I have to give credit to Julie for this little tip. This is her creation. Somewhere along the line she just started doing this to simplify and speed up the process of evaluating properties for their cashflow potential. As she confessed last month, she doesn’t like numbers and math to evaluate properties. And, this technique is one simple calculation that tells her to continue looking at a property or to move on. While I spend hours pouring over spreadsheets and killing the battery on my calculator to assess the cashflow of a property, Julie can make her decision whether to investigate a property further in 60 seconds.
Julie calls it the 1% Rule
All you need are two numbers: the price of the property and the rental income you will get each month. If the monthly income is 1% of the purchase price then you are pretty much guaranteed a property that will cashflow.
For example, if you have a property that costs $300,000 and it gets $3,000 per month in rent, Julie’s simple calculation tells her that it is a property she’d like to learn more about. The numbers are looking really good.
If you have a property that costs $300,000 and the rent is $2,100 per month, it’s hitting .7%. She’d probably still look into this property, but she’d do it knowing that the money will be tight. Anything lower than than .7% is going to be really hard to make cashflow without either a big downpayment, lower purchase price or higher rent.
The 1% Rule in Action – Making Sure Properties in a Specific Area have the potential of producing positive cashflow:
We’re looking at areas in Canada and the U.S. where we will record our upcoming video series. In the video series we’re going to follow our real estate investing process from start to finish to buy a property. One of the places I have been researching is Austin, Texas.
Let me show you how I’m using Julie’s 1% Rule in the evaluation of properties in Austin:
I did a search on Realtor.com, and I found 10 single family homes in the St. Edwards area, ranging in Asking Price from $289,900 to $299,900 (because I limited my search to a max. of $300,000).
Multiply .01 (1%) by $290,000 and you get $2,900. If you can get around $2,900 rent (per month) in that area on a house that costs approx. $290,000, then you can be very comfortable that you will have a strong positive cashflowing property.
You can even drop the 1% to 0.8%, and you will still likely have a positive cashflow property. Why not just use 0.8%, you ask? 1% is just a rule of thumb. Basically anything over .7% is worth looking into further. But, you can decide the exact number you’re looking for based on your objectives, the strength of the area, the size of the down payment you have and the cost of financing you can obtain.
If you can put down 25%, you can decrease the 1% rule to 0.8% or possibly even 0.7%. However, if you can only put down 10% and the bank is going to charge you 7% interest rate, you will want to achieve closer to the 1% rule.
Let’s look at the 1% Rule decreased to .8%. Let’s say you have a 25% down payment for this example:
If you have 25% to put down and are going to use the 0.8% rule, that would be .008 x $290,000 = $2,320.
You want to have approximately 35% of your rental income available for expenses (management, insurance, property taxes, maintenance, etc.). So, if you can achieve $2,320 in monthly rent, subtract 35% for expenses, and that leaves you with $1,508 ($2,320 x .65) available for your mortgage costs.
$1,508 in a monthly mortgage payment at 5.5% interest rate, with a 30 year amortization can afford a $267,420 mortgage. In other words with a big down payment and the low interest rates available in today’s market, the .8% rule will work.
If you bought the $290,000 home with only 10% down, this would leave you needing only a $261,000 mortgage ($290,000 x .90 = $261,000) yet the $1,508 monthly payment can actually pay for $267,420!
But, Julie complains that she can’t do the math in her head on .8%, so she sticks with 1% and just knows that a little bit lower than that will still work.
It’s just a simple rule of thumb for quick and easy assessments. Once you’ve found properties that have potential for cashflowing, you still have a lot of work to do to make sure the property is a good one to buy. At least using this trick you can feel comfortable that you will be spending the time learning more about a property that has good potential.
Published January 13th, 2009