Downside of the 1% rule...

[John Williams]

Here's why I don't like the 1% rule...

A buy-and-hold investor should think long-term. 

The 1% rule doesn't matter as much if you have a 5-10 year investing horizon because it does not take into account appreciation or other benefits of holding (tax benefits, etc.)

The 1% rule stops a lot of folks from getting started. 

Think big picture.

Consider all the benefits of the investment over an extended period of time and get started! Take action! You'll thank me later!

[Stuart Udis]

@Kevin Sobilo I believe cash flow is necessary to a certain extent. First, it is necessary to achieve favorable financing terms and secondly, I do believe cash flow should carry most rental properties with limited exceptions. Where I disagree is with new investors who get hurt more than any other investor when investing for cash flow. Their pursuit of cash flow normally leads them to the worst of the worst neighborhoods where the spreadsheets never capture the accurate operating expenses and no consideration for neighborhood fundamentals is part of their analysis. Making matters worse, these properties are normally in neighborhoods that are disproportionately impacted by OpEx and CapEx. Most of what I write from here applies to this type of property because that's what is customarily purchased by new investors who prioritize cash flow and should not be construed as general principles of real estate.

I also disagree with the notion appreciation is expensive. If real estate with proper fundamentals is purchased well and appreciates, there are a few avenues to pursue:  LTCG tax treatment on an eventual sale;  deferring taxes through a 1031; or a refinance where there are no tax consequences. All are great tools.

Yes there are transactional costs associated with each but there will come a time where the cash flow properties incur transactional costs as well. First, many move on from their cash flow properties quickly when they realize they aren't in fact the cash cow they believed they were buying. Again, these are normally in the lower tier  neighborhoods that rarely perform on resale as their appraisal may suggest. During ownership, these tend to be more expensive to operate relative to other real estate and lastly, for the limited few who can weather the storm and can effectively operate these properties, there is still a need for refinances. Its not as if they are owned in perpetuity with no transactional costs. That's wishful thinking at best. 

[Kevin Sobilo]

@Stuart Udis, you are largely on point, but somewhat not relevant to using the 1% rule.

Yes, someone ONLY focused on MORE cash-flow can have tunnel vision and ignore other pertinent aspects of investing, BUT the 1% rule has noting to do with ONLY focusing on cash-flow. It is a simple rule of thumb to help you mentally filter through deals. That would be like claiming people should ignore speed limit signs because they don't advertise the road, traffic or weather conditions. Speed limit signs have a purpose and value even though they don't account for every aspect. Helps you make decisions as you need to make them. 

Deferring taxes with a 1031 doesn't put that money in your pocket for your own use like cash-flow. So, that example is not relevant/comparable.

For a 1-4 unit in a cheaper cash-flowing market a the costs to refinance are not cheap relative to the equity being pulled out in many/most cases. 

[Corby Goade]

Totally agree. I'd rather pay more for quality properties in desirable areas than lose money every month on a deal that looked good on a spreadsheet.

[Stuart Udis]

99.9% of investors who are chasing the 1% rule are solely focused on cash flow and spend no time whatsoever analyzing markets based on fundamentals.

[Kevin Sobilo]

Quote from @Stuart Udis:

99.9% of investors who are chasing the 1% rule are solely focused on cash flow and spend no time whatsoever analyzing markets based on fundamentals.

I agree, BUT 95% of investors aren't interested in analyzing markets as they invest local to where they live! Most investors are small mom & pop investors I believe. So, for those people especially it is a small useful tool. It is also useful for remote investors after they have chosen a market to invest in.

I used it yesterday myself! I was meeting with an investor who is prepping to sell a single family they bought and rehabbed 15 years ago and rented out since. They asked me, "Would an investor consider buying this from me?". Without having to analyze the numbers I was able to respond with a reasonable explanation of why an investor would not be able to pay as much as owner occupant for his house.

I guess people who eschew the 1% rule would go back and spend an hour putting together a detailed analysis to answer that question. To me, that was useful and we moved on to discussing more productive things.

[Amy Pfaffman]

Well put! I especially like your point #4. That really spells it out.

Quote from @Kevin Sobilo:

@John Williams, a few comments:

1. IMO the 1% is just rule of thumb for filtering potential deals. If you are looking for cash-flow, you can apply the 1% rule and scan through many deals and then only focus on ones that have potential cash-flow. That's about all its good for.

2. Cash-flow is KING! Yes, appreciation has the potential help you hit the jackpot and make you more wealth. However, cash-flow is better for a number of reasons. Perhaps the most important of which is that its more predictable and more CONTROLLABLE. Except for forced appreciation, you have no control over appreciation after you buy a property whereas you can make decisions along the way to improve your cash-flow. Raise rents, reduce expenses (shop insurance, appeal taxes, refinance, etc).

3. You mention tax benefits. That is where cash-flow shines as you have an income to use those tax benefits with.

4. Appreciation is EXPENSIVE! Yes, it costs you money!!! Its locked up in the equity of the property and it will cost you money to touch it. If you sell, you pay closing costs, commissions, taxes (including depreciation recapture), etc. Even if you refinance, you have origination costs, appraisals, etc.

So, while cash-flow is tax advantaged aka CHEAP; appreciation is EXPENSIVE!

5. Most beginning investors need to and should invest for cash-flow. Most small time investors can't afford the risk to buy and hold a property that doesn't make money in HOPES that it appreciates enough. In additional new investors are more likely to understand cash-flow than how to predict appreciation. 

[Paul Azad]

     I think the 1% rules best value may be to protect less experienced investors from overpaying for a rental Income producing property. As we all know, the only Cardinal Sin of investing in any asset class is "overpaying".

There are often long stretches of flat SFR markets in US. like '79-'83, '89-'94, or even down markets like '06-'13 where single family home values dropped 36% on average across country, so 1% rule may help keep some investors out of trouble by at least having some cash flow to safely carry the mortgage during those times.

Perhaps the SFR market is overvalued now and 1% rule is just a simple valuation tool like a P/E multiple in equities telling people to stay clear.

      My parents bought many SFRs in 70s and 80s and with mortgage rates at 18-19% but always made money as rents greatly exceeded mortgage payments, because home prices matched incomes for 200 years prior to 1994, then FED started money printing x 30 years until now. (systolic pressure rising so won't get into that)

And many less experienced individual investors in SFRs don't do as well as others and "well" means what could you have done otherwise. Chart below shows last 45 years, about 14% in sp500 and 8.7% in rental income producing real estate, nominal not real.

so maybe if the 1% rule is telling you that single family rentals are too expensive? Then perhaps you could invest in something else until the single-family rental market is back to an affordable range, and in the meantime, you could also make a lot more money.

[John Teachout]

I always used the 1% rule as a useful metric when we were purchasing our SFR portfolio. We were pursuing cash flow, not equity growth. If a property didn't have the potential to cash flow, we weren't interested in it. All it was used for was as a screen to determine whether a property was worth further consideration. For others to decide to not use it, that's fine but it's foolish to say it has no value as many thousands of investors utilize it all the time. That's like people saying buying SFR is dumb and one should only invest in multi-family. Everyone can invest in real estate in their own style and be successful at it.

[Joe Villeneuve]

Just because "1000's use it", doesn't make it a good idea.