1% rule in NJ doesn't really work?

Question

Living in NJ we've been looking at a few properties and it seems the 1% rule doesn't really work because of the high taxes.. Example:

$130,000 property. Owner had cats so it really just needs new carpets to get rid of the smell but we'll say it needs about $10,000 incase there are surprises. This property should easily rent for $1,500 a month covering the 1% rule. The problem is the taxes on this place are $4,800. It would still be cashflow positive but only generating about a 7% return on original investment.

From what I've read you really wanna be like 12%+ otherwise its really not worth the headache as you could just invest in an REIT getting about the same return.

Anyone else run into this kinda thing?.. am I missing anything on the numbers? Its seems like in NJ it really needs to be the 1.4% rule.

Scott Trench · Answer

1% rule is bogus in my opinion. Here's why:

Suppose I have a $100,000 property that rents for $1,000 and a $500,000 property that rents for $4000. In both cases, I put down 25%. Same structure - assume it magically transplants such that one is in the midwest (LCOL), and the other on a coast in a HCOL.

Case 1 gets me a $75K Loan at 4%, with 1% taxes and 1% insurance, my payment is $525 per month. I assume $250 per month for CapEx/maintenance and $100 for vacancy and self-manage. This isn't a great deal, but bear with me for discussion purposes.

In this case I net $125 per month in cash flow on $25,000 down. A 6% Cash on Cash annualized.

Case 2: I put down $125K on the $500K Place. With 1% taxes and 1% insurance, my payment is $2,625 per month. But here's the tick - I can assume basically the same CapEx and Maintenance with a slight COL adjustment. Materials, appliances, etc all cost within a reasonable variance of one another around the country. I can assume $350 in this case to account for higher labor costs if I hire work out. I still have to assume the same percentage vacancy ($400). If I self-manage, my monthly rent is $4,000 and my monthly outflow is $3375.

In this case I net $625 per month on $125,000 down. Also a 6% Cash on Cash.

What people miss here is that many of the costs associated with operating a rental property do not scale linearly with the cost of the structure. Again, at the very least the materials cost associated with many CapEx or maintenance requests are reasonably flat throughout the country. And, while it will vary by market, I suspect my property taxes and insurance, as a percentage of my property's value, is lower than my peer investing in a similar type of structure in a much cheaper location.

It is possible and indeed highly probably that many properties here in Denver that you can buy at 0.8% rule, or 0.75% rule produce a better cash on cash ROI than properties that you might buy at much lower price points and rental rates at the 1% or even 2% rule in other parts of the country, for the reasons listed.

Finally, I suspect that I manage a different class of tenants at my rental rates of $1300/month on average than the fellow who manages a property in the $500-600 rent range in the midwest. It's possible that I have a dramatically different landlording experience than my peer in a different market investing at properties in the 1.5-2% rule range.

Hope this is helpful.

Mike Bonadies · Answer

@Jason Clarke There are many properties that pass the 1% rule. I own several units in the area and all of them pass the 1.25% rule which I personally use in a pinch. Areas that have properties that pass the 1% rule (and sometimes even the 2% rule):

Gloucester County (certain towns)Salem CountyCumberland County (Bridgeton, Millville & Vineland)Camden County (certain towns - Camden, Gloucester City, Lindenwold, Clementon, Brooklawn, Pine Hill, etc...)Cape May CountyAtlantic County

The more north you get the harder it gets to find good cashflow deals but they still exist.

Eric P. · Answer

We ended up scoring a property for $97,000 rented back to the owner for 3 months at $1,300 then did some minor renovations and had the original floors from 1890 refinished, turned out amazing and is now rented to a great military couple at $1,700 a month. This was an off market purchase from a friend of the family who was retiring and moving out of state and was just looking for a quick easy move. House is now worth about $140k so we did very good on this one. Finding another one is certainly going to be a challenge.

Joe P. · Answer

I think what people are missing is the "1% rule" is simply a qualifier, not meant to be an accurate proforma of a property's ability to cash flow.

