For years, the 1% rule was treated as a scientific fact, and today I want to put an end to that. The 1% rule is just a rule of thumb – and an outdated rule, too. Created in a different time, it overstates the role of cash flow in the current real estate investment climate.
What is the 1% rule?
The 1% rule uses a (rightly) popular metric known as the rent-to-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 RTP for an entire area, take the median rent and divide it by the median home price. For example, if there is a median rent of $1,000 in a city and a median home price of $200,000, the RTP would be 0.5%.
To calculate the RTP for a specific deal, do the same. Take the rent you think you can get for the property and divide it 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 calculated based on the price of the property. The math is also correct.
I simulated cash-on-cash return (CoCR) for the top 576 markets in the United States and then correlated the CoCR return with the RTP for each city. The result was a correlation of 0.85, which means there is a really strong relationship between RTP and cash flow.
My complaint here is not with the use of RTP as a measurement. I think it’s an excellent way to screen markets and backtrack on a deal.
My complaint is with the rule that RTP has to be over 1% to be a good deal. I see on the forums and hear directly from people that they didn’t buy a deal because they can’t find anything that meets the 1% rule. Stop!
This is not a law. It’s not gospel. It’s a rule of thumb that used to be more useful than it is now.
Why the 1% rule is not useful today?
Investors developed the 1% rule in a very different market. After the financial crisis, house prices fell much faster than rents. This is the perfect scenario to create a high RTP: high denominators, low numerators.
This trend continued into the early 2010s, then house prices started to recover and rents failed to keep pace, causing the average RTP across the country to drop. Look at this chart.
During the financial crisis, rents fell slightly, while house prices took a real plunge. (Note that house price and rent are plotted on different axes to show the shape of their respective growth.)
But the market has changed. Home valuation exceeds rental growth. Yes, this is partly due to the COVID-19 pandemic, but it started before that. RTP and cash flow are just harder to find than before.
We have to adjust our expectations. What was considered a benchmark in 2011 cannot reasonably be used as a benchmark in 2021 if you want to be an active real estate investor.
My second complaint is that 1% is a nice round number, but it doesn’t really represent the line where cash flow becomes positive or negative. In fact, my research shows something quite different. Check out some of my findings.
- The average RTP in the largest US metropolitan areas is 0.51%
- The average CoCR in major US metropolitan areas is -7%. Yaks.
- 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%.
To me this says something exciting. The average deal now yields -7% CoCR. You can get something way above average (1%) with an RTP of just 0.56%. You can also find excellent cash flow in cities with an RTP of less than 1%. Philadelphia is just one of the examples.
What to use instead?
While it doesn’t ring true, for city or neighborhood screening, anything above 0.5% should be considered.
We are talking about the average deal in a city. If the average is an RTP of 0.5% and a CoCR of 1%, you can definitely find even better deals if you search diligently.
If you’re using RTP for a specific deal, anything above 0.65% is probably worth analyzing fully using real spend assumptions rather than just RTP as a proxy. That’s the only way to really understand cash flow and CoCR.
This brings me to my last point.
Cash flow is not that important. Shocking, I know. But let me explain.
If your goal is to quit your job soon, or you’re approaching retirement age, cash flow is super important. If you are one of those people, ignore this last point.
But if you’re like me and plan to continue working full-time for another 10-15 years (not as an investor), you should invest for total return, not just cash flow. You need to consider all the ways you can make money investing in real estate when analyzing a deal: cash flow, valuation, depreciation, and taxes.
By just looking at the 1% rule and saying yes or no based on cash flow alone, you’re looking at just one of four key factors. Depending on your strategy and life stage, 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 believe that cash flow is the most important factor in deal analysis because it is the most predictable. I do not agree with it. Taxes and depreciation are the most predictable. And if you think you can’t predict valuation, that’s not entirely true either, but that’s a topic for another post. But for now I’ll leave you at this.
I made a calculator report on Pyjama People for a fake deal with the following input.
- Purchase Price: $200,000
- Closing Fee: $4,000
- Rent: $1,000/month
- Payout: 0.5%
- Valuation: 2%/year
- Rental growth: 2%/year
- Cost growth: 2%/year
I then made the cost assumptions so that I would barely make a profit. Barely breaking even and forecasting modest valuation and rental growth, I ended up with cash flow of a whopping $7 per month and a CoCR of 0.19%. I’m falling in love with this deal, right?
If I held this deal for five years, my annual return would be 12.5%. With 10 years. it would drop slightly to 11.4%
Sign me up.
How does it work? Well, with a 2% increase in property value (a very modest assumption), your property will grow in value from $200,000 to $221,000 in five years. During that time, your tenants have paid off more than $15,000 of your mortgage for you. That works out to about $35,000 in profit (we’re rounding up here) in just five years on your $44,000 initial investment. Like I said, sign me up.
If you can find a (non-real estate) investment that you believe will provide an 11% return for 10 years with less risk, let me know where it is. I don’t see it anywhere.
If you want to quit your job after 10 years and need cash flow, you can scale down your portfolio to generate more money. If you build enough equity over time, cash flow becomes easy.
My goal is to build $2-3 million in equity before I retire (whatever that means). If I have $3 million in equity, I can liquidate my entire portfolio and buy real estate for cash at a 5% cap rate and $150,000 a year cash flow. With a better cap rate, say 7%, that $150,000 per year could be $210,000 per year in cash flow. Seems damn good to me.
I probably won’t do something that extreme, but I could. I will probably continue to leverage and balance cash flow with other forms of returns. But the point is to think about the long game.
Don’t be too guided by cash flow if you don’t need cash right now. Look at the total return.
I’m not saying you shouldn’t look for cash flow – cash flow is great. All other things being equal, a deal with cash flow is better than the same deal without (duh). But it’s not the only thing. And in this crazy market where high RTPs and high CoCR are hard to come by, you can still make excellent money investing in real estate if you invest 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 convenient for those who don’t need cash right now.
Do your deal analysis and compare your total returns to alternative investments, and the deals you find, even in this hot market, will be better than the alternatives.