I'm writing this post to shed some light on a problem I keep encountering with aspiring investors who are new to real estate.
They read a book or two, hop on BiggerPockets and learn about a few ways to analyze a potential deal, and somewhere along the way they form a "Golden Number" that all future deals must have to be worth considering.
The 1% Rule is the biggest violator on here, but it could be any other metric that the investor has created an unrealistic standard for that they try to apply to every deal. No matter the property type, geographic location, or local averages for the metric.
The classic example of this is a new investor who calls me up and wants to find a great rental in a B class area with above market rents, low crime, great schools, etc. and expects to pay $100k less than those properties are going for on the market. Not going to happen.
In this article I'll take a look at a few other common examples and show how when they're dogmatically used to analyze real estate to the exclusion of all other factors, you're doing yourself a major disservice and are passing up on tons of potential deals.
CASH ON CASH RETURN
BiggerPockets already has an excellent article written on Cash on Cash Return that I will borrow from below:
"Calculating cash-on-cash return is simple. We simply divide the received net cash flow for the year by the amount of cash invested. It will produce a percentage rate that measures the received pre-tax cash flow relative to the amount of money invested to acquire the asset.
The cash-on-cash return is a great metric and is widely used throughout the real estate industry both investors and real estate agents. The primary reason for this is due to the metric’s simplicity in calculating the percentage return.
The cash-on-cash return specifically drills down in the return on the capital invested. It does so by only considering returns that are driven by the property’s net cash flow.
Because the cash-on-cash return is only looking at the net cash flow and comparing it to the actual amount of cash invested, it’s a great indicator for the effect of leverage. Using leverage will decrease your cash-on-cash return, which makes the metric a good way to measure different levels of financing."
But the big problem with cash-on-cash return is that it doesn't account for taxes, loan paydown, or appreciation, which are all a huge part of your actual returns on investment.
When you take those things into consideration, you can get a way different evaluation of the same property or market using different metrics.
For a real world example of this, consider this article here about the Best Cities to be a Mom-and-Pop Landlord:
"Oklahoma City is the best city to be a small-time landlord in the short term, which is when comparing rental income versus assumed monthly mortgage payment, according to a new research released Friday by real estate website Zillow. In that city, short-term profit amounts to $536 a month.
However, the greatest returns are actually in markets like San Jose and San Francisco where there are short-term monthly losses, but the long-term earned equity makes them the best markets to invest in.
Including home equity gains, tax benefits, property and income taxes, and maintenance, in addition to the difference between monthly rental income and mortgage payments after holding the property for six years, San Jose, Calif., with $8,927 in long-term profit, is the best city to be a small-time landlord."
So while the Bay Area might of had negative cash on cash return, it made FAR greater profits over time than the high CoC markets did. And buy-and-hold real estate is a long term game, which is why CoC isn't the best metric to use as a single filter.
I see this happening a lot on the west coast in markets like California and Arizona, and investors expecting to get 12% cash-on-cash returns like we're in some high cash flow market like Cincinnati or Oklahoma (it might even be rare there, not my market).
If you know of a way to get this kind of first year return in the current market where you're at, please do share.
More on this "geographic metric swapping" below...
IMPOSSIBLE METRICS LIKE THE 1% RULE
The big problem with a 12% cash-on-cash return or the 1% Rule where the gross monthly rents should be 1% of the purchase price is that in some markets they are next to impossible to find and therefore completely useless.
Let's use both of them to analyze the purchase of a $250,000 property in Anytown, USA. We won't even account for other expenses to keep it simple, and will just use the PITI as the base expense.
Purchase Price: $250,000
25% Down: $62,500
PITI @ 5% INT: $1,340/mo
Rent for 12% CoC: $2,000/mo
Rent for 1% Rule: $2,500/mo
Now, take a look at what your tenant could buy that property for themselves:
Purchase Price: $250,000
5% Down: $12,500
PITI @ 4.5% INT: $1,710/mo
Difference from 12% CoC: -$290/mo
Difference from 1% Rule: -$790/mo
So why on earth would your tenant agree to pay you $300-800 more per month for rent when they could purchase the property with only 5% down and pay way less? Unless you've mastered the Mind Control Powers of Dracula this is simply never going to happen.
