The 1% rule has been treated like a scientific fact for years and I want to end that today. The 1% rule is simply a rule of thumb – and an outdated one at that. It was created at a different time and overestimates the role of cash flow in today’s real estate investment climate.
What is the 1% rule?
The 1% rule uses a (rightly) popular metric called the Rental Price Ratio (RTP) to estimate cash flow.
RTP is a great proxy for cash flow because it is so easy to calculate. All you need are two inputs: rent and price.
To calculate the RTP for an entire area, take the median rent and divide it by the median home price. With an average rent of $ 1,000 in a city and an average home price of $ 200,000, the RTP is 0.5%.
To calculate the RTP for a specific deal, do the same. Take the rent you think you can get on the property and divide that by your estimated purchase price.
It seems like a rough measurement, but it really works. So much of your expenses – monthly payments and interest, insurance, taxes, etc. – can be roughly derived from the property price. The math also fits.
I simulated the cash-on-cash return (CoCR) for the 576 major markets in the US and then correlated the CoCR return with the RTP for each city. The result was a correlation of .85, which means there is really a strong relationship between RTP and cash flow.
My complaint here isn’t the use of RTP as a measurement. I think it’s an excellent way to dig into markets and figure out a few details about a deal.
My gripe is the rule that the RTP has to be above 1% to get a good deal. I see on the forums and hear straight from people that they didn’t buy a deal because they can’t find anything that matches the 1% rule. Stop!
It’s not a law. It’s not a gospel. It’s a rule of thumb that was more useful then than it is today.
Why the 1% rule doesn’t make sense today
Investors developed the 1% rule in a completely different market. After the financial crisis, real estate prices fell significantly faster than rents. This is the perfect scenario to get a high RTP: high denominators, low numerators.
This trend continued until the early 2010s. Then house prices began to recover and rental rates did not keep pace, lowering the average RTP across the country. Look at this diagram.
Rents fell slightly during the financial crisis, while home prices actually fell. (Note that the house price and rent are plotted on separate axes to show the shape of their respective growth.)
But the market has changed. The growth in apartments exceeds rental growth. Yes, that’s partly because of the COVID-19 pandemic, but it started before that. RTP and cash flow are just harder to find than they were before.
We have to adjust our expectations. What was considered a benchmark in 2011 cannot be meaningfully used as a benchmark in 2021 if you want to be an active real estate investor.
My second criticism is that 1% is a nice round number, but it doesn’t really represent the line where cash flow goes positive or negative. In fact, my research shows something completely different. Check out some of my findings.
- The average RTP in the largest U.S. metropolitan areas is 0.51%
- The average CoCR in the largest US metropolitan areas is -7%. Yikes
- Philadelphia has an RTP of 0.77% (mixed with BPI data according to some census data) but still offers a CoCR of 11%. Sign me up!
- Avondale, Arizona has an RTP of 0.56% and a positive CoCR of 1%.
For me that says something exciting. The average deal is currently -7% CoCR. With an RTP of only 0.56%, you can achieve something well above average (1%). You can also find great cash flow in cities with an RTP below 1%. Philadelphia is just one of the examples.
What to use instead
While it doesn’t sound the same, anything above 0.5% should be considered for city or neighborhood screening.
We’re talking about the average deal in a city. If the average is an RTP of 0.5% and a CoCR of 1%, you can find even better offers with a careful search.
If you are using RTP for a specific business, it is likely worth fully analyzing anything above 0.65% using real spending assumptions rather than just RTP as a proxy. This is the only way to really understand cash flow and CoCR.
This brings me to my final point.
Cash flow isn’t that important. Shocking i know But let me explain.
If your goal is to quit your job soon, or if you are nearing retirement age, then cash flow is very important. If you are one of those people, ignore this last point.
But if you’re like me and plan to work full time (not an investor) for another 10-15 years, investing for total return, not just cash flow. When analyzing a business, you should consider all of the ways you can make money real estate investments: cash flow, appreciation, amortization, and taxes.
If you just look at the 1% rule and say yes or no based on just cash flow, you’re looking at just one of four important factors. Depending on the strategy and phase of life, you should prioritize different mixes of return generation. For some, cash flow is the most important thing. For others, the value of the total mix may be the best. The 1% rule overlooks this.
Some investors consider cash flow to be the most important factor in analyzing transactions because it is most predictable. I do not agree. Taxes and depreciation are the most predictable. And if you think you can’t predict appreciation, that’s not entirely true either – but that’s a topic for another post. But for now I’ll leave that to you.
I made a calculator report on Advance Guide for a fake deal with the following submissions.
- Purchase price: $ 200,000
- Closing cost: $ 4,000
- Rent: $ 1,000 / month
- Payout ratio: 0.5%
- Increase in value: 2% / year
- Rent growth: 2% / year
- Spending growth: 2% / year
I then cooked the cost assumptions so that I would barely break even. With a tight breakeven point and a predicted moderate appreciation and rent increase, I’ve achieved a cash flow of a whopping 7 US dollars per month and a CoCR of 0.19%. I’m getting crushed on this deal, right?
If I stick to this deal for five years, my annualized return would be 12.5%. At the age of 10. it would decrease slightly to 11.4%
Sign me up.
How does it work? Well, assuming a 2% increase in value (a very humble assumption), the value of your property will grow from $ 200,000 to $ 221,000 in five years. During that time, your tenants paid off more than $ 15,000 of your mortgage for you. That adds up to about $ 35,000 in profit (we’re rounding here) in just five years on your initial investment of $ 44,000. As I said, register me.
If you find a (non-real estate) investment that you believe will provide an 11% return for 10 years with lower risk, please let me know where it is. I don’t see it anywhere.
If after 10 years you want to quit your job and need cash flow, you can deleverage your portfolio to generate more money. If you build up enough equity over time, cash flow becomes easy.
My goal is to build up $ 2-3 million in equity before I retire (whatever that means). When I have $ 3 million in equity, I can liquidate my entire portfolio and buy real estate for cash up to a 5% cap and cash flow of $ 150,000 per year. With a better cap rate, say 7%, $ 150,000 a year could be $ 210,000 a year in cash flow. Sounds damn good to me.
I probably won’t do anything as extreme as this, but I could. I will likely continue to leverage and balance cash flow with other forms of return. But the point is to think about the long game.
Don’t get too attached to cash flow when you’re not in need of cash. Look at the total return.
I’m not saying you shouldn’t be looking for cash flow – cash flow is great. If all other things are the same, a deal with cash flow is better than the same deal without (duh). But it’s not the only one. And in this crazy market where high RTPs and CoCR are hard to find, you can still make excellent money investing in real estate when investing for total return.
Examine the bigger picture. The 1% rule is just a guideline for people who value cash flow. It’s not a good rule of thumb, and it’s not very helpful for those who are not in need of cash right now.
Do your deal analysis and compare your total return on alternative investments and the deals you find are better than the alternatives even in this hot market.