This one is a classic of real estate investing that was commonly known and practiced years ago. But in the years since the housing bubble destroyed all sense of realistic property values, it's been mostly forgotten, and is now virtually unknown to newbie real estate investors. In fact, you could say that one of the reasons for the collapse of the housing market, at least where investment property was concerned, was the general way in which the 1% rule had been ignored since the late 1990's.
The 1% rule simply states that a property should rent for at least 1% of it's total value. Put another way, your rental property is worth 100 times one months rent. If your property rents for $500 per month, then it's worth $500 X 100 or $50,000. If more investors had known and followed this rule during the housing boom years, we would have seen a lot fewer foreclosures on single family houses that were sold as investment property between 1998 and 2007.
The 1% rule is a valuable tool for real estate investors who invest primarily in single family homes, for several reasons. Yes, it is an excellent ratio for rental rate to total value. But it also acts as a control mechanism that functions well to keep investment property values at a realistic level. When real estate investors keep the 1% rule in mind when making offers on properties, they are much less likely to pay too much for a property.
Of course that last statement assumes that an investor has taken the time to do proper due diligence to determine what the realistic rental rate would be for a given property before purchasing it. As obvious as it sounds, you'd be surprised just how often this mistake is made. The biggest mistake one can make in single family rentals is assuming a property will rent for more than the market will bear. Verifying an accurate rent rate before making an offer is essential for making sure that you will not over pay for a single family home that you intend to use as a rental property. From a fundamental perspective, properties that can be rented for at least 1% of their total value are much more likely to have a positive cash flow. Up to a point...
Every rental market has a ceiling beyond which rental rates cannot rise. That is the crossover point between the cost to rent and the cost to own. Once a rental rate reaches a certain point in any given market, it becomes cheaper to buy. Those homes with rent rates that exceed this point will have high vacancy rates and negative cash flow in most cases.
This means that you can't arbitrarily assume that you can always raise rents to keep up with the cost of a property. For example, in the Atlanta, GA market, where I've had years of experience, I have found it to be a consistent rule that you can't cash flow rentals if the rent rate goes above about $1500. In the metro Atlanta market, where homes are less expensive than many other large metro areas, the vast majority of rental homes rent for less than $1500 a month.
If you approach your property buying by first verifying the most realistic rental rate for a property you are considering, then offer no more than 100 times that amount for the property, you'll be in good shape if your offer is accepted. If your offer is rejected for being too low, don't worry. Let someone else overpay and deal with the headaches that will be the inevitable result.
Fundamentally, once housing prices reached a point at which they were low enough to buy at a price that would allow for a 1% rental rate, it was time to start buying. Smart investors know this, and thus the buying has already begun to reach a frenzied pace. As a result, housing has stabilized for now, and prices appear to be improving, though very incrementally. For investment purposes, the 1% rule is a key fundamental that can help you steer clear of cash flow problems, even if you are a novice investor.
Donna S. Robinson is a real estate market analyst, investor and investing coach located in Atlanta, GA. Follow her on twitter at donnaconsults - Check out her latest book, Basics Of Real Estate Investing just released on Amazon.com