What is the 1% Rule Anyways...

Question

...but a load of crock.

Ok - here's my question: what did the 1% rule ever assume?

I understand it is a pre-filter rule of thumb. Heck, I used to defend it. But I'm looking over numbers and I'm starting to think it may have always been a bit of a unicorn that appeared once when the stars aligned, but otherwise doesn't really make sense under MOST conditions.

I've nerded out a little and ran numbers comparing interest rates, P+I payments, and initial principal balances and I've found with MY assumptions, that the 1% rule is actually NEVER a valid filter.

My assumptions are:

1) Cap-ex, maintenance, vacancy, and PM costs are around 33% of rent.

2) My desired cash-on-cash return is 12%.

3) My taxes and insurance, for argument's sake, are a combined $550.

Under these assumptions, 1% never works under any interest rate conditions. Which I GET means that someone's numbers will work if they have different values for their assumptions.

So I have to wonder - what assumptions create the right mix of numbers for the 1% rule to work? Pick your interest rate. Heck - I'll come back as I continue analyzing this and provide you with my findings.

Andrew Syrios · Answer

They used to talk about the 2% rule, which was basically a ruse to get you to buy in the absolutely worst part of town where you got 2% on paper and only on paper. I torn that thing to shreds a long time back: https://www.biggerpockets.com/blog/2015-05-06-2rule-die-horr...

The 1% rule used to mostly work as a "pre-filter rule of thumb" as you say. But these days, even the 1% rule is often unrealistic and pushes you toward terrible areas.

Matthew Hull · Answer

Alright - I was mistaken about the 1% rule not working in any interest rate condition.

If I stick with my numbers and I'm trying to buy a duplex that rents for $3000 in today's 7.25% interest scenario, I'd have to not exceed $154,000 of debt at that interest rate in order to hit my numbers. If I could find a duplex that sells at that number and is rent-ready, I'd actually be pretty close to 2%.

The problem is that if I inverted my analysis and said, "Hey - this hits the 1% rule!", and I look at houses that are $300,000 or so at a 7.25% rate, then I'd find my numbers would be significantly short of my revenue goals. I'd have to sacrifice my cash flow or cheat my operating expenses, or both, in order to make 1% work. And maybe it would never work.

If I protect my numbers, interest rates would have to be 3.5% or so in order for a 1% house to work (assuming 20% down), which means for $3000 rental revenue to work, the debt load would have to be about $235K at that interest rate (give or take with variable taxes and insurance numbers). I'm sure this was definitely a thing that was achievable in the COVID years...

So the 2% rule seems like it would get you a lot closer to your mark than 1% in today's interest rate climate.

1% really does seem like a unicorn.

Now - here's the nitty gritty. If I hold my interest rate to 7.25% and run my numbers, the ratio of rent to purchase price changes depending on the rental rate. The lower the rent, the greater the ratio needs to be. Here's what I'm seeing:

For a $1000 rental, I need to have no more than $16,400 in debt in order to make my numbers. This is a 4.89% rent to purchase price (assumes 20% down).

For a $1500 rental, I need to have no more than $50,800 in debt. That's a 2.36% ratio.

For a $2000 rental, it would be $85,300 of debt. That's 1.88%.

For $3000, it would be $154,200. That's 1.56%.

The reason the debt number is so low is because I need the principal and interest to be low enough to achieve my profit and operating cost goals. That's directly related to the interest rate.

The reason the ratio changes as the rent rate drops is I am holding my taxes and insurance constant in this model (comparing houses within the same city). So if my taxes and insurance numbers are similar from house to house, then the low-rent houses are not going to have enough revenue to take on more than just a little debt.

So it would seem if the ratio is variable based on rental rates, that comparing rent to price is a ridiculous filter since you need a different ratio for each rental rate. You'd have to have a matrix of rental rates correlated to how much debt your numbers could take on, then filter your searches by asking price at those numbers for just those houses that could rent at those rates. The rent to price ratio is an interesting artifact of this exercise, but it doesn't tell you if something will be profitable.