There’s a lot of “rules of thumb” floating around out there related to real estate. The one I hate the most is the 1% rule.
It’s wrong. It doesn’t work. Period.
Let me explain…
The 1% Rule Explained
Let me take a step back and explain the 1% rule first.
In a nutshell, it says that the monthly rent for your rental property should be at least 1% of the property value. If you can meet this goal then you can make some good money in real estate.
So, if you find a property that rents for $1,000/month and you can negotiate a price of $100,000 then you’re in good shape.
…at least according to the people pushing the 1% rule.
Breaking Down the 1% Rule
Let’s say that that you find a property that is $100,000 and rents for $1,000.
We know around 5-10% goes straight to vacancy. So, that leaves you $900.
And 50% of that goes to expenses. Leaving you with $450.
And a 30 year mortgage on an $80,000 loan (I assume 20% was put down) is around $429.
So, that leaves you around $20 – $70 (depending on vacancy) each month.
…not very sexy is it?
The Break Even Ratio
Traditionally, the 1% rule was considered the break even rule. Where you would most likely cover your debt when rents are 1% of your purchase price.
So, what happened?
I don’t know for a fact, but I think a couple of things happened.
Turnkey Real Estate Companies
First, I think that turnkey companies started pushing it as a solution. A turnkey company finds a distressed property, rehabs it, puts a tenant in there and sells it to you for at or above market price.
There is definitely some value to what turnkey companies do, but often they based their prices on the 1% rule and not necessarily on market value. That allows them to get higher prices in generally low cost markets.
They justify it with free education. They teach you that if you can get 1% of the value as rent, then the deal is great and you can make a ton of money…
To people on the west coast or other high-cost areas, this seems awesome because the ratios there are closer to 0.5%. So, relatively speaking, they are “great deals” even though they are overpaying.
There are a ton of new gurus out there pushing all kinds of different ideas. Some are good and some are not, but the 1% rule keeps popping up, especially with online education.
Often, these are run by people who own a few properties and have done really well since the recession. It makes sense if you think about it. If you bought at 1% back then and rents and prices have almost doubled, then you are way above 1% based on what you purchased it for.
But, that is buying based on speculation that the market will improve, not based on the fundamentals of the deal.
Another common guru you see out there now is someone who’s only been investing for a few years. Even if they are doing great but they haven’t really been around long enough to see and understand the nuances.
They don’t realize that the 1% rule works when there are massive rent growth and appreciation but could never work in a sideways or downward trending market.
What About Using it As a Filter?
People will suggest using the 1% rule as a filter to go through hundreds of deals quickly. Here’s how they suggest you do it:
list all the prices, list all the rents, then calculate the ratios. Anything under 1% toss out and anything over 1% keep and look at deeper. So, a spreadsheet might look like this.
Based on this, you should consider buying the first, third, and fifth property on the list because the ratios are all above 1%.
But, this is missing a HUGE amount of detail. What is most important is not what it’s receiving for rent today, but what it could be receiving after you own it. So, you should based your numbers on potential rent not current rents.
Based on the new spreadsheet, the best potential deals are the 4th and 6th. While others may have potential as well based on the 1% rule, you see some really good ratios on deals you would have previously discarded.
That’s why the 1% rule is kind of silly. It leads you to discard potentially great deals in favor of more marginal deals.
Focus on The Numbers
The rent to price ratio is an important ratio to consider before purchasing anything. Just remember, it is a rule of thumb. Also, remember what it truly means:
The 1% rule is the break even rule not a rule to earn you money.
Rules of thumb are designed as a reality check. Things like the 50% rule to expenses or the 1% rule are there to act as a guide. If you are running the numbers and you’re rent is 1.5% while everyone else is at .75%, then you should think twice.
Or, perhaps your expenses are at 25% and everyone else is running at 50%. Then you should double check.
They are not and should never be used to make a buying decision.
That’s why I give away simple calculators like this one, to point you in the right direction.
How To Invest In Real Estate With (Almost) Zero Taxes
So you just sold one of your stock or bond investments and now you’re about to get crushed with capital gains taxes, right?
You see, you still have options to defer or even completely eliminate those taxes using a new loophole in the system.
Let me explain.