The simple fact is these metrics are completely broken beyond a specific price point, to the point of being almost useless.
The only way you're going to get close to the 1% Rule on residential properties in west coast markets like Sacramento or Phoenix is with a fourplex. And it'll be rare at that. And probably in a neighborhood you don't want to invest in, or in a condition that's going to require tons of additional capital in maintenance and repairs.
What good is a 1% Rule property if it's full of bullet holes and you can't collect the rents?
Obviously there's more to the picture than just a single ROI metric. Here's how you can use them to analyze a property.
COMPARE AGAINST THE AVERAGES FOR YOUR MARKET
If you're going to use ANY metric, you should compare each potential property's scores for the metric against the average for that geographic market. And I would even consider narrowing it down further to neighborhood, price point, and property type.
For example, I recently did an analysis of all 2-4 unit properties in Sacramento priced between $400k and $600k. The average 1% Rule score was 0.58%. Not too glamorous when you compare it to that "gold standard" of 1%.
But there were three properties that scored above 0.75%, WAY above the average. So these properties could be considered "great deals" even though they are still below the 1% mark because they perform so much better than average for the area.
The problem occurs when new investors bring cashflow figures from Oklahoma and expect to find them in San Jose, or take appreciation figures from California and try to apply them to any flyover state. You're going to be looking for a deal for a LOOOONG time if you do.
All in all, real estate is complex investment that should be analyzed using many different metrics in tandem to analyze the potential long term returns on a given property.
If you abandon all other metrics for some "golden number" or something, no matter what that golden number is to you, you're doing yourself quite the disservice and will pass up on many great deals because of it.
OTHER THINGS TO CONSIDER WHEN ANALYZING DEALS
Think of all the other things that must be considered when analyzing a potential deal:
- Crime Rates
- School Ratings
- Population Growth
- Job Growth
- Rent Growth
- Historical Home Value Appreciation
- Nearby Commercial Development
- Gentrification / "Up-and-Coming" Neighborhoods
- Long-Term Projections
- And so much more
For example, more than 2 years ago I made a massive post about the coming "Millennial Migration" from the Bay Area to Sacramento, and have seen how much that migration pattern has changed the local real estate market there.
I bought a owner-occupied short sale in October 2016 for $260k with only 5% down. Nearly three years later it's worth $350k and generating over $500/mo in positive cash flow.
If I had been stuck on getting a certain metric like the 1% Rule or 12% cash-on-cash return, I would've totally missed this opportunity. Don't let that happen to you. Look at the bigger picture and think long-term.
Want another migration pattern years ahead of time? Here you go. Thank me later.
MIGRATION PATTERNS AND TRENDS
According to a new survey by Edelman Intelligence, 53% of Californians are considering moving out of state due to the high cost of living. Millennials are even more likely to flee the Golden State — 63% of them said they want to.
In fact, some other states are actively targeting California companies. Arizona launched one such effort in 2013, after Californians approved a tax hike. Texas, too, has tried to seduce companies away from California.
The difference in cost of living and taxes and close proximity make Arizona a nice alternative for these migrating Californians, particularly if they're from Southern California. SoCal has more than 5x as many people as the Phoenix Metro Area, so it's simply an issue of supply and demand... and traffic hahahah.
How many SoCal millennials do you think are willing to finally give up the beach for affordable housing? The median home price in Phoenix is HALF what it is in Los Angeles and hundreds of thousands cheaper.
P.S. If you're a millennial in SoCal reading this, realize that Puerto Peñasco AKA Rocky Point in Mexico is less than four hours away from Phoenix if you really must see the ocean on a regular basis.
How many of the 10,000+ Baby Boomers turning 65 every day and retiring are sick and tired of snow and cold weather in northern states and are deciding to come to Arizona and wear shorts on Christmas in warmer weather?
