Is the 1% rule ever coming back?

[rocketpj]

Our area is definitely not a 1% residential zone, far from it with the insane prices in the city nearby.

There are always blind spots in the market if you look.  I'm always surprised at how few people talk about Commercial property on this site.  Around here rents are at best about 0.3% of a typical selling price for a SFH, maybe a little better for one of the few apartments or townhouses around, or if you buy rural (which has its own set of issues, such as septic fields etc).

In the commercial area it is much different.  I bought a mixed use commercial building that actually has two apartments (and 42 other units, storage, offices etc) for about what I would have paid for a duplex.  The building needed a lot of work, but it was at 1.5% when I bought it, and now that the work is all but done and I am close to fully rented it is closer to 4.5%.  It did require a year of full time labour to upgrade, not to mention $90k in materials and tradespersons (I can frame, drywall, putter and do basic plumbing and electrical, but I can't upgrade a sprinkler system or install a fire alarm system).

A year of hard work and a bit of risk has moved my FIRE date from 12 years in the future to basically now, though I have no desire to stop working on things.

Most RE investors are completely fixated on residential property, and don't even consider commercial.  Commercial rents are often higher, you can often get multiyear leases, the tenants have an interest in maintaining the property, and at least around here the rents can be triple net (they pay rent, utilities and property taxes).  Of course there is a risk if a tenant goes out of business, but you have a lot more remedies against a business than residents - you can lock the doors and auction their stuff if they disappear, for example.

That said, my next buy might be residential, if I find the right property, or it might be a small business with the right parameters for me.  Come up with/research a set of criteria that make the math and your efforts worthwhile, then keep looking and talking to people.  The good opportunities come up and vanish very fast, the garbage stays on the market for awhile waiting for the greater fool to come along.

[Another Reader]

In the commercial area it is much different.  I bought a mixed use commercial building that actually has two apartments (and 42 other units, storage, offices etc) for about what I would have paid for a duplex.  The building needed a lot of work, but it was at 1.5% when I bought it, and now that the work is all but done and I am close to fully rented it is closer to 4.5%.

My guess is you are in flyover country or some other location where business is not booming.  In the Bay Area, you won't find anything like what you describe.  Too much competition and cap rates in the threes.  Right now, the Phoenix market is also overheated.  There is nothing in commercial or industrial properties that makes any more sense than residential.  The world is awash in liquidity.  Too much cash out there chasing too few assets.

[Jon Bon]

FWIW I have learned that appraisers in my area use the .08% rule. So even banks as slow as they are to adjust to the market have realized if they only lent at 1% rule for investment properties they would not have very many loans to make!

[waltworks]

Banks can and do loan on way worse than .8%, JB. Remember - they don't care if you make a profit, they just care if you're going to be able to pay the nut each month (and that they'll be able to make themselves whole via foreclosure if not).

If banks only loaned on, say, .5% rule and better houses, I'd guess most of the "investment" properties purchased in the last half-decade would not have been funded.

-W

[Jon Bon]

Banks can and do loan on way worse than .8%, JB. Remember - they don't care if you make a profit, they just care if you're going to be able to pay the nut each month (and that they'll be able to make themselves whole via foreclosure if not).

If banks only loaned on, say, .5% rule and better houses, I'd guess most of the "investment" properties purchased in the last half-decade would not have been funded.

-W

What you are saying is of course true. What I was getting at is that loans are subject to the selling price being lower then the appraisal price. So based on rents houses currently are valued at .08%. Granted this is just a single data point in a single market. This does not account for all cash/large DP buyers. The is also something to be said about the independence of an appraiser but that is a whole different conversation.

So it might be fair to say the .08% rule is the new 1% rule.
*For now at least!

[BicycleB]

Just curious. @Jon Bon, you keep writing ".08% rule."

Are you saying that banks in your part of the Midwest lend on rental properties where the monthly rent is .08% of the purchase price? In other words, they will mortgage a $100,000 property that charges rent of $80 per month?

[Telecaster]

Just curious. @Jon Bon, you keep writing ".08% rule."

