Author Topic: I'm not even close to the '1% guide' for my home  (Read 5139 times)

nereo

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I'm not even close to the '1% guide' for my home
« on: July 15, 2014, 01:54:24 PM »
At the end of 2012 we purchased our apartment with the ridiculously low interest rate of 3.04% on a 25yr note.  With closing costs, down payments and the mortgage we paid $225k, and so far we've been thrilled with our place.  Similar apartments in our area have been listed (and sold) for $250k.
Our monthly mortgage (which includes all taxes and building maintenance) is $1100, of which currently ~$450 goes toward equity.  We're also making extra payments but for now let's ignore the role those play.

Before deciding to purchase our current place we spent a month looking at over a dozen places to rent and concluded that we were unlikely to find a place that rented for <$1000/mo in our area.  We are fairly confident that we could rent out our place for $1200-1300/mo, and currently we rent out our spare bedroom for $500/mo.

I've since noticed MMM and others on these blogs saying they look for 1% of monthly rental income relative to purchase price, and we come in way under that.  There's no way I could rent this apartment for over $2k/month.   But, I also know I'd be paying about the same amount (taxes & basic maintenence included) for renting an equivalent place and not gaining any equity in the process.  So I'm very comfortable with my decision - and yes I just love owning my own home, and all that entails.

So... what am I missing here?  from a strictly economical point of view was my decision a poor one?  I tend to think it was economically very slightly positive, since my total expenses are just barely above rental costs in this area, and I am gaining equity.  But if I view it as a potential future rental property, then it doesn't come close to meeting the '1% guideline'.  We'll be living in this house for at least another 5 years, but then we could use it as a rental.  I love how the % that goes towards equity increases every month, and that my monthyl payment stay constant year-over-year while rental prices rise.

anyone care to put me straight?

waltworks

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Re: I'm not even close to the '1% guide' for my home
« Reply #1 on: July 15, 2014, 01:58:54 PM »
A primary residence is not evaluated (or at least shouldn't be in most cases) the same way as a rental, since you are paying for it's actual (housing) function.

You may want to read some of the other sell/rent and 1%/50% rule threads in the forum and then come back if you still have questions. As a rental, your place sucks. As a home to live in, it sounds like it's great. So in 5 or 10 years or whenever you want to move, you can sit down and see what you could get by selling vs. renting and evaluate it as a rental at that point (maybe rents skyrocket and prices plunge... or vise versa). No need to worry about it much now.

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marty998

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Re: I'm not even close to the '1% guide' for my home
« Reply #2 on: July 16, 2014, 05:05:48 AM »
Your purchase price isn't $225k. I would see your purchase price as the equity (deposit) you put down.

I know others have a different opinion on that. But to me, that is what your return % should be based on. Having said that, I live in a very different realestate market!

SDREMNGR

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Re: I'm not even close to the '1% guide' for my home
« Reply #3 on: July 16, 2014, 07:44:04 AM »
It sounds similar to prices and rents in San Diego, perhaps slightly worse.  Your purchase isn't bad and you'll do fine between cash flow and appreciation. 

Because you are buying a primary home, you do end up paying more money for the investment return earned. But your low cost loan offsets the less than 1% rent rule of thumb greatly.  Different markets have different characteristics and markets where rent may not cover costs may have greater appreciation in good years. So you will still make money if you hold the apartment into the future.  You can look at your cash on cash returns and also after tax and depreciation returns and I'm sure the numbers will be at or near 10-15% returns before appreciation.  That compares favorably with the stock market.  It's not the best real estate deal ever but it's pretty good for your first home.  It's a safe deal.

Snowboard junkie

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Re: I'm not even close to the '1% guide' for my home
« Reply #4 on: July 23, 2014, 10:48:02 PM »
There is no strictly economical point of view vis a vis your own home. 

former player

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Re: I'm not even close to the '1% guide' for my home
« Reply #5 on: July 23, 2014, 11:37:58 PM »
I'm not sure where the 1% rule comes from: I had never even heard of it before coming on these boards.  I'm pretty sure that it is impossible to judge investment across wildly disparate property markets (this forum is read world-wide) by one limited and simplistic measure.  Why 1%?  Why measure returns only in rental income and ignore capital gains (there are some property markets which have them)?  Why measure returns against purchase price only? (1% rental means slum properties only in some markets).

People who invest in property for rental returns are presumably the people for whom the 1% rule is potentially most useful.  As far as I can tell, they are equivalent to the people who invest in shares for the dividends rather than capital growth.  It's a valid strategy to be a dividend investor, or rental income investor, but it's not the only way to go.

waltworks

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Re: I'm not even close to the '1% guide' for my home
« Reply #6 on: July 24, 2014, 08:55:52 AM »
Well, it's basically because if the property doesn't make the 1% rule, you probably won't make any money on it.

Housing isn't really comparable to stocks because the capital appreciation historically on US stocks is like 7% after inflation, and on houses it's 1% or so. So until the whole last decade of bubbles, nobody really bought houses for appreciation. If you want to make money, 1% rule is a very good way to evaluate a rental. It's not the end of the story but it's pretty rare to see something that doesn't meet the 1% rule that's going to work out well as an investment. Maybe there are places in the world where housing appreciation is just nuts and rental rates are super cheap so investing in residential RE makes sense for appreciation reasons, but I don't know of any personally.