Enough to make AZ the #2 retirement destination in the US, second only to Florida.
Perhaps these two migration factors are why the Phoenix Metro Area is set to DOUBLE in population by the year 2050. Tucson will play a huge part of it two as the cities grow closer and closer together, filled up with millennials moving from expensive California and Baby Boomers moving from colder northern states.
To some, this may sound like a sales pitch for a market that I just so happen to be a licensed real estate agent in.
To them, I would say "Why do you think I moved here in the first place? The heat?" LOL :-P
But those aren't the only migration patterns affecting real estate values. Consider the following:
2018 Top Inbound States for Population Growth
- South Carolina
- North Carolina
2018 Top Outbound States for Population Decline
- New Jersey
Are there migration patterns and other trends affecting your local real estate market? Is tech bringing new jobs to your city? Are high taxes and cost of living pushing people out? Are there "Secondary Markets" nearby that could receive a massive surge in demand?
Because that's exactly what's happening with Sacramento and the Bay Area, and Los Angeles and Phoenix. And it could be happening in your market too.
TOO LONG, DIDN'T READ
In summary, my advice to you is to consider ALL aspects of a potential investment, regardless of how complicated that puzzle might be to put together. You can't just rely on one single piece (like a single metric or standard you adhere to).
I know, I know... you don't have time to do all that research or even read all of this post. Which is why there are licensed professionals like me to do a lot of that work for you. I still advise you do your own due diligence, but networking and the sharing of knowledge is what Bigger Pockets is all about.
If you're dead set on achieving some certain ROI figure, ask in the forums where you can find markets that offer it. If you're looking for it in a certain area, ask in the forums if your expectations are realistic and what kinds of returns others are finding instead.
@Wes Blackwell too long
I think that was probably all accurate info but I don't think anybody is going to read it lol
Bravo!!! Excellent rant Wes!! ;))
Also, don't rule out the power of intuition. It doesn't get the credit it deserves.
Or maybe it's because it's perceived to be a more "Female" thing.
But sometimes your "gut feeling" just knows best! ;))
@Wes Blackwell That was a great read. It's definitely something that I've been stuck thinking about for a while now. I'm looking to purchase my first rental property in Cincinnati to house hack, and I have realized that rarely do duplexes in B neighborhoods here meet the 1% rule. I'm going to use additional calculations like cap rate and gross rent multiplier to compare similar homes to find a great deal. It'll also be hard to find a good deal on the MLS that meet these criteria so I do plan on mapping my target neighborhoods through driving for dollars and letter campaigns.
I think generally speaking if you are looking at the midwest, or somewhere in the south, you should look at 1% rule in a C class area or up as a GENERAL starting point and then deep dive analyze from there. In Cali, Arizona, etc you are generally not going to find the 1% rule ANYWHERE except for maybe a D- or F neighborhood. There's your summary :-)
Another one I find tiring: ”minimum 20% discount”
I see a lot of new investors with no experience (save attending a webinar or two) lead with this line: that they are only interested in great deals with a minimum 20% equity position on purchase. The problem: 20% off of what?
- Off of list price?
- Of speculative market opinion at the time?
- Of income-based market valuation?
- Of the ARV (even if you aren't rehabbing anything)?
Our market happens to be experiencing a 98% list-to-sales price ratio and record low days on market; submitting offers at 80% of sticker price and hoping one sticks is not a very efficient way of doing things (even if you read it in a book).
@Wes Blackwell I was always look at deals from four different perspectives a cap rate analysis, discounted cash flow analysis, precedent transactions, and sales comps. I mainly do commercial multifamily though.
@Wes Blackwell - Well stated and argued. I always have time for your long and insightful posts. 😁
@Wes Blackwell I read it. Very thought provoking. Thanks for sharing.
The IRR function in Excel is a lot easier than people think.
@Wes Blackwell great input. Good info and advice is worth the read regardless of how long a post is. To achieve your goals, why pass up on free information with the potential for better understanding?