People say that you can make money on a 1% rule property -- well, maybe, but rubber needs to meet the road. That might work in an area where there are low taxes, the property doesn't need much work, and there is demand at the rent price.

Realistically, the 1% rule is a good basis to check if a property meets the minimum to review further. Nothing more, nothing less. And that's only for cash flow -- lots of people buy for appreciation, that's their game if they want it.

A non-seasoned investor says "1% rule doesn't work!" but a seasoned investor will say "this property should be evaluated on its merit to see if it will work."

I've removed the "1% rule" from my vocabulary. People ask me how I determine if a property will work or not, and I say I need as much information as possible to estimate rent, minus ALL expenses. The property either stands up for cash flow, or it doesn't, and every property is different.

Mike Bonadies · Answer

@Jason Clarke I have 21 units solely in South Jersey. Most of them are in B- to C- neighborhoods. Most are close to Philly so the economics part of the equation is there but crime and finding a perfect tenant can be a problem.
Below are specific areas but there are many, many more than what I show
-Winslow
-Pine Hill
-Clementon
-Gloucester City
-Brooklawn
-Vineland
-Pennsville
-Westville
-Brooklawn
-plus many other townships

Jason Clarke · Answer

That's a fair point, Donald. But having a high net worth (i.e. high equity) may be priority to some and allow future monetization, whereas good cashflow now may be focus for others. So depending on the goal/point of your investing, the market and its attributes would be worthwhile in considering when beginning to pick up properties. That said, at this point in my investing journey, I wouldn't buy a non-cashflowing property even if equity buildup & appreciation were expected. Eventually, that could change...I'm just not there yet.

Donald Bondi · Answer

While the high taxes are a killer (I live on Long island where "low" taxes are around 10k" so I understand), there is something to say about someone paying down your mortgage and building up your equity. Real estate has so many advantages it's amazing.

Jason Clarke · Answer

Hey Ozzie. You being a contractor could be considered a competitive advantage given you'd be putting in sweat equity & have exisiting materials ready to use...something not everyone else can easily accomplish. If choosing to work on your own place keeps you from earning money you otherwise would, I'd still consider it an opportunity cost that bears including in your costs to acquire and get rent-ready. Either way, the point I was making in an earlier post regarding inability to apply 1% rule in NJ and cashflow due to high taxes still holds. Let me know if you find something different. Run numbers w/rehab costs and without and see what you get in each scenario. I'd be interested in results if you're willing to share.

Jason Clarke · Answer

Hi @Joe P. I agree that the 1% rule should not be taken literally. What I was stating is that even as a qualifier, using 1% rule may still be aggressive given that many NJ properties wouldn't cashflow particularly in light of the high property taxes. More specifically, I'd say using something above 1%...say 1.5% would give you a better selection of properties to do deeper analysis for cashflow. Thanks for the post.

Hi @ Scott Trench. The nonlinearity of maintenance and capex costs is not something I considered. It's an interesting thought and I'd be curious if it actually bears out in real life. In your example, lower cost market warrants 25% of gross rent for maintenance & capex vs 8.75% in higher cost area. That's quite the disparity. Does the extra $100/mo TRULY reflect the added labor cost in a higher priced area? I'd be curious on others thoughts on this, as well. I don't know. If this turns out to be true, then I need a better way to reserve for maintennce & capex than simply using 10% and 25%, respectively and equally as important...I need to get into these higher priced markets then.

I certainly believe tenants would be different in each market, which is correlated to hassle factor, expected damage to units at each turn, expected legal fees (when filing for eviction), etc. So there is definitely some gains there and it's a fair point. Thanks Scott.

Jason Clarke · Answer

Thanks @Mike Bonadies. That's quite the list. Kudos to you! Would you still buy the same properties now in those areas and continue to build up your portfolio at current home prices and rental income?

And that sounds like an awesome deal @Eric P. Good luck on scoring more of them!

1% rule in NJ doesn't really work?

1% rule in NJ doesn't really work?

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