HOW DO I KNOW A RENTAL HOME WILL BE PROFITABLE? EXPLAINING THE 1% RULE.
The 1% Rule.
Ever heard of it?
The 1% rule is a quick and easy way to determine if your rental home is going to make you money. This rule helps you know if your property will cash flow (ie, will you make money after your mortgage, repairs, taxes, insurance, and other bills are paid?). Will there be money left for profit?
Here is how the 1% rule works. If you can rent the home out for 1% of the price of the home, then it will likely produce income. When you consider the total price of the home, you need to consider your "all in" price. If the home is ready to go, then the total price is the home price and any associated loan or closing costs. If the home will require any renovations, then the price is the purchase price (including any loan/closing fees) + renovations = total home price.
Once you have determined your total home price (let's say for ease of math that the all in home price is $100,000), then you need to be able to rent that home for 1% of that price, or for this example, $1000/month.
If you can achieve that ratio, then you most likely will end up with a profitable rental home.
Some people are more strict, and opt for a 2% rule to ensure a greater margin for profit. Some rental markets are not as lucrative and 2% is harder to achieve.
What if your home doesn't meet the 1% rule?
Well, then you probably need to keep looking. There are lots of reasons why, but let me give you the most obvious example that makes me strive to meet the 1% rule.
Historically, a mutual fund in the stock market achieves about 7-8% returns annually. When you invest in a mutual fund, you literally spend a few minutes making the transaction and then you move on. You might spend a little time checking your investment, but essentially, it becomes a passive investment and does not cost you any additional time.
Therefore, if you are going to spend your time renovating, renting and managing a rental home, you should expect something more for your time than what you could otherwise achieve passively in the mutual fund. You need to get paid for your extra effort and time. If you can meet the 1% rule, you will likely see better returns on your money than what you'd see in good to average mutual fund. You are rewarded for your additional work with additional returns.
This is just a brief overview into how the 1% rule comes into play. There is a lot of additional math that does need to be considered, but usually the 1% rule is a fast and easy way to size up a property and see if it will work for you. Many people are confused by the 1% rule because they don't understand why it matters; I hope that this helps break it down a little bit.
Have you purchased a home that meets the 1% rule? Do you consider the rule when you are looking for rental homes?