@Wes Blackwell Well said, and I’ve had the same frustrations seeing people focus too much on the wrong things like the 1% rule and “cash flow”. Over the years I’ve tracked numbers closely on my properties. Many of the ones that looked the worst on paper according to the “rules” have performed the best in reality. Why? Because of other factors that don’t show up on spreadsheets or that we don’t factor in enough, such as turnover rate/churn, rent increase/gentrification, appreciation, build quality/property condition, quality of tenant base/LOCATION, random uncontrollable events, quality of management, chaos theory... so many investors are too data-driven these days. Real estate investing has so many variables which can’t be predicted. Whether we want to admit it or not, throwing a dart at the map and buying wherever it hits could easily produce better results than relying strictly on rules and spreadsheets. Data points and metrics tell us very little about how a property will actually perform over time. Many new investors following these arbitrary rules also make the mistake of thinking that their numbers are smarter than a quality local agent, which is a huge mistake because there is a lot more value in an experienced agent that has local knowledge than there is in any analysis software. I’m not saying analysis is useless, but it’s only helpful if used in combination with construction knowledge and local market knowledge in order to determine the overall QUALITY of the property, not just how it scores according to a few “rules”. “Not everything that can be counted counts, and not everything that counts can be counted.”
Albert Einstein, Physicist
Well said about the construction knowledge. There's all this dangerous faith in the extraordinary power of the home inspector to tell you what's wrong with the property and how long things will last on the property. When these new investors explode here, usually with something like an SFR that's 40-60 years old, they say nothing about roof design, basement wall construction, beam placement, site slope, drain extensions, none of the things they should obviously be thinking about in buy a property they intend to hold 20+ years. Because they know nothing about how these things will affect the long-term holding costs of their investment, and their assumption is that the numbers will tell you everything and the home inspector and his report are absolutely going to inform you about everything an investor needs to know about a property in order to decide if s/he wants it. And when you point these things out, these new guys always get offended. "What, you expect me to get rich in buying and rehabbing houses and actually learn about how houses are built and rehabbed?"
But somehow, the guru seminars keep churning them out, beginner investors who go into this with no residential construction knowledge and no desire to learn anything about how houses are built and maintained.
The analogy I always make is of a port-a-johnny salesman. Do those guys ever try convincing investors that there's big bucks to be made in port-a-johnnies and the investor will never have to smell poop? No, because anyone making money in port-a-johnnies is way too smart to believe that line.
Excellent info., Wes. I think the 1% rule is outdated in California and many other places. Every buyer is competing with an excess of other buyers, whether they be investor or prospective owner-occupants. It's gone from a business based on numbers that make economic sense to become a game of how much over value can a buyer risk paying? It's complete speculation that makes no sense in so many situations. Buyer's need to understand they're essentially buying two parts in each purchase:1) the amount that will bring you a decent return on your investment,and 2) the amount you need to pay as a premium due to excess demand/ shortage of property driving prices up. Tragically, this second part causes incredible financial devastation on buyers unable or unwilling to pay the second part when prices continue to increase beyond reason. Those who paid the premium and ride the appreciation look brilliant when their investment values rise, but I see nothing to brag about when the price paid was abnormally high in the first place. I wouldn't want to be an investor starting out today. It's much more difficult than 20 years ago, which time wasn't that easy, by the way.
That’s all fine and nice but I don’t care what’s hot and happening in San Francisco or Dallas or Egypt .. I’ll still buy my old 10-15k houses and get my 40% returns . Yes the population declines yes good jobs leave yes some lady down the road got mugged but those metrics are things I don’t even consider for the most part to be honest . When I run an ad and get several dozens and of applicants trying to get my place daily all those metrics go out the window to me because no matter what there is always a huge amount of the population that need to rent and it’s increasing .appreciation is great but I’d rather have the tenant pay my house off in two-three years and get big cashflow . I want 3% rule atleast .
Good post. The people who didn't make it to the end or skipped to the end missed some valuable insight.
