Rental Property Café™: Episode 11: Does the 1% Rule Still Work?

In this episode of the Rental Property Café™ Video Podcast hosts Cynthia Meyer and Veronica Woods discuss the “one percent rule” in real estate, whether it is a real rule or just a guideline, and the role it plays in choosing a property.

In Episode 11 of the Rental Property Café™ Video Podcast they cover:

☕	Is The One Percent Rule a real rule? [00:00:59]
☕	What using the One Percent Rule will tell you [00:01:18]
☕	Is the One Percent Rule still valid in this market? [00:03:29]
☕	Other factors that impact your bottom line [00:05:48]
☕	Focusing on the net [00:08:15]
☕	Can the One Percent Rule help you evaluate neighborhoods? [00:09:59]

TAKEAWAY QUOTES:

“ What matters is your bottom line. Is the property going to be, or likely to be, profitable for you as the investor? You have to dig beyond this initial metric, to know if you have a good deal.” - Cynthia Meyer

“...the other key is really thinking about not 1% this year, but what is the wealth that you can build over the longer term of the asset” - Veronica Woods

About the Rental Property Café™

The Rental Property Café™ podcast offers a real estate tool kit for busy professionals who are building a real estate portfolio. In each episode, co-hosts Cynthia Meyer & Veronica Woods explore ways to grow a successful real estate business while growing your career.

About Cynthia Meyer

Cynthia Meyer is a financial mentor, CERTIFIED FINANCIAL PLANNER™, CFA® Charterholder, real estate investor, blogger, and the founder of Real Life Planning. She offers unbiased financial planning and learning resources to real estate investors. Cynthia is a first-generation rental property owner, who built a rental property portfolio with her husband, Steve, while they were both building their careers. She lives in NJ, where she balances teenagers, her financial planning practice, and a rental property business.

About Veronica Woods

Veronica Woods of Daniel Woods Real Estate, real estate advisor and investor, is passionate about helping her clients create wealth, legacy, and lifestyle through real estate. She works with people to buy, sell, rent, and develop residential and small commercial real estate in Delaware County and Philadelphia, PA. An MBA in finance from the Wharton School, Veronica also shares her real estate wisdom with new investors on her YouTube channel.

Transcript - Rental Property Café™ - Episode 11

Does the 1% Rule Still Work?

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[00:00:00] Cynthia Meyer: Does the 1% rule really still work? Hi, I'm Cynthia Meyer with Real Life Planning.

[00:00:05] Veronica Woods: And I'm Veronica Woods of Daniel Woods Real Estate.

[00:00:08] Cynthia Meyer: And welcome to the Rental Property Café™.

[00:00:22] Cynthia Meyer: Today Veronica and I are talking about the 1% rule, which as a real estate investor or real estate curious person, you've probably heard a lot about.

[00:00:31] Is this rule a real rule? And doesn't really still work in this market? This is the first in our series on getting the numbers right. The next few podcasts we're going to be talking about that critical component of making investment decisions. Getting your numbers. Setting realistic expectations. The numbers are one component of a bigger picture, but it's really important when you're setting projections, to make sure that you're as accurate as possible.

[00:00:59] As you can see on the [00:01:00] screen, the 1% rule is a guideline or rule of thumb that says in a general, a rental property will be profitable if your monthly rent is 1% or greater of the purchase price plus the renovation costs that are needed to make it rentable. It really tells you if it's worth your time to run a fall budget analysis. But there's a lot of confusion about this that I'm hoping we can talk about today.

[00:01:28] Veronica Woods: By the time investors get to me, the local market expert, we're way past the 1% rule. So they kind of start at the 1% rule just thinking about, " Do I want to invest in Philadelphia or Cleveland or Detroit?" Once they get to that point, I'm really getting more deeper into the numbers. The 1% rule is really just a starting point- do I even want to be in this market or not?

[00:01:53] Cynthia Meyer: That's an excellent point. It's going to help you narrow the funnel from everywhere, particularly if you're [00:02:00] thinking about being an out-of-state investor, to specific geographic areas and maybe even specific neighborhoods within that geographic area. So a lot of times, I hear in my practice at Real Life Planning, there's a busy professional who is willing to invest out of state, but they don't even know when to get started. They want to pick a market that's likely to be profitable, where they can build a team.

[00:02:24] Is it California? Is it Indianapolis? Is it Philadelphia? Applying those guidelines to narrowing the geographic location is the first place to start. So it's art. It's not just math there are ranges.

