Should I adhere to the 1% rule in a low cap rate market???

Question

In a market like southern California where the cap rates are for the most part under 5% it has been very difficult for me to find any type of MF property that meets the 1% rule (rents being at least 1% of purchase price).

Should I just keep looking until I find the needle in the haystack or are there other criteria that is more important when trying to invest in a cash flowing buy and hold investment property?

Steve Vaughan · Answer

Even in my little town of 40,000 nobody's heard of, appreciation is the largest part of my IRR.  That's what matters at the end of the day when all is said and done, your IRR.  COC is one metric.

Cash-flow, while necessary for most in the beginning, becomes less important as you grow and mature.  Hinging everything on the hopes of a couple hundred bucks a month for me now seems silly.

I call them value plays.  The tired landlord's wife makes them 'call that guy' because she is sick of picking up after renters' dogs.  She will never again pick up dog crap for a dog that isn't hers.

The cash-flow?  Not great.  Break-even if I'm lucky during the hold, but from day 366 on... lots of equity to tap or tax-favorable gain to exit with and re-deploy.

Going under contract to sell the dog crap house, FSBO today.  Cash-flow since I bought 2 years ago?  Break-even + a little maybe if I include the depreciation offset.  BRRRR'd earlier this year for $36k.  Additional net gain at sale will be another $40k.  (Wouldn't have bothered with the refi, but didn't know the renters were moving out- putting it on my sale list.)  My IRR on this one house was 36% per year.  Yep, by buying right (be 'that guy') and experiencing appreciation, 72% over 2 years. It's not all about cash-flow.

Not all cheap places are inexpensive.  If the only place to find cash-flow is the other side of the tracks, buy up.  I can get 1%ers in the hood, but they don't appreciate and just give me indigestion.

It's beneficial to have a good w-2 in expensive markets.  I haven't had one in 14 years, but whoa if I had!  Good luck out there in SD!

Dan H. · Answer

I agree with everything that

@Steve Vaughan

indicated but want to add that duplex to quad cash flow fine when conventionally financed at far below the 1% rule if self managed not including equity pay down and fine when using a PM if including equity pay down.

In this market I am happy if I can get a 0.75% rent to sale price ratio with the property being in a nice area and no indicators that the property will require a lot of effort to PM.  This nice cash flow is using realistic maintenance/cap expense numbers that most inexperienced investors would think is high but I believe to be accurate.

Run the numbers on a 0.75% rent to sold price on a duplex to quad conventionally financed.

Then realize rents are going up and that a year from now the property will have better cash flow than today.  Realize any forced appreciation opportunities.  Realize prop 13 caps the tax increase. Realize the historical appreciation realizing it goes in waves (so short term depreciation has occurred but the long term appreciation has for over 50 years surpassed inflation and virtually every other market).

Good luck

Larry Turowski · Answer

@Ellis Hammond These are useful rules of thumb, not hard and fast rules.  What many investors have found is that they will not cash flow on a financed property when the rent is less than 1% of the cost of acquisition plus any rehab costs.

If you are investing strictly for cash flow, then I'd heed their advice.  My rentals are strictly for cash flow and I feel like I need to do a LOT better than 1%.

Cash flow isn't everything, though.  Your net worth can be growing due to equity growth even if the property isn't cash flowing.  If you are an investors who can see around corners, maybe you are investing for the 5yr or 10yr appreciation.  Or maybe a property cash flows like crazy but you'll never sell it for what you bought it for.  These are all factors to consider.

If you are dead set on that market you are going to have to determine what a good deal there is.  Talk to a bunch of local investors.  And be ready to change your strategy.  Maybe it is a better market for flips than holds.

Account Closed · Answer

Just don't invest in long term holds in low cap rate markets right now @Ellis Hammond :)

Brent Coombs · Answer

Good one, Thomas!

Casey Murray · Answer

@Ellis Hammond My experience shows it's harder to find the 1% rule in the coastal areas since properties are priced so high. But when you look at properties going inland (Vista, Escondido, El Cajon, etc.), the rent to purchase price is more realistic as this crazy housing market is driving rents in areas previously overlooked.

The 1% rule isn't a good standard to go by since you can drive up rents in future years coupled with appreciation. Feel free to contact me with questions and best of luck on your real estate journey!

Thomas S. · Answer

Speculating on appreciation seems to be the most common approach in your market provided you have deep enough pockets to support a negative cash flow property.

Your goal will be to get to the point of liquidating before a market down turn or have the time to ride it out back to positive appreciation.

However based on the present opinion of west coast investors there is no reason to ever anticipate a down turn in your market. The expectation is that appreciation will continue indefinitely.

Should I adhere to the 1% rule in a low cap rate market???

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