Investing in real estate is profitable but only if you invest in the right property. You can enjoy predictable cash flow, tax advantages, and excellent returns from real estate investment. One of the ways investors identify a property that is worth investing in is by using a very powerful investing rule of thumb which I want to introduce to you now: The 1% Rule. Every single day, more and more people are beginning to gain interest in real estate investing because of the several benefits that it has to offer. It can be an excellent addition to an investment portfolio and a way to diversify your investments to secure cash flow. Not to mention, one of the benefits of investing in real estate is that it offers greater asset stability due to the real estate market generally being less volatile than say the stock market.
Real Estate Benefits
Investors like real estate because of the stable returns that stem from rental income and property appreciation. Buying a real estate property in the right location can give you a steady flow of cash for a long time and you can even be a tool you use to save for retirement. This is a form of passive income and you can generate more income by investing in multiple rental properties at once. In terms of appreciation, buying in the right location and having the property be a desirable one are some of the core tenets of successful real estate investing. But the benefits continue!
Real estate investing also comes with some tax benefits as well! The income you earn from your rental property is not taxed as an income tax. In addition to this, real estate owners can benefit from tax breaks by depreciating the value of their property. Some extra costs associated with management can also be deducted for the purpose of tax, like the cost of electricity, internet, and water.
If you invest in real estate in a good location, the payment you receive each month from your tenants should be enough to cover your mortgage leaving you with some profit to enjoy as well. Moreover, real estate can offer you protection against inflation since you can slowly increase your rents to keep up with increased costs of living in your local marketplace. However, you won’t enjoy these benefits if you aren’t able to invest in the right property. Investing in real estate is not as simple as many people think. Finding the right investment property can be challenging especially for beginners. You may have numerous options to choose from making the decision that much more difficult. It may take you several weeks if you decide to go through this process and you may end up more confused. To make this process simple, there are screening tools used by expert real estate investors to make the process of finding a new property easier and faster. This is where the 1% rule in real estate comes in as a tool to help you narrow down your search for a property.
The Search
If you want to make a profit from a rental property, then it must have a positive cash flow. Net cash flow is difference between your monthly costs on the property and the money you receive as rent. A positive cash flow means that the total amount coming from your property, after tax has been deducted, is greater than the operating cost. Positive cash flow is one of the reasons why real estate investment is attractive and important to succeed in when buying this asset type.
I already mentioned that the rent from your property should be enough to cover your mortgage and this is an example of positive cash flow. When you buy a property, you have to cover some expenses such the mortgage and its associated interest, property management fees, and some repairs and maintenance. If you have to use all the money that you make from your property to cover these expenses, you will have zero net cash flow. This means that you are not collecting any money in excess of your costs which puts you in the position of having to cover any unforeseen expenses with your own personal funds. If you end up in a negative cash flow position for too long, you may even begin to contemplate whether you want to keep the property going forward. But back to positive cash flow.
Another reason why positive cash flow is important to your real estate success is that it makes you attractive to lenders. If you want to use a loan to purchase your property, your lender will have to assess the property to determine whether you qualify and how much they can lend to you. If your lender is concerned about how you are going to pay back the loan then buying a property with a good outlook for positive cash flow is something you should keep in the forefront of your mind.
Investing in real estate has its risks however, but luckily you can minimize these risks by investing in properties that have the potential to provide you with a positive cash flow. If you buy a property that is more likely to put you in a negative cash flow position then you may find it difficult to pay the mortgage. If you default your payment, you can lose the property and your down payment. But if you invest in a property with more profit potential then you won’t have to worry about your mortgage because the property will pay for itself. That is, the rent from the property would cover your monthly mortgage costs. be used as payment for your mortgage.
Positive cash flow is also important if you want to build your real estate investment portfolio. The extra money that you make from properties will not only help you pay for the property but also contributes to your savings to purchase another property. The more property you have with positive cash flow, the more money you will make and can then re-invest. Now let’s dive into the details of the 1% rule.
1% Rule
The 1% rule is a rule of thumb that helps real estate investors narrow down their search for properties. The theory of the rule is that for any property to generate a positive cash flow, the rental income every month must be equal to or greater than 1% of the total investment. The purpose of this rule is to guide investors to know how much to charge as rent in order to have profits left over after expenses are paid every month. The total investment, for calculation purposes, is the amount you paid for the house including the cost of repairs and renovation.
When looking for a property to buy, you may be presented with numerous options and it can become a daunting task to select the best one. The 1% rule should be used as a prescreening tool to select the properties that may be worth considering. While this is an important rule to follow, there are other considerations like the state of your local housing market, the quality of the neighborhood you are looking to buy into, and the current rate of rent in the same area.
Example #1
To calculate if the property you want to buy meets the 1% rule, you have to divide the investment value by the total investment and multiply it by 100. The calculation is rather straightforward but let’s go through a quick example anyways. Let’s assume that the cost of a property is $100,000 and you are hoping to rent it out for $1,000 per month. The 1% rule calculation is $1,000 divided by the cost of the property which is $100,000 multiplied by 100. In this example, the answer result would be 1%.
You could also have a case where the value of the property is $200,000 and the cost of renting it out is $1,200. The calculation, in this case, would be $1,200 divided by the cost of the property which is $200,000 multiplied by 100. The answer, in this case, is 0.6%.
In the first example, the property meets the criteria for the 1% rule. However, in the second example, the property did not meet the 1% rule. Using the 1% rule, the first property would be given further consideration while the second property would be removed from the list of potential houses.
If you know what the monthly rent of a property is worth, you can use the 1% rule to calculate the maximum amount you should spend to purchase it. If you don’t know what to charge, you can also use the 1% rule to set a rate that can give you a positive cash flow. To calculate the maximum amount you should pay for a house using the 1% rule, multiply the value of the rent by 100. That is, if rent is $1,500 per month, the maximum amount you should pay is $150,000. And if you want to set a rate using the 1% rule, simply divide the total cost of purchase by 100. That is, you charge at least $2,000 per month for a property that cost you $200,000.
As I mentioned earlier, the 1% rule is important because there are other costs involved in buying a property such as the upkeep cost and property tax, insurance, acquisition fees, and closing fees. If the property does not meet the 1% rule, you may end up with a negative cash flow. Let me share another example to illustrate this point.
Example #2
Let’s assume that the cost of a property is $200,000 and you purchase it with $40,000 down at 3% for 30 years. This means that you have to pay back $675 every month as the mortgage. If you rent out such property for 0.6% of the total investment, you would be charging your tenant $1,200 per month. If you subtract the monthly rent of $1,200 from the monthly mortgage of $675 you will be left with $525 every month. Before you think you are making a profit, you need to put into consideration the cost of other expenses other than the mortgage. It is assumed that about 50% of your monthly rent will be used for these other expenses. That means you may spend up to $600 every month for maintenance, taxes, and property management. The new calculation is $600 minus $675 which leaves you $75 in the red every month. This means that you may have to spend an extra $75 every month to maintain your property. This is about $900 every year.
Now, there are also times where a property will meet the 1% rule but it still should be passed over as an investment opportunity. For instance, the property may be in a crime-ridden part of town or the property may be older and you anticipate a lot of money needing to be invested into it in a few years time. Alternatively, you may desire a certain profit rate per month that the 1% simply cannot meet therefore you may actually scale up this desired percentage to say 1.5% to ensure your rent collections are sufficient to offer you money to cover expenses and pad your bank account too.
However, there is no doubt that the 1% rule offers a great means of assessing rental property’s financial viability and by using this tool, you can expedite your house hunting process and capitalize on the great investment opportunities that exist out there!