Something is alluring about the idea of investment real estate. The notion that you can build equity in a property while getting a steady monthly check delivered directly to your bank account without needing to do much work is a powerful one. While most landlords find that real estate is not quite a passive investment option, many agree that it is a highly lucrative asset class that features unique tax advantages.
The pull of a tangible investment property is so powerful that HGTV is now America’s third most-watched television network. Whether you love Fixer Upper, Flip or Flop, or Good Bones, you probably wonder whether adding an investment property to your portfolio would be a sound decision. For many retirees and soon-to-be retirees, the answer to that question is a resounding “yes!” Investment properties typically outperform the stock market and are mostly passive investments. The prevalence of high-quality property management companies, little-or-no money down mortgages, and low-interest rates all make it a perfect time to consider adding rental property to your asset mix.
You should know that you are not alone if you are sold on the idea of rental real estate and are holding yourself back from buying your first investment property because you are afraid that you are making a mistake. Rather than avoid this asset class entirely, set aside a bit of time to research investment properties in your area and start using the “1% rule” of investment real estate to analyze your next deal and spot a winner.
The 1% Rule
The 1% rule is a rule of thumb designed by real estate investors to help them quickly decide whether a particular property is worth pursuing. This rule empowers landlords to quickly scan MLS listed properties and off-listing deals and spot the real diamonds. The rule suggests that rental properties are likely to be sound investments when the expected monthly rent rates are at least 1% of the home’s purchase price. Plugging this equation into a calculator will give you a simple, usable result:
100 x rent / purchase price
Properties that produce a value of less than 1.0 may not be worth your time. Unless you believe that the property is in a rapidly appreciating neighborhood, the home has sentimental value, or you think that development will redefine the market, a house with a score below 1.0 may become a money-pit once upkeep, vacancies, and eviction costs come into play. Properties that score above 1.0 are worth further consideration. These properties are potential cash machines that will keep generating strong cash-on-cash returns.
Soon-to-be real estate investors can find average rent rates using any number of online services. Rentometer, Rent Cafe, and Rent Jungle are all excellent, free resources that can help you find local rental information. Keep in mind that these tools give average rental rates, and rental prices can vary based on the exact location or even from building-to-building. Speaking with a knowledgeable Realtor or property management company before submitting an offer is a great idea.
Hidden Costs and Other Considerations
The 1% rule’s simplicity is also the source of its most significant risk. The rule excludes substantial costs that can sour deals that look great on paper. Major expenses that are not considered by the standard include repairs, HOA fees or special assessments, property taxes, insurance, and closing costs. Utilities that you will be responsible for, property management costs, financing fees, and legal expenses are also entirely ignored by this rule. These costs can add up!
Hidden damage, problem tenants that you inherit from a previous owner, or significant capital repairs you need to make to heaters, air conditioning units, or driveways can all throw off your numbers. Property tax reassessments levied once a property turns from a residence to an investment property can also be a source of added expenses.
While it is good to be aware of these extra expenses, they are not something that should paralyze you with fear. First-time investors can reduce their risk of a bad experience by getting a proper inspection to minimize surprise expenses. Speaking with experienced property management companies and requesting expense sheets for their managed properties can also help you ensure that you do not miss a cost that could change your opinion on a property. Most management companies will provide you with templates to earn your business.
Ready for a Deeper Dive?
Rental property is an excellent option for those seeking above-stock-market rates of return with a semi-passive investment. If you are considering making a rental property part of your investment, start by running paper deals. Screen properties on the MLS, Redfin, or Zillow with the 1% rule and start plugging data into online calculators like the New York Times’ Rent-or-Buy calculator or Bigger Pockets’ Rental Property Calculator. Once you start feeling confident, make your first deal happen!