Are you saying that banks in your part of the Midwest lend on rental properties where the monthly rent is .08% of the purchase price? In other words, they will mortgage a $100,000 property that charges rent of $80 per month?

I'm on the lower end of experience level, but when I bought my SFR rental the bank never asked about rent.  All they cared about was my assets, credit score, and income. 

[waltworks]

JonBon, I'm also confused. When I've purchased rentals, the approval of the loan l is purely based on purchase price/appraisal (plus my credit/assets). AFAIK the bank is completely uninterested in the rental rate.

Now, if I've got several rentals and I'm using the cashflow on them to qualify for another loan, then the bank cares that I'm getting more money from the rental than I need to put in. They have some formulas for that that are 50% rule-like, as I understand it.

They don't ever analyze a property based on anything like the 1% rule, though, in my experience. Can you explain how it works where you are?

-W

[Papa bear]

I’m guessing that the appraiser used rental income to guesstimate the home value. I’ve had appraisers use 75x monthly rent as one of their line items for valuation.

Potentially, this appraiser is using 125x monthly rent, or a .008 rate for valuing the property.

Given the area the property he is in contract in, that would make sense as a valuation, as I have property in the same location.  It is almost entirely driven by investors and values are only based on rent multipliers.  This area used to be consistently 1% rule properties, but over the last few years, properties are selling in the .75 - .85 range.


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[Jon Bon]

Yup sorry guys, decimals are tricky.

I could have written .008 or .8% as both would have been fine, but I combined them. Yay math!

So on the appraisal there was a traditional "comps" section but there was also an income approach where comps were pulled on rents. Further down there was a section potential operating costs, reserves for bigger items roof etc. Basically a mini income statement of the property. So based on that income statement the value was pretty much exactly  following the .8%. So in the end they came up with 2 different numbers that were very close.

Now that I think about it they probably just use the larger of the two numbers so they can make more loans! This was new to me as well, I usually dont look at my appraisal all that closely as I follow the market in my area better then most.

Again just a single data point in a single market but I thought it was noteworthy.

[waltworks]

Huh. I've NEVER heard of an appraiser doing that (estimating home value based on prospective rents), and I've done the rental property rodeo more than a few times. Appraisals in my experience are 100% about the bank making sure that if they foreclose, they'll at least break even selling the place. They could care less about what it would rent for.

-W

[Another Reader]

Huh. I've NEVER heard of an appraiser doing that (estimating home value based on prospective rents), and I've done the rental property rodeo more than a few times. Appraisals in my experience are 100% about the bank making sure that if they foreclose, they'll at least break even selling the place. They could care less about what it would rent for.

-W

I haven't financed any properties in years, but the old residential appraisal forms had the income approach included on the form.

[tralfamadorian]

Huh. I've NEVER heard of an appraiser doing that (estimating home value based on prospective rents), and I've done the rental property rodeo more than a few times. Appraisals in my experience are 100% about the bank making sure that if they foreclose, they'll at least break even selling the place. They could care less about what it would rent for.

-W

I haven't financed any properties in years, but the old residential appraisal forms had the income approach included on the form.

+1

[Enough]

Anecdotal, but closing on a single family rental on Friday.  Purchase price is 30,500  +2,500 in repairs.  Will rent for $700-$750.  Class C property.

[CanuckExpat]

Huh. I've NEVER heard of an appraiser doing that (estimating home value based on prospective rents), and I've done the rental property rodeo more than a few times. Appraisals in my experience are 100% about the bank making sure that if they foreclose, they'll at least break even selling the place. They could care less about what it would rent for.

-W

If you are purchasing a property and plan on using prospective rent on that property as part of the income you need to qualify, then the lender will request an appraisal which includes the estimate of market rent for the unit(s). You pay more for the rental appraisal. (This all depends on lenders rules and procedures, whether they will even allow prospective rent to count towards income)

They also use those estimated market rates to generate the income based market valuation of price, and that is based on comparable. i.e. if comparable properties sell for 100x market rents or comparable properties sell for 50x market rates. So this "rule" will change based on market conditions as decided by comparables (and the appraiser)