[00:02:38] Veronica Woods: I think the nuance of is it Philadelphia? Understanding that there's a lot of variation within even within a Metro area. So you really have to peel the onion a lot further to be able to really narrow down your focus. But I do think the 1% rule, if you take it for what it is, it's a good starting point.

[00:02:58] Cynthia Meyer: It helps you figure out if it's worth the [00:03:00] time to go a little deeper.

[00:03:02] Veronica Woods: Exactly.

[00:03:03] Cynthia Meyer: The other question that I've been getting from clients a lot is whether it's still valid in this market. I would have to say on average, many rental property investors aren't getting 1% with a new purchase right now, unless they're doing a major rehab. You might be getting more like 80 basis points or eight tenths of 1% to start with right now.

[00:03:23] What are you seeing in the Philadelphia area and just in broader, do you think it's still valid in this market?

[00:03:29] Veronica Woods: I do think it's a challenge now in this market, mainly because the prices, the appreciation overall on the real estate market, especially on the single family side, even though there has been a story of rents increasing, what I've been seeing in most of my markets, they're not increasing as fast as the house prices. There was a bump in rent last year coming out of a pandemic.

[00:03:54] In 2020, it was kind of a holding pattern on a lot of rents. There was a lot of jump up in [00:04:00] 2021. Now we're into 2022 and the housing market is still really strong. It's really hard just to kind of keep the pace and fully fill your properties with able tenants right now.

[00:04:14] Cynthia Meyer: It can work. So for example, we recently did a 1031 exchange, which I've talked about before on the podcast in the middle of last year, from a single family home into a duplex, in a nice suburb of the Detroit area. We bought the replacement property for approximately $330,000. Initially, it was not a 1% property. It was about an 80%, 80 basis point property. But we have since had two vacancies. At the new market rates, now we're getting almost $3,600 a month in rent gross on that $330,000 investment. With a little time and patience, it's still possible to get there.

[00:04:57] Veronica Woods: I think so. Your goal [00:05:00] was to be the profitable, which you kind of get into, I guess in the next part is your specific numbers working is really what's important.

[00:05:08] Cynthia Meyer: That's exactly right. If the property isn't going to be profitable to you with the way you're going to manage it, with your expenses for maintenance and utilities, and for your financing costs, which isn't of increasing concern right now in a rising interest rate market that your mortgage rate might be higher.

[00:05:27] What matters is your bottom line. Is the property going to be, or likely to be, profitable for you as the investor? That's the most important thing. So you've got to, number one, focus on the net, not the gross. You have to dig beyond this initial metric, to know if you have a good deal.

[00:05:46] Veronica Woods: I would add that there are other factors.

[00:05:48] You mentioned some of the factors that may impact your bottom lines. If you're out of state, it may be harder for you to understand is, what's your likely turnover timeline [00:06:00] for that particular building? Some properties may be a 1%, but it may it may take you longer to find a good tenant and have you factor that in that vacancy into your numbers? Or maybe you're at a price point where it's hard to find a tenant that's earning three times the rent so that you feel comfortable that there'll be a longer term tenant. Those little kind of nuances really do impact your bottom line.

[00:06:25] Cynthia Meyer: I think that makes a lot of sense. So factor in the appreciation assumptions and also your holding period if you're not planning to hold it for a really long time, to make sure that it's going to end up being cashflow positive for you.

[00:06:38] You guys have heard me say this over and over again, that I look at the point of rental property investing is to make net rents. That's my personal point of view. And that appreciation is secondary. Rental cash flow is the cake, and appreciation is the frosting. You don't just eat frosting.

[00:06:56] Veronica Woods: Well, I also think it kind of depends on what your financial goals [00:07:00] are.

[00:07:00] So if you know that you're going to be investing over a longer term horizon, and you're not really dependent on the cashflow to do anything, but just reinvest it, there's definitely some better markets that you can get a higher appreciation over the next 10 years versus there are some markets where you're really dependent on cashflow and they're not going to get a great appreciation over the next 10 to 20 years. People make a lot out of money if they're able to come and keep that cashflow over that time horizon. So I think the other key is really thinking about not 1% this year, but what is the wealth that you can build over the longer term of the asset, I think is really important.

[00:07:46] Cynthia Meyer: Ideally, you can do both. You can have a reasonable amount of inflation protection. So your price appreciation keeps pace with inflation. You may have a marked demand appreciation rate, where there are more buyers than [00:08:00] sellers for properties in your area.

[00:08:02] And then you have inflation adjusted rent that is going up over time. Hit that, all those three things at the same time, over a longterm investment is really a beautiful thing. That's what we're all looking for.

