While the 1% and 50% rules are widely used by people of varying levels of experience, they're just guidelines that aren't a hard and fast rule. I know in my market for example that 1% is insufficient, I need closer to 1.5% or higher. This got me thinking about these rules of thumb and I wondered if these two rules mathematically compatible?
***let me add once again that I know these are not hard and fast rules. I wanted to do the math on them and understand the conditions of them a little deeper, so I figured I'd share the nerd math. It also gives us something to think about when looking at these rules and purchasing factors***
For those of you who are unfamiliar with the rules, let me recap:
1) the 1% rule says that if rents are 1% of total price/value, you stand a good chance of cash flowing on an investment
2) the 50% rule says that you should plan for roughly 50% of rent going towards non-mortgage expenses
Are the rules mathematically compatible?
Let's take the example of a 30 year fixed mortgage at 5%, assuming 80% LTV (for those that don't know, meaning that the your loan is 80% of the value of the property). Whether this is on the purchase or after refi is irrelevant in this example as either way your mortgage payment and 1% rent estimate are both based on the same value.
On a $200,000 property, the 1% rule says that we should be able to cash flow at $2,000. The 50% rule says that we should plan for $1,000 in non-mortgage expenses. This leaves $1,000 to cover the mortgage payment and any profit.
The mortgage payment on a $200k property at the terms above comes out to $859. This means that on a 5% loan using these rules, you should anticipate ~7% of your rent value to be profit ($141 at this price). If your interest rate exceeds 6.375% however, you now break even or have no profit.
THE VERDICT: at current rates, they are compatible; however if mortgage rates increase above 6.375%, the two rules are mathematically incompatible
Ok, that was a fun exercise. So what?
Most importantly, it tells us that we absolutely cannot leave 20% in the deal if we want even an 8% return ($141*12=$1,692/year profit, which is a 4.2% COCROI leaving 20% in). It tells us that we need to find a way to pull money out of the deal, or we need to look for a property that exceeds the 1% rule.
Quick rules of thumb to estimate off of are fantastic time-saving tools if used properly, but can have potentially disastrous financial consequences if taken as gospel without further analysis. I have a couple of recommendations for any new investors when using these rules, and ultimately when doing any type of analysis:
- Know your target COCROI going into your analysis. Pick whatever fits your investing goals, but think critically about it
- Adjust your assumptions as you get more information. For example, if you plan on investing in a neighborhood with an HOA, in a flood plain with much higher insurance, or in an area with extremely high taxes, the 50% rule will likely be too low and you need to relook your assumption
- THESE RULES ARE NOT GOSPEL!!! Use them to screen properties, and then do your own deep analysis to see if the numbers actually work out for you
- **I can't get the rest of these numbers to go away, sorry about the horrible formatting. Hope the fun little exercise helped someone!
Awesome post. I think it comes down to due diligence as well. If I'm looking at properties online on zillow, redfin, or whatever other site I think I can look at asking price and maybe rentometer to get me a quick thumbs up or thumbs down with those two rules. I like 1% as a bare minimum where you should hope your analysis can yield higher or you can do something to increase rents and get that ratio to a safer value.
Also with mortgage rates as they are it is also encouraging more people to purchase homes where if interest rates rise dramatically we may see purchase prices lower and so our analysis can change from a COCROI standpoint.
good to see some posts like this to keep people thinking. know your market, know your expenses, and work tirelessly to find deals that work for you and your criteria!
don't be afraid to say no or turn away a deal if it doesn't meet your numbers!
@Nathan Norway . Good post. Not sure what amortization term you used, it should be 25 years or less. Not sure if you factored principle reduction from loan payment. Utilities are a huge factor. If tenants pay heat and/or water it’s swings the numbers. My portfolio is more in the 1.3-1.4% range, all multifamilies except one, most with boilers for heat and window AC units. It’s becoming more common in this area to have a utility surcharge.
@Jeff Ronningen great points. I was going as simple as possible-no return from paydown calculated, utilities are roughly grouped i to the 50% rule, etc.
@Patrick Menefee , I think those rules work for the north/east states where property taxes are high when compared to property valuations. If I used those rules in AZ, I’d be buying nothing but ‘slumlord’ properties, or not own anything. cap rates >10% are like unicorns, they basically don’t exist today.