Originally posted by @Mike Dymski :
The IRR function in Excel is a lot easier than people think.
I find it amazing that IRR is simply not really discussed on this site.
What a great discussion going on here and it comes at a time when I’m trying to fine tune my math. In my cash on cash I’m using the following metrics to arrive at a price in which I would buy (with a loan):
Down payment (20%)-
Interest (erring on the high side)-
Tax (looking ahead 2-3 years)-
Insurance (erring on the high side)-
Capex/repairs (looking ahead 10 years)-
Rent (the lowest I’d expect to get)
I determine the total out of pocket and then I divide that by net income (annually) for my cash on cash number. The percentage one is willing to accept is a totally personal thing, I feel 10%+ makes it a good deal.
I live in NJ. Trying to find something with a 10% return usually has me anywhere between 25-100K below the asking in a market where it’s likely for the seller to get the asking.
One thing that is confusing to me is using appreciation in their formula. My math is based on a buy and hold, a long term rental, not selling an appreciated house. To me appreciation is just speculation anyway. If I do end up selling, I consider appreciation and the principle that has been paid down as icing on the cake (if in fact the value of the home had increased).
I am fairly new at this. Maybe my math and thinking is way off. I do feel that it has prevented me from getting into what I had perceived as a few bad deals. If anyone has any criticism I’m all ears.
@Jim K. your blessed to live in a market were houses are cheaper than used cars.. and this is true in many parts of the US.. the value of the asset has nothing to do with replacement value.. if those houses burned down they would not be replaced.
so your buying economically obsolete homes.. and for a local this works perfect.. you don't need rules.. you know your price points for a local who is hands on is just so skewed towards your success that no further deep dive is needed..
I wrote a post when I first got on BP about 4 years ago that went to 200 to 300 reply's.
( 1% rule 2% rule KILLS VALUES) and it does in markets that are cash flow only.. there is no reason to buy rentals that are not positive cash flow when you know the values are far less than what it cost to replace and your admitting going in your not expecting any appreciation over the years if you get that its icing on the cake.. we see that verbatim on reply's.
But for out of area investors this is hugely dangerous thinking .. If investors are buying for these rules metrics and rents don't rise substantially and tax's stay flat.. the value of the asset is going to go down.. not up.. the value tracks rents and fix costs..
in a market like yours its all about local knowledge and scale.. your just buying a business your not investing in real estate per se.. no different than running a storage facility etc.. value is all based on rents. much like MF>
Haha, I just added to that verbatim.
This is a post brought to you by the Arizona chamber of commerce. It’s just a fluff piece for Arizona. Nothing against Arizona, but the top industry in Arizona are what tourism, mining and manufacturing?
Originally posted by @Ray Hill :
Haha, I just added to that verbatim.
You and thousands of others here are the buzz words... " I am buy and hold forever" "I am a Cashflow investor" " I don't expect appreciation" " Appreciation if gambling I am not a Gambler " "Appreciation is icing on the cake " these are the most common things beat into investors heads these days. and then regurgitated..
I mean I have never invested in the hopes my property would not go up.. I expect it to .. other wise why do it.. I can buy any number of business that will cash flow far better than rental properties..
To me cash flow is simply to hold the property while it appreciates if you get a little positive fine a little negative fine.. what cash flow investors who follow those mantras do though is they take on Risk they are simply not aware of by setting up a criteria that puts them squarely into tough to manage properties or properties that are only appropriate for very local hands on professional landlords.
The 1% Rule was a dumb rule-of-thumb-dumb calculation never made any sense during any period nor in any state. The only way to determine whether or not a property is a good investment is to do all the math and...
you have to stretch the projections out for as long as you want to own the property. I am finding that 99% of the brokers, real estate agents and gurus, even on this forum, do not have a clue regarding how to do the proper calculations. I go to every real estate club possible and I meet real estate brokers who have been advising people about how to invest for 30+ years and they are pushing investors to stay away from multi-units while claiming that single-family units are better, easier to rent, easier to clean, the tenants stay longer and the ROI is better. B. S.!!! There are too many people (way too many) who do one deal and they are selling the garbage advice for money.
