Why you might not want to use the 1% rule.

I learned the "1% rule" from listening from the BP podcasts, and quickly adopted it as a way to analyze deals in seconds to see if they are worth further investigation. For anyone reading this that isn't familiar with the 1% rule, it simply states that if you can receive 1% of a properties purchase price each month in rent, it will probably be a solid investment. From a quick glance it seems like a very rational concept. The income produced by a property should be proportionate to the purchase price. By receiving 1% of the purchase price each month, you should be able to cover a mortgage of 80% of the property's value, property tax, insurance and all your other capital expenses and hopefully cashflow each month. 

I used the 1% rule to analyze a number of houses that I eventually bought after a more in depth look at the numbers. It seemed to work well. However after purchasing a very cheap house based on the fact that it beat the 1% rule (It was actually about 1.3%) I started second guessing the 1% rule. Recently I started analyzing some very expensive properties and have now come to the conclusion that the 1% rule only seems to work well in certain  property price ranges. 

The biggest monthly expense most well leveraged investment properties have is the mortgage, but herein lies the problem. The monthly mortgage payments are not proportionate to the other expenses when it comes to properties of largely different prices.

The last paragraph might have been hard to follow, so here is an example. The house I bought for cheap was $95,000. With an 80% mortgage for 25 years at 3%, the payments came to $360 per month. Property tax was about $160 and insurance was about $150. That means $360 for the mortgage and $310 for expenses. The mortgage represented 54% of the monthly expenses. 

Now compare this to a property I just analyzed which has a list price of $650,000. Again, with an 80% mortgage for 25 years at 3%, the payments would be $2,465 a month. Property tax on the property is $330 per month, and insurance would be about $250. The mortgage represents 81% of the monthly expenses. With the more expensive property the expenses are higher, but not in proportion to the mortgage payment.

What difference does this make? A very important one. Remember, you make money on leveraging money (ie the mortgage) not the other monthly expenses. Let's run the numbers on these two properties. I mentioned the $95,000 house was at about 1.3% monthly income to purchase price. It rented for $1,200 per month. Minus the mortgage, vacancy of 8%, prop tax, insurance and $150 maintenance fund it cash flowed $284 per month. Not bad.

Now the $650,000 property. (2 duplexes on one lot). Monthly income would be about $4,500 per month. This would put it at a very low 0.7% income to purchase price. The mortgage, vacancy of 8%, prop tax, insurance and $300 maintenance would leave $1,150 cashflow each month.

Now each deal would obviously need more due diligence and factors like the age of the buildings and using property management would effect these numbers. There are also many variables as to what your goals are for the properties. The cheaper property has a higher cash on cash of 18% annually vs the more expensive house at 11%, but the more expensive house will probably make that up in higher ROI due to the higher debt pay down.

This is all very complicated, which is exactly what the 1% rule was supposed to simplify, but here you have a property exceeding the 1% rule at 1.3% that is not a better investment than a property well under the 1% rule at just 0.7%. 

I don't have a magic formula that can replace the 1% rule to use as a tool to analyze properties in seconds, but I can suggest you see what works in the price range you are looking to buy in and what your goals are. If you are buying $40,000 properties, you should insist they be well above the 1% rule before looking into them further, and if you are looking at multi million dollar investments something well under the 1% rule might still provide great returns.

The 1% rule leads you to believe that cheaper properties are more profitable, which isn't the case. As some markets get very expensive, you might need to abandon the 1% rule, or you might miss out on some great opportunities.