And yes, in many markets, this means buying rental property is a stupid move, and there are no properties available that meet the rule. C'est la vie. Buy a property somewhere else that does, or invest in something else.

You can argue about it all you want but the "rules" exist for a reason - they tend to be pretty accurate. Dig around in the older threads here and you can find a number of in-depth discussions of this exact topic.

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johnhenry

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Re: I'm not even close to the '1% guide' for my home
« Reply #7 on: July 24, 2014, 01:48:17 PM »
I'm not sure where the 1% rule comes from: I had never even heard of it before coming on these boards.  I'm pretty sure that it is impossible to judge investment across wildly disparate property markets (this forum is read world-wide) by one limited and simplistic measure.  Why 1%?  Why measure returns only in rental income and ignore capital gains (there are some property markets which have them)?  Why measure returns against purchase price only? (1% rental means slum properties only in some markets).

People who invest in property for rental returns are presumably the people for whom the 1% rule is potentially most useful.  As far as I can tell, they are equivalent to the people who invest in shares for the dividends rather than capital growth.  It's a valid strategy to be a dividend investor, or rental income investor, but it's not the only way to go.

The 1% rule is only a very broad rule of thumb that provides an easy way for an investor to give a place a quick thumbs-down or a closer look.  A prudent investor would certainly need a more detailed analysis before proceeding.  But for investors focused on cash-flow and not "betting" on appreciation, the 1% rule is a good blunt instrument to cast aside property that definitely won't perform well (where cash flow / current income is concerned).

Without a doubt, many investors have done extremely well when their real estate appreciates rapidly.  But I think the small time real estate investors, who may hold portfolios from a couple units to a few dozen units, must often get started one unit at a time.  Due the likely conservative nature of the members of this forum, it makes sense that they (we) prefer investments with more known elements and fewer unknowns.  Of course there's risk in all investment, but I think it's fair to say that a knowledgeable/experienced investor can more accurately predict their immediate cash-flow than the future appreciation.  If you are lucky/experienced enough to choose a place that will experience rapid appreciation, a) it will often have a bigger price tag which may exclude beginning/small investors which means that b) they are also likely to start off cash-flow negative.

If you buy a place anticipating negative cash-flow, then you MUST be right about the appreciation or you are SOL.  Not to mention the timing factor.  For small time, individual investors, like those on this forum, liquidity is often important.  Since most of us are focused on individual retirement (early), we may not have the luxury to have large chunks of our portfolio tied up in assets that will certainly cost us money now and may never realize the appreciation at/before the time we need to sell.  After all, appreciation can only be realized if you sell (of course you can borrow against it, but again, that may not be as important to those on this forum).  Positive cash flow is realized year after year.

That may be why there are more investors on this forum focused on cash flow and find the 1% rule useful, though very broad and preliminary.

As you pointed out, these properties aren't available in every market and investors who demand cash flow just don't own real estate in markets like that, even if its where they live.

arebelspy

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Re: I'm not even close to the '1% guide' for my home
« Reply #8 on: August 13, 2014, 11:26:50 AM »
Yes, you may be losing money in the long run over renting (having to pay capital expenditures, repairs, etc.), but you get to own it.

You also won't have vacancy or turnover costs in a primary home, so that helps explain why you may not need to hit 1% to have it make sense.

Calculators like the NYT Buy vs. Rent can help you see which is the "economical" decision, though it won't always come down to that.

http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
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Mr Mark

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Re: I'm not even close to the '1% guide' for my home
« Reply #9 on: August 13, 2014, 02:50:38 PM »
Being a long way from the 1 % rule could indicate your neighborhood is overpriced. I recently sold a place for 600k that wouldn't have leased for more than 3k, and taxes were at least 7k/ yr. Crazy.

Individuals will buy sfh for more because of:
- hope of appreciation.  This is not a basis for larger scale real estate investing, which must be cashflow positive.
- cheap mortgages so why not!
- years of brainwashing
-  the benefit of not being subject to a short term lease,  or unable to modify or look after house
-  no suitable rentals within school district

basically, the place you live is seldom an investment. The cost of consuming that accommodation is expenses. Far too many people live in an expensive house, bought on debt, and do not have offsetting stash investments. Its the house equiv. of driving a new suv with a car loan.


Daleth

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Re: I'm not even close to the '1% guide' for my home
« Reply #10 on: August 13, 2014, 05:18:57 PM »
Your purchase price isn't $225k. I would see your purchase price as the equity (deposit) you put down.

I know others have a different opinion on that. But to me, that is what your return % should be based on. Having said that, I live in a very different realestate market!

I agree, to an extent. You calculate your returns based on the money you actually spent, not the total amount of money required to purchase the place, because the mortgage you get to buy a place will be repaid either by whoever buys your place from you in the future or, for an investment property, by your renters--it won't come out of your pocket.