I've been investing for more than 50 years and I made millions of dollars before 2001. Starting in 2001, I met the smarted most-experienced real estate broker who won an award from President Bush for making a certain number of people millionaires in the real estate business. I got a simple business business model and a simple math formula from him and since 2001 I made more than $30 million by investing in real estate.
All you gurus are missing the boat and I never read in any book, nor saw in any podcast, nor heard during any over-priced workshop what I am going to tell you.
THE BUSINESS MODEL - Purchase only the properties that will give you a 50% to 100% return on your money within 1 to 2 years. That means, you want to double your investment capital every one to two years.
How is something so difficult accomplished? By setting this goal, having the mind-set, looking at as many properties as you need to, by taking the time to do the simple math that no wannabe guru taught you.
How do you make 50% to 100% every year on your investment capital? When looking at single family properties you need to purchase properties that are undervalued and/or you make up part of the difference with cash flow. Suppose, a seller wants $160,000 for a home. You offer $110,000 and the seller comes back with $120,000. You purchase the home with $40,000 down and the day you close escrow you just made a 100% ROI on your money. You rent the property and get a $4,000 annual cash flow. At the end of the first year you earned a 110% ROI. Keep the property for life, or put in on the market without a real estate agent, sell it and start over again. If you live in the property 2 years you don't pay capital gains tax.
What investors are not doing? They look at the ROI when they purchase single-family properties and they don't stretch the ROI out for 1, 2, 10, 20, 25 and 30 years. By doing this an investor can see that with my business model you can earn 50% to 100% on single-family properties every 1 to 2 years, but after a few years the ROI starts to average out to an overall average of 10% to 14%.
Now, we get into another area. Most investors have the mind-set that they will buy several homes, have the tenants pay down the mortgage and they will be on easy street. This is a lame business model because you don't get rich by collecting rents. In 30 years, the rents you collect is just a little additional income. Especially after considering your average over 30 years was only 10% to 14% and the cost for everything 30 years from now is 5 to 20 times more expensive.
Here is another thing nobody tells investors. You can purchase multi-unit properties for 30% to 40% less per unit, get the same amount of rent, more cash flow per unit and the profit you earn can exceed the entire price you paid for the property in 3 to 5 years. Using 30% to 40% less than you pay for single-family homes you can earn with multi-units a 40%+ average ROI over a 30-year period compared to a 10% to 14% average ROI for single-family properties.
How can this much money be made with multi-units. It is done by having the right mind-set with the goal to achieve this, by taking the time to understand the reasoning and power of the Gross Multiplier, by doing projections starting with the day you close escrow and increase the rents, by calculating your annual rent increases and calculating annual profits when factoring your Gross Multiplier and by stretching out your projections 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 20, 25 and 30 years. I have a software program that does the math, but BP will not allow me to give it away without paying to be a Pro Member and for advertising. So, since I am not going to pay $600 to give information away you can ask me how to do the math and I will see if I can help, but you don't have to be a rocket scientist to do it.
"I see this happening a lot on the west coast in markets like California and Arizona, and investors expecting to get 12% cash-on-cash returns like we're in some high cash flow market like Cincinnati or Oklahoma (it might even be rare there, not my market).
If you know of a way to get this kind of first year return in the current market where you're at, please do share."
I'm sharing how to find the 12% COC returns. He's right that it's doable in Oklahoma. In OKC you've just got to look in areas that might not how all the feel-good cosmetics/sidewalks/maintained yards etc, but that definitely have the returns. I'd focus on NE OKC and just south of the river. They might have a bit higher crime or a bit more maintenance along the way, but I've not seen that impact my rentals other than a homeless person looking for somewhere vacant to sleep for the night. 14% COC is totally worth going over and asking that person to leave so you can get the property rented!
A lot of OOS investors will shy away from these areas because they feel scary, but when you use the bottom line as your method for evaluating these areas make more sense than any other.
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