2% Rule? 50% Rule? Here’s the #1 Real Estate “Rule” I Use to Assess Property
Ah, the everlasting debate about which is the best formula to use to avoid failure and succeed at being a real estate investor. My great-grandfather used the 1% rule: Rent the property for at least 1% of the purchase price, and you should be safe. In many places this rule seems to have gone by the wayside, and now it’s the famous 2% rule. Two percent of purchase price, and you’re almost guaranteed to not lose! And hey, if you can get to the 3% rule, you’ll be rich in no time!
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Or how about the 50% rule? If the property rents for $1,000 per month, then you should plan on spending at least $500 per month on expenses and vacancies, not including your principal and interest payment. This is obviously meant to be used over the long term. As many discussions on BiggerPockets have outlined, this is a very general guideline, and it should be used as just that, a general guideline.
My wife and I have used the 1% or 2% rule more than we have the 50% rule, and overall they have done what they are asked to do. We have had cases, however, where even with these “rules,” we have had very bad years on certain properties.
How I Lost Money on My “1% Rule” Property
Take, for instance, a property we purchased in mid-2012 in Texas. This was a brand new construction, a never lived-in property. It was just over the 1% rule, but it was a brand new home, meaning it had a full warranty for one year, so if there were any problems (not caused by the tenant), we wouldn't have to pay for the repair. And many of the major systems were covered for up to 5 or even 10 years. I'm happy to report that in 2013, we didn't have a single call from our property manager for a repair. I'm unhappy to report that we made less than $500 the entire year on the property.
How can that be? We were over the 1% rule. We didn’t have a single repair. Here’s what happened.
The property was rented for $1,650 per month, and the tenants had been in the property since shortly after we purchased it. Suddenly, early in 2013 we were getting our monthly statements from our property manager, but we weren’t seeing the money deposited into our account. This had happened late in 2012 as well, but she had made a lump-sum payment to get us current right after the first of the year.
Then we received word that the tenant was breaking their lease. The happy couple decided they weren't so happy and had split up. Per the lease agreement, the tenants were responsible for all rent until we could get the property re-rented so we had a small level of comfort. Then things got worse. The next week we received an email from our property manager after numerous inquiries that she had shut down her business the week before, as she was now bankrupt.
Coincidentally, we hadn’t received the first email announcing the news. So now we had a vacant unit, no property management company and a bankrupt property manager who owed us over $5,000. We had two properties with her and were now missing both security deposits on two month’s rent on one. By the time we got a new property management company lined up, got the house rent-ready and got a tenant in, it had been over 2 months. That, my friends, is how we made less than $500 on one property while adhering to the 1% rule and having no maintenance issues.
The 1% rule did hold up to its end of the bargain, as we didn’t lose money and we hadn’t used it as a golden rule, just as a guideline, as it should be used. We were disappointed with all that happened, but we were happy we didn’t lose money. We’re still happy that we have the property, and it’s now back to making us over $400/month and we still have an asset we can sell if we need to. We still look at the 1% guideline when evaluating properties, but we have a different rule that weighs much more heavily on our decision. This is our “Comfort Rule.”
What is Our “Comfort Rule?”
When we are evaluating a property, we try to get hard numbers on as many things as possible. While you may not be able to get an exact amount for taxes and insurance, you can get pretty darn close if you do your research. My wife has been in the mortgage industry for years so we can get very accurate numbers without having to hassle a loan officer if we'll be financing the property.
Other expenses such as utilities, if we’ll be paying any, vacancy, and maintenance — the ones you can’t get hard numbers for — we calculate using our best judgment based on our past experience and input from others, and we try to be conservative in our estimations. As I said, we will quickly run the 1%/2% rule to see if it works. If all of these things check out, then we move on to our most critical decision, are we comfortable with the property and the numbers? This is the ultimate decision. Are you comfortable with the purchase you are about to make? Are you comfortable that you can float all of the expenses on the house during a disaster like we had? If you’re not, regardless of what the numbers tell you, then it’s not a good deal for you.
There are plenty of rules and guidelines out there to use to try to ensure your success in real estate investing, but none is going to be a sure thing. Even our “Comfortable Rule” isn’t a sure thing, but it definitely makes us a whole lot more at ease when purchasing a property than any of these other rules.
What rules do you use when evaluating properties for purchase?
Leave a comment below, and let’s discuss!