The 1% rule used to be a pretty good first step in determining whether a property would likely make a good investment. By calculating 1% of a property’s price – which would be the monthly rent target – it was the quickest way to determine yes or no whether to consider renting a property.
If you could probably get that number, you would go ahead with other due diligence methods, such as determining the cap rate, neighborhood assessment, and home inspection. If you didn’t think you could get close to 1%, you would move on to another property.
The 1% rule worked in pre-pandemic times. But it doesn’t work anymore. For example, in 2015 the median home price in Atlanta (where I invest) was $187,000. I could easily get houses in the $150,000 price range and charge close to $1,500 a month for rent.
In January 2022, the median home price in Atlanta was $375,000, so inflated prices mean it’s unlikely to get 1%. In March 2022, the average rent in Atlanta for a three-bedroom home of about 1,500 square feet was $2,295. A $200,000 house now puts you in a different kind of market. Instead of a three-bedroom, two-bathroom home in a safe family neighborhood, you’re more likely to look at a two-bedroom, one-bathroom home in a not-so-nice neighborhood, where you probably can’t go. fetch big dollar.
So you can see that with our current inflated house prices, the 1% rule no longer applies. If you were to follow him now, you probably wouldn’t make a deal.
Another method for determining potential rental prices
A better way today to determine how much rent you are likely to get is to look at neighborhood comps, houses similar to the one you are considering in your area that are on the rental market. You can also use an online rent comparator. I use Rentometer, and it’s pretty accurate for my area. Additionally, some online property management companies offer this service to members.
Once you have determined if there is a healthy rental market, start looking for a single family home in that area. Let’s say your target price to acquire the property is just below the median – $350,000. And you want a three-bedroom, two-bathroom house in a nice family neighborhood, where the rent is $2,000 a month. Instead of using the 1% rule, calculate the cap rate.
How to determine the capitalization rate
Determine the cap rate by subtracting the operating expenses from the gross annual rent to get the net operating income (NOI). Then divide your NOI by the purchase price of the property to get the cap rate. Many investors use 50% as a ballpark figure to calculate operating expenses, but I usually use 40% because it’s more accurate for my investments. You want your cap rate to be higher than what you could get from other types of investments.
Note that a very high cap rate generally signals an at-risk property, often in a crime-ridden or other type of undesirable neighborhood. You can invest in it, but you might have more rent-free periods.
Using the above example of the $350,000 house at $2,000 monthly rent, your cap rate would be 4.1%. Breaking it down, $24,000 (gross annual rent) minus $9,600 (operating expenses) equals $14,400 divided by $350,000 (purchase price of the house), which gives you 4.1%. By getting a cheaper property, lowering operating expenses, charging more rent, or a combination of several factors, you can increase your cap rate.
Before the pandemic, I wouldn’t invest in a property with a cap rate of less than 5%. But now I don’t mind getting a lower cap rate if I can reasonably expect house prices and rents to appreciate, which they should do in my area for 2022.
In an appreciating area where you can rightly increase the rent the following year, you might get a better return on your investment, depending on your increased expenses as well. Keep in mind that it’s not good practice to rip off your tenants by raising the rent by more than 5%, which in this case would be $100. So if you bill $2,100 the following year and your expenses stay the same, your cap rate on that property becomes 4.5%.
Should you buy a property today or wait?
It is not easy to buy property in most countries at the moment due to inflated prices. But if you want to invest in real estate, you probably shouldn’t wait for prices to drop, because you could be waiting forever. Prices set to rise 12% in 2022, with ‘no end in sight’, says Fortune.