Issues with the “1% Rule”
The “1% Rule” is a quick rule of thumb that some investors use to quickly evaluate whether a prospective investment property is worth examining more closely. In short, if the after renovation rent for a house is expected to be $1000, then an investor would be willing to pay up to $100,000 for this rental house (purchase price plus rehab). However, there are some issues with the real estate 1 percent rule.
Effective Cap Rate vs. Market Cap
Zelman & Associates gathers and analyzes data on several thousand rental houses each month across the US including information from the large single-family REITs. While there are some variations from market to market, especially with respect to property taxes, many rental houses will deliver an NOI of about 50% to 55% of the gross income. Using that same $1000 per month rent, and assuming YOU can get 55% of gross, we can estimate the NOI for this house will be about $6600. That translates to a 6.6% Cap Rate – which is great, if you can find it. One of the issues with the real estate 1 percent rule is, lately, most of the B quality rental houses in Metro Atlanta are trading at about a 5.5% Cap Rate. This would be the current “Market Cap Rate”. So if you insist on buying a B quality property at a 6.6% Cap, in a 5.5% Cap market, you may not find anything to buy.
The biggest issue with the real estate 1 percent rule is that while you try to find a property at a 6.6% Cap, you are losing money. Your loss, while your cash is sitting in the bank, is not the difference between the 5.5% Market Cap and the 6.6% Target Cap. Your loss is the difference between the 5.5% Market Cap and the interest that your bank is paying you for that cash.
Cap Rate vs. Internal Rate of Return
If your focus is on the house’s Cap Rate, then you almost always end up with low end (C-) properties. These are the properties that will generate the highest rents relative to the purchase price. Why is that? Because these lower quality properties do not appreciate as rapidly, over time, as do higher-quality B and A quality houses. I acknowledge that during the 2010 through 2015 time frame these C quality houses experienced very good appreciation. But that was because their values had fallen so far, relative to higher caliber properties, between 2008 and 2010. Now that the market has recovered, these low-end houses do not appreciate as rapidly as higher-quality houses. If you live in a major city or large town, then you probably have areas, school districts, or neighborhoods that are more valuable per square foot than houses that are similar in age and construction but happen to be in the less desirable area. Both houses were built around the same time using the same construction, but one is much more valuable than the other because the rate of appreciation is higher in the “better” area.
One of the differences between investing in houses compared to any other real estate is that the sales value at the end of your holding period is usually not correlated to the Cap Rate. With every other real estate investment, the sales price is tied to the market Cap Rate and the property’s NOI. And that can be true for rental houses too IF the seller is 1) selling a portfolio of rental houses or 2) selling houses in a part of town where the majority are rentals and few residents can afford to buy. In the 2nd instance, the probable buyer is another investor. But with many rental houses, the sales price has nothing to do with Cap Rate. The most likely retail buyer is an owner occupant that does not care how much the house was renting for. They care about amenities such as the commute to work, the quality of the schools, shopping, parks, etc.
When I invest in B quality properties, I have found my internal rate of return is higher than with the C quality properties BECAUSE of the appreciation. Cap Rate only looks at cash flow. IRR looks at cash flow AND appreciation AND loan amortization. IRR gives you a much better understanding of the TOTAL return generated by a property.
If you want to start analyzing properties based on IRR rather than Cap Rate, and you do not have a good tool for that, you can go to www.excaliburhomes.com/excaliburs-cash-flow-calculator-2020 and download a copy of the Excel spreadsheet which we use.