The 1% rule: no more

I remember two years ago when I started to underwrite smaller deals, there was a rule that was tossed around on all the blogs and forums. It’s called the 1% Rule. What this means is that the monthly rental income should be equal to 1% of the total purchase price.

For example, a property for sale for $200,000 should have monthly income of at least $2,000. 

Sounds pretty simple, right?

Well on the surface, it should be pretty easy. However, due to the past two years of COVID, lower interest rates and inflation rises have caused people to use real estate as a place to securely stash away cash as a hedge against the powerless dollar. What this has done has caused prices to rise to a point that the 1% is not a feasible option.

Let’s use the original example of a $200,000 property earning $2,000 per month. While rents have raised steadily, the purchase price has grown exponentially quicker. Now, that same property may be selling for $280,000.

As a result, somebody sourcing deals that fit this 1% rule have to adjust their expectations or else they will have a real tough time finding deals.

As a result, investors have focused on equity and appreciation rather than cash flow.

Investing for equity build up and appreciation isn’t as attractive because it won’t help you replace an income or build up insane cash reserves, it can yield nice yearly returns when you decide to sell or refinance a few years down the road.

While you may buy something that isn’t cash flowing too well in the first couple of years, when the value is growing at a pace higher than inflation, and you are only paying 3%-4% on the borrowed money, you will see substantial returns down the road. Again, this is a strategy for somebody who can go without the cash for a few years. 

If you are still in search of cash flow, you will likely find them in the lesser appreciating areas. However, consider it a warning that sometimes, these tougher areas can mean more of a job for you, than an investment. That’s just my two cents.

Where do you see prices going in the next year or two?