[00:08:14] Veronica Woods: I agree.

[00:08:15] Cynthia Meyer: So another thing to add to point 1, focus on the net not the gross is to ask yourself if you're in a low cash flow or a neutral cashflow environment on a particular deal, are you going to be able to raise rents to market rents? What do you think about that, Veronica?

[00:08:34] Veronica Woods: If you're running your 1% rule on the max rent from the area, you have to be careful of what is the real market in your area. Maybe you had $1,500 in your model, but the other houses in the neighborhood are struggling the rent for $1,400.

[00:08:53] So no matter if you know your calculator says market rent is $1500, the reality is you can't get to [00:09:00] the $1400. There's really kind of a pressure on how far you can raise rents, even though you think there's grounds for it.

[00:09:07] Cynthia Meyer: That's an excellent point. And on the other hand, if you're buying a property that's tenant occupied, for example, and that you do not expect the existing tenants to continue to be in the unit at below market rate rents, you may have the opportunity when that unit turns over to bring it back up to whatever the market rate is at the time.

[00:09:29] Veronica Woods: Right. So it's more back to the timing issue that you would eventually get the market rates, but it might take you a little bit longer to adjust.

[00:09:39] Cynthia Meyer: And factor that into your calculations for your particular deal. Not just rely on this broad guideline.

[00:09:46] Veronica Woods: Exactly.

[00:09:47] Cynthia Meyer: So what about understanding the neighborhood trends? Taking it down more to a micro level within neighborhoods. How would somebody use the 1% guideline in that situation?

[00:09:59] Veronica Woods: [00:10:00] I think once you get to neighborhoods, I think you're probably not talking strictly 1% role anymore. You're trying to assess, in my opinion, I'm really down to just cashflow. I really think the cashflow evaluation and understand that and the appreciation trade-off is paramount. Once you start talking in how you can have the local expert help you the most, is when you start trying to compare individual neighborhoods against each other to figure out where you want to focus.

[00:10:35] Cynthia Meyer: That's an excellent point. So getting some input from local experts.

[00:10:39] For example, in your Philadelphia area, you were an expert on different neighborhoods, right? And you can help steer an investor to one or the other, depending upon what their goals are. Just in general, if you're trying to compare across a larger geographic lines, right? Say from state A to state B, for example. Setting some [00:11:00] parameters for yourself and then running the numbers on individual deals and comparing them one against the other.

[00:11:05] We are going to tackle finding these types of numbers a little bit later in this series. We're going to talk about cashflow per door, the impact of financing, the role of appreciation and other numbers to consider such as vacancy and turnover, that Veronica mentioned that we need to know that our beyond rent and expenses that can affect profitability.

[00:11:25] Veronica Woods: I really recommend people to put a list of criteria together. I wouldn't make an investment off of any one particular in of itself. Each investor may have a different list or a different metrics that make sense for them. Some people, may never care about 1%.

[00:11:42] They may be shooting for the point 80 that we are talking about right now. But they have some other more stricter criteria that's important to them. So I really think its important and in a lot of them are numbers based, but there's more than one criteria that's [00:12:00] important. I want to emphasize that.

[00:12:01] Cynthia Meyer: Yeah. I'm glad you did because especially if you're following a lot of real estate education. We can be tempted to think that what applies to most, applies to everybody. But it doesn't necessarily do that. What's most important are your numbers in the context of your financial goals and your situation.

[00:12:18] In summary, we want to emphasize use the 1% rule to tell you if it's worth it to run a full budget analysis on a particular geographic area and then a particular deal.

[00:12:30] Run your own numbers to make sure that it works and take into account rising rates right now.

[00:12:36] Have targets per market, then drill down for specific deals.

[00:12:42] So we've really enjoyed this conversation this morning. Veronica, as always, you are one of my favorite people to talk to in the Rental Property Cafe. And for those of you who are listening, please watch some of the other videos in the series that are coming forward.

[00:12:56] If you're looking for a related podcast to start with, [00:13:00] go to video podcast, episode eight in the Rental Property Cafe: Are you ready to build and scale your real estate portfolio?

[00:13:07] So, thanks very much.

[00:13:09] Veronica Woods: Thank you.

☕ See more financial planning guidance for real estate investors from Cynthia Meyer on the Real Life Planning blog: https://reallifeplanning.com/blog

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☕ Connect with Veronica Woods of Daniel Woods Real Estate: dwoodsrealestate.com/letsconnect

☕ Do you have a topic suggestion or want to be a guest on future episodes? Email your ideas to podcast@reallifeplanning.com.