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!
