The 1% Rule Is Dead

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For years, the 1% rule has been treated like scientific fact, and I’d like to end that today. The 1% rule is simply a rule of thumb—and an outdated one at that. It was created during a different time and overvalues the role of cash flow in today’s real estate investing climate.

What is the 1% rule?

The 1% rule uses a (rightfully) popular metric, known as the rent-to-price ratio (RTP), to estimate cash flow.

RTP is a great proxy for cash flow because it’s so simple to calculate. All you need are two inputs: rent and price.

If you want to calculate RTP for an entire area, take the median rent and divide it by the median home price. For example, if there’s a median rent of $1,000 in a city and a median home price of $200,000, the RTP would be 0.5%.

To calculate RTP for a specific deal, do the same thing. Take the rent you think you can get for the property and divide it by your estimated purchase price.

It seems like a crude measurement, but it really works. So many of your expenses—monthly payments and interests, insurance, taxes, etc.—can be roughly devised from the property’s price. The math checks out, too.

I simulated cash-on-cash return (CoCR) for the top 576 markets in the United States and then correlated the CoCR return to the RTP for each city. The result was a correlation of .85, which means there really is a strong relationship between RTP and cash flow.

My gripe here is not with using RTP as a measurement. I think it’s an excellent way to screen markets and do some back-of-the-envelope math on a deal.

My gripe is with the rule that RTP has to be over 1% to be a good deal. I see on the forums and hear from people directly that they haven’t bought a deal because they cannot find something that meets the 1% rule. Stop!

This isn’t law. It’s not gospel. It’s a rule of thumb that used to be more useful than it is today.

Why the 1% rule isn’t useful today

Investors developed the 1% rule in a very different market. After the financial crisis, housing prices declined much faster than rent. This is the perfect scenario to create high RTP: high denominators, low numerators.

This trend continued through the early 2010s. Then home prices started to recover, and rent rates did not keep pace, lowering the average RTP across the country. Look at this chart.

CHART TK

During the financial crisis, rents declined modestly, while home prices took a real dip. (Note that home price and rent are plotted on different axes to show the shape of their respective growth.)

But the market has changed. Housing appreciation is outpacing rent growth. Yes, this is partly due to the COVID-19 pandemic, but it started before that. RTP and cash flow are just harder to find than they were previously.

We need to adjust our expectations. What was considered a benchmark in 2011 cannot be reasonably used as a benchmark in 2021 if you want to be an active real estate investor.

My second gripe is that 1% is a nice round number, but it doesn’t actually represent the line where cash flow becomes positive or negative. In fact, my research shows something quite different. Check out some of my findings.

1. The average RTP across the largest U.S. metros is .51%
2. The average CoCR across the largest U.S. metros is -7%. Yikes.
3. Philadelphia has an RTP of .77% (according to some census data blended with BPI data) but still offers a CoCR of 11%. Sign me up!
4. Avondale, Arizona, has an RTP of .56% and a positive CoCR at 1%.

To me, this says something exciting. The average deal yields -7% CoCR right now. You can get something far above average (1%) with an RTP of just .56%. You can also find excellent cash flow in cities with an RTP below 1%. Philadelphia is just one of the examples.

What to use instead

While it doesn’t have the same ring to it, for screening cities or neighborhoods, anything above 0.5% should be considered.

We’re talking about the average deal in a city. If the average is an RTP of .5% and a CoCR of 1%, then you can absolutely find even better deals if you are diligent in your search.

If you’re using RTP for a specific deal, anything over .65% is probably worth analyzing fully using real assumptions for expenses rather than just RTP as a proxy. That’s the only way to actually understand cash flow and CoCR.

This brings me to my last point.

Cash flow isn’t that important. Shocking, I know. But let me explain.

If your goal is to quit your job soon, or you’re nearing retirement age, then cash flow is super important. If you’re one of those people, ignore this last point.

But if you’re like me, and you plan to keep working full time (not as an investor) for another 10-15 years, you should be investing for total return, not just cash flow. You should be factoring in all of the ways you can make money in real estate investing when analyzing a deal: cash flow, appreciation, amortization, and taxes.

By just looking at the 1% rule and saying yes or no based solely on cash flow, you’re only looking at one of four important factors. Depending on your strategy and stage in life, you should prioritize different mixes of return generation. For some, cash flow is the most important. For others, the value of the overall mix might be the best. The 1% rule overlooks this.

Some investors think cash flow is the most important factor in deal analysis because it’s the most predictable. I disagree. Taxes and amortization are the most predictable. And, if you think that you can’t predict appreciation, that’s not exactly true either—but that’s a topic for another post. For now, though, I will leave you with this.

I ran a calculator report on BiggerPockets for a fake deal with the following inputs.

• Purchase price: $200,000
• Closing costs: $4,000
• Rent: $1,000/month
• RTP: 0.5%
• Appreciation: 2%/year
• Rent growth: 2%/year
• Expense growth: 2%/year

I then cooked the expense assumptions so I would barely break even. With barely breaking even and forecasting modest appreciation and rent growth, I wound up with cash flow of a whopping $7 per month and a CoCR of 0.19%. I’m going to get crushed on this deal, right?

Nope.

If I held onto this deal for five years, my annualized return would be 12.5%. With 10 years. it would drop slightly to 11.4%

Sign me up.

How does it work? Well, with 2% property appreciation (a very modest assumption), your property grows in value from $200,000 to $221,000 in five years. During that time, your tenants have paid down more than $15,000 of your mortgage for you. That comes out to about $35,000 in profit (we’re rounding here) in just five years on your initial investment of $44,000. Like I said, sign me up.

If you can find a (non-real-estate) investment you think will deliver 11% returns for 10 years with less risk, please let me know where it is. I don’t see it anywhere.

If after 10 years you want to quit your job and need cash flow, you can deleverage your portfolio to generate more cash. If you build enough equity over time, cash flow becomes easy.

My goal is to build $2-3 million in equity before I retire (whatever that means). If I have $3 million in equity, I can liquidate my entire portfolio and buy properties for cash at a 5% cap rate and cash flow of $150,000 per year. With a better cap rate, let’s say 7%, that $150,000 a year could be $210,000 per year in cash flow. Sounds pretty damn good to me.

I probably won’t do something that extreme, but I could. I will likely continue to use leverage and balance cash flow with other forms of returns. But the point is to think about the long game.

Don’t get too hung up on cash flow if you don’t need cash right now. Look at the total return.

I’m not saying you shouldn’t be looking for cash flow—cash flow is great. All other things being equal, a deal with cash flow is better than the same deal without it (duh). But it’s not the only thing. And in this crazy market where high RTPs and high CoCR are hard to find, you can still make excellent money investing in real estate if you invest for total return.

Examine the bigger picture. The 1% rule is just a guideline for people who value cash flow highly. It’s not a great rule of thumb, and it’s not very helpful for those who don’t need cash right now.

Do your deal analysis and compare your total return to alternative investments, and the deals you find, even in this hot market, will be better than the alternatives.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.