Would you like some extra cash every month? Silly question, I know.
Real estate investment can be a noteworthy source of extra income. It has the added bonus of being passive income, meaning it doesn’t take too much effort to earn.
Rushing in blindly won’t get you anywhere. Knowledge of the one percent rule offers a handy guideline in the decision to invest in a specific property. And that is only the beginning.
To buy or not to buy
This is what the one percent rule is all about. It is the crystal ball of real estate investment as it tells you whether the property you are looking at is a worthwhile investment.
Fortunately, you don’t need your old math teacher on speed dial to do the calculation. Chad Carson, real estate investment advisor, describes the one percent rule as follows:
The monthly rental income from the property should be more than or equal to the purchase price of the property. This includes repairs you might need to do on the property.
You can also look at it the other way around:
100 X monthly rent = maximum purchase price.
OR
Maximum purchase price / 100 = monthly rent. Dividing by 100 gives you 1%.
If you know how much the property rents for, this quick calculation enables you to predict whether purchasing the property in question will lead to financial gain or loss.
On the flipside, if you have to determine how much you should rent a property for in order to make a profit, take the purchase price (remember to include alterations) and divide by 100.
Here’s a simple example to clarify. Imagine the property is selling for R1 000 000. You like it, but you are not sure if you should buy it.
If there are no repairs to be done on the property:
1 000 000 / 100 = 10 000.
Therefore, in order to make a profit on this property, you will have to charge monthly rent at R10 000 or more.
If you already know that this property is being rented for, example, R8 000 per month, the picture changes.
8 000 X 100 = 800 000.
Therefore, if you purchase the property for more than R800 000, you are looking at a loss and might want to pass and look for the next opportunity.
That is the one percent rule – it is simple, yet useful. What it comes down to is that, if you follow the rule, your rental income is more than your mortgage payment on the property.
The one percent rule is a quick estimation that prevents you from ending up with huge financial crises.
What it is not, is the be-all and end-all of buying rental property. You could almost see it as merely an educated guess.
This is because the one percent rule does not take aspects like insurance, taxes and maintenance into account.
How to use the one percent rule
So, a property passes the one percent rule. Now you can buy it, sit back and watch the big bucks roll in.
Not quite.
The one percent rule is merely your first step, a pre-evaluative step. A property that passes the one percent rule is not a sure thing, but only a maybe.
Carson further advises that when you have a property’s 1% number, that is, the amount that should be charged for rent, you can compare that to the property’s market rent.
If it is close to the 1%, it’s worth it to investigate further. If it’s much less than the 1% number, it’s a definite no.
The one percent rule is thus a quick way to eliminate properties that could catapult you towards financial loss.
After considering many options, eliminate the unworthy ones and just work with your list of ‘maybes’.
Further aspects that you will investigate before making a final decision include the condition of the property, repair estimates, operating costs, cap rate and the neighbourhood’s risk profile.
Other tools for property evaluation
The one percent rule isn’t the only tool in your kit for assessing the potential value of rental real estate. The following are also valuable indicators:
- Gross rent multiplier. This refers to another simple equation, this time to determine how long it will take for your rental property to be paid in full.
You will get the answer in months by taking the purchase price and dividing it by the monthly rent. In the case of the R1 million property where the monthly rent is R10 000, it works like this:
1 000 000 / 10 000 = 100. A hundred months equal just over eight years, which is how long it will take for the property to pay for itself in this case.
According to personal finance writer Candice Elliot, anything higher than 12 is considered too high. Ideally you should be aiming for a number below eight.
- The 50 percent rule. This rule gives a more long-term perspective. It states that the operating costs of a property will consume 50% of rent paid.
These costs do not include mortgage, but it does include the previous-mentioned items not being taken into account by the one percent rule.
They include utilities that the owner of the property is responsible for, insurance, property taxes, repairs and maintenance.
Looking back at your R1 million property that is being rented for R10 000, the 50% rule implies that your profit is only R5 000 per month, over the long term.
Logically, things like repairs and maintenance might not be necessary some months – and then at other times everything breaks at once.
That R5 000 per month is thus an average over a number of months.
- The 70% rule. This rule helps you determine the maximum price you should consider paying for a property.
This amount should not be more than 70% of the property’s value after all repairs have been completed, minus repair costs.
If a property was valued at R1 million after repairs have been completed, and the repairs cost R200 000, we will apply the 70% rule like this:
1000 000 X 70% = 700 000 (this is 70% of the property’s value after repairs)
700 000 – 200 000 = 500 000 (minus repair costs)
The investor should not be paying more than R500 000 for this property.
As with the 1% rule it is important to remember that none of the above is set in stone, they are there to act as guidelines.
Bottom line
There is no such thing as easy money, but if you enjoy planning and calculating, rental real estate investment can offer you exciting rewards.