So for a pure investment property, I would calculate the returns based on what it cost to buy (down payment and closing costs) plus what it cost, if anything, to get it ready to rent out (repairs/upgrades etc.), plus what it cost each year to maintain the place in rentable condition.

For a primary residence, I would add one more expense to the formula: the extent to which your mortgage payment is higher than what you would have paid to rent. It doesn't make sense to count your ENTIRE mortgage payment as an investment in your house, even though it does give you equity, because whether you bought the place or not you were going to have to spend money to have a roof over your head. If your alternative was to live in a yurt in your parents' back yard maybe you can count the whole mortgage payment, but most of us will either rent houses/apartments or buy them, so estimate what rent would've cost--it's just the cost of having a roof over your head, whichever way you get that roof--and subtract that from the mortgage payment.

In other words, say it costs you $200/mo more to own than to rent, and there's nothing else to counteract that number (i.e. you aren't renting out a spare room or otherwise using the house to make money in a way you couldn't have done in a rental)--then add $2400/year to the above costs, and that's what it cost you to own the place. Calculate your return based on that.

former player

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Re: I'm not even close to the '1% guide' for my home
« Reply #11 on: August 14, 2014, 01:35:26 AM »
What % rate is used to calculate a good return on a holiday rental?  Enquiring minds would like to know whether higher expenditure on a home which would be a good holiday rental (seaside or city centre pad in a tourist destination) could be financially justified by potentially higher returns if let out.

arebelspy

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Re: I'm not even close to the '1% guide' for my home
« Reply #12 on: August 14, 2014, 07:25:20 AM »
Your purchase price isn't $225k. I would see your purchase price as the equity (deposit) you put down.

I know others have a different opinion on that. But to me, that is what your return % should be based on. Having said that, I live in a very different realestate market!

Of course your return should be based on what you have into it (it's called cash on cash return), but you should compare it to an all cash purchase and see what return that would get you (cap rate), and your return will be related to that purchase price anyways, because even if you only put down some small percentage, you're paying a mortgage on the rest of the balance, so the purchase price is directly relevant to what your return will be.
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thebeachbum

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Re: I'm not even close to the '1% guide' for my home
« Reply #13 on: August 15, 2014, 04:39:49 PM »
You should check out biggerpockets.com there are a lot of really smart people over there.

The 1% rule is actually a more lenient 2% rule (which you will find on BP) which states that you should be able to rent out your house for 2% of the purchase price ie a 225K house should be able to rent for $4,500/month. now I know what you are thinking, THAT IS CRAZY, and I agree, but there are people out there that get deals like that. That being said I think the 1% rule is realistic, and that a somewhat savvy investor should land somewhere in the middle, I usually look for 1.3% but lets look at where the numbers come from and why there is a 1% rule.

Lets assume you buy a $100,000 house and put 20% or $20,000 down at 4% your monthly payment of just principal and interest is going to be roughly $382/month.

Now the 50% rule states that 50% of your monthly income will go to Taxes, insurance, maintenance, vacancy and cap ex. Now I personally don't like the 50% rule, because it doesn't account for what you rent it for, you could rent your house for $1 a month, and I don't think $0.50 would cover your costs, but the fact is that this is a long proven rule, because generally all these things are stated in percentages. roughly shown below

Vacancy 10%
repair 10%
PM 14%
Tax Insurance 16%

Lets use the 1% rule to determine our 50%
1% of $100,000 home is $1,000 and 50% of that is $500 we now add that to  the 382 we are paying in principal and interest
500+382= $882/month so if we rent the house out at the 1% rule, we will be netting $118/month

which is $1416/year. Now what kind of a return is that? $1416 our return divided by $20,000 our initial investment equals about 7% return, which we all would agree you would get in a vanguard fund. and this is why the 1% rule exists, not because you cant rent out a house for less than 1%, but because it is not any better of an investment (but a lot more of a headache) to own a rent house instead of just throwing that money into a vanguard fund.

Now I know what you are thinking, what about appreciation? what about principal payments?

Appreciation-Appreciation should follow inflation 3% per year on average, anything above that is called speculation, not that money cant be made land spec-ing it is not investing it is gambling and therefore I do not count that in my projections, its the icing on the cake.

Principal pay down- Some people will argue that hey you forgot to include principal pay down, I mean after all someone else is buying you a house. and that is a valid point. I would just say have you looked at a amortization schedule? your principal portion of your payment starts really small and grows really slowly until at the end of the 30 year note you are paying mostly principal, so i would say that if you are in it for the long haul, then sure 1% works and the principal pay-down is the above and beyond return on your choosing to invest in real estate instead of index funds. But since the principal pay off is so slow early on that extra return can be wiped out if you decide to sell it relatively quickly say less than 5 years and that's also assuming that there is not decrease in the value of the property.

Now I will say that there are a lot of people who would say that using the 1% or $1000 for 50% rule is generous and we should use closer to the 2% so as you can see the profits would disappear quickly, but that is my best explanation of the 1% rule, and why it exists, and why if its below 1% or significantly below 1% you should probably just sell and throw the money into a vanguard fund and save yourself a headache