these losses but a smart rental property investor should be able to find deals with positive monthly cash flow after factoring all of the expenses mentioned above while also benefiting from long-term property appreciation.
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