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Note that I did not say “what you should charge”, but rather what your tenants likely can afford. Affordability is going to be a huge issue going forward, as renters fight the headwinds of increasing payroll taxes, inflation of food and energy costs, the new health insurance mandate, and stagnant incomes.

One of the challenges most landlords are facing today is the dwindling buying power of most of their tenants. Though not all tenants are in this situation, US Census data shows that the vast majority of wage earners in the U.S. are not making very much money…

Here are some facts it’s helpful to know:

1. According to Social Security wage data, 50% of all wage earners made less than $27,000 in 2011.
2. An additional 16% of all wage earners make less than $42,000 per year.

This means that fully 66% of all wage earners make less than $42,000, with three-fourths of them below $27,000 per year.

As a rule of thumb for lower income renters or buyers, allocate no more than 36% of net take home pay, and that is what the typical tenant should be able to afford in rent. Of course this depends on other debts such as car payments, credit cards, and such, but generally, 36% is a commonly used percentage for calculating how much of a mortgage payment a buyer can afford. The same rule of thumb can be applied to a tenant.

Real estate agents and lenders commonly use the gross income number and calculate from that, but I prefer to keep things rooted in reality, so I strongly recommend using net take home pay for this calculation, because clearly, tenants or buyers cannot make use of income that will be deducted for payroll taxes. You are not doing yourself or a prospective tenant any favors if you try to stretch what a tenant can afford beyond what is realistic.

When looking at a prospective rental property you are considering buying, I recommend using the above rule of thumb to help estimate your likely positive cash flow on the property. Search online to find out what the median income is in the immediate neighborhood where your subject property is located, and calculate an affordable rent rate for the subject property.

For example, let’s say that your property is located Albany, Georgia, a typical, midsized city in the south western section of the state of Georgia. According to the detailed Census Data that is available online here, Albany has a median income of $17,424, well below the average of $25,383 that is shown for the entire state.

Multiply $17,424 by .36 and you’ll get $6272.64 – This is the amount that a person with the median income in Albany, GA can allocate to pay rent for an entire year. Taking $6272.64 and dividing by 12 months, I get $522.72 per month. This is what a single person earning median income should be able to reasonably afford in rent each month.

And conversely, if you are using the 1% rule as a guide for making an offer on a property to be used for rental, you could assume that a 1-2 bedroom unit might be worth $52,272. (The “one percent rule” states that a property should rent for 1% of it’s value, or conversely, a rental property is worth it’s monthly rental amount times ten.)

A three bedroom home rented to two adults, each earning median income, could be estimated to gross $522.72 X 2 or $1045.44 per month. Using the 1% rule as our guide, this property is worth approximately $104,544.

Knowing what your tenants can afford helps you insure that you do not pay too much for a rental property going in, and also helps insure that your tenants will be able to pay on time every month. And when tenants can afford their rent, they are likely to stay longer, which reduces your vacancy and turnover costs.

This is merely a way to work with the fundamentals in your market, because real estate investing strategies work best when your strategy is in line with the general market fundamentals in your area.
Donna S. Robinson is a real estate investor, author and market analyst located in Atlanta, GA. Follow her on twitter at donnaconsults. Her book, “Basics of Real Estate Investing” is now available on Amazon.com for Kindle Readers.

Image by the great 8 via flickr.com

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.
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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