Opportunity Fund Investing is a newly-minted tax-advantaged method of investing in real estate that will accessible to individual investors, not just institutional capital.
What are opportunity funds?
Opportunity Funds are a new tax -advantaged investment vehicles created as part of the Tax Cuts & Jobs Act of 2017.
The concept was introduced as part of the Investing in Opportunity Act – a bipartisan bill that was included alongside the broader tax bill -but has received far less attention until now.
The goal is to help spur greater private-sector investment in targeted communities across the country called Opportunity Zones.
What are opportunity zones?
Opportunity Zones are designated census tracts selected by the state and federal governments for economic development.
Opportunity zones can be found in every state and in urban, suburban and rural areas. These are areas that have historically been passed over by investment capital, and meet certain qualifications with respect to poverty levels and/or sub-median income levels.
Qualifying census tracts must meet a minimum threshold of its population living below the poverty line, and/or a max average income of 80% area median income.
This hardly means, however, that these areas should be unappealing to investors.
Many of the opportunity zones already established are centrally-located infill neighborhoods in thriving metros that, while less affluent than their cities overall, already exhibit signs of economic vibrance and should continue to develop alongside the broader metro.
Market fundamentals already support investments in many of these census tracts. This new system of tax incentives should make such investments all the more compelling.
Why invest in opportunity funds?
Qualifying investments offer three unique and compelling tax advantages – investors can defer paying federal capital gains from recently sold investments until December 31, 2026, reduce that tax payment by up to 15%, and pay as little as zero taxes on their Opportunity Fund investment if held for 10+ years.
Opportunity Fund investing also offers the chance to have material impact on the well-being of under-resourced communities.
This presents the opportunity for individual investors to include real estate in their portfolio of “triple-bottom-line” investments – those that not only yield compelling returns, but also yield positive social impact.
Even if you’re only concerned with net returns, however, the tax advantages alone should pique your interest.
What kind of gains are eligible for tax deferral?
Investors may defer capital gains tax on any recently sold investment – including the sale of stocks, bonds or real estate – so long as those gains are rolled over into an Opportunity Fund investment within 180 days of sale.
Simply put, this new program for tax-advantaged investing is a sea-change in how investors are able to reduce capital gains tax, and carries the potential of funneling huge volumes of capital to communities across the country that need more affordable housing and more efficient access to equity for small business.
If done well and with proper oversight and guidance from the Treasury Department, this may truly create win-win-win investments across the country.
Many markets in the U.S. are suffering from an acute affordable housing shortage.
This exciting new program affords individual investors the chance to invest in the revitalization of neighborhoods across the country, while potentially earning very compelling after-tax returns.
Vacation Rentals: How Profitable Are They?
In the past, vacation rental owners had to perform the necessary maintenance tasks and market the properties to find guests or pay someone in the locality to do so on their behalf.
Bookings were low and the cost of maintaining the vacation homes was high. Thankfully, the firms that manage vacation rentals are using new technologies to eliminate these issues and deliver a comprehensive service on a high level that the vacation rental industry has not seen.
Many travelers are avoiding staying in hotels in favor of vacation rentals.
Why Vacation Rentals?
Some of the benefits of vacation rentals include:
- Variety – Vacation rentals offer different decor, amenities and views among other things. Travelers select their own vacation rentals and preferences based on their budget and how they want to define their vacation such as close to the beach or a golf course among other locations.
- Additional space – Vacation rentals are more spacious than hotels and are therefore popular with people traveling with their families.
- Comforts of home – Vacation rentals provide the comforts of home and some of the things that a typical home does not have. There are multiple bedrooms, comfortable living rooms and adequate space to sprawl out. Vacation rentals are more comfortable than staying in the bedroom of another person like with Airbnb.
- Privacy – Vacation rentals have private entrances and private balconies. Therefore, patrons do not have to walk through the lobby after returning to their unit.
- Cost effective – Since vacation rentals are spacious, families often rent them together. This makes the homes more cost effective than hotels.
- Easy booking and check out – Technology such as online payment platforms enable guests to save time. They do not have to wait in line to check in or out.
Improving Vacation Rental Technology
Technology has played a huge part in making the short-term rental market grow. Online listing firms such as