Dispelling the 1% Rule

[Stuart Udis]

Investors share various reasons for how they qualify income producing assets, but from my personal interactions and observation, the 1% rule is raised more than any other reason. In fact, I see the 1% rule relied on more than all other reasons combined. It seems to be widely taught and followed but see this as an incredibly flawed underwriting technique that has no bearing on the properties capitalization rate.  I will share my primary reasons but would like to hear other’s take on this underwriting technique as well.

1. Expenses disproportionately impact lower rent collecting properties. Take for instance an “A” located 1 +1 duplex where units rent for $2,000/m and compare the building to an identically designed “C” located 1+1 duplex in the same market where units rent for $1,200/m. Now assume each unit is occupied by 1 person. Common utilities paid by the landlord will be similar if not the same; standard services (extermination, changing filters, snow removal, fire safety inspections etc.) will cost the same.
2. Expenses will vary depending on the market. The cost of doing business varies from municipality to municipality. A $200,000 duplex might have identical rents in municipality “A” and municipality “B” but the property tax rates will vary, local regulations will dictate licensing requirements, labor rates will vary &  the particular location will dictate insurance premiums since insurance carriers will weigh local replacement costs and whether the municipality is viewed as being a “plaintiff friendly” in arriving at insurance premiums.
3. Better situated assets will attract better tenants. While you shouldn’t categorize all tenants and it’s the landlords responsibility to properly screen, the tenants who reside in better situated housing and pay higher rents are more financially responsible meaning lower rate of rent loss and will generally take better care of the property which combined will result in less time allocated towards management functions if self-performed or more favorable management fee structures if 3rd party management companies are utilized (which ties back to #1, as well).

[Mike Dymski]

A % rule of thumb is normal for qualifying hundreds of leads and is common for experienced investors who know their market, niche, cost structure, and have underwritten hundreds of opportunities.  The % just varies by investor and market for the reasons you mention and then has to be verified with real numbers on each opportunity.  The fact that a single "1%" was named is just a function of culture and human desire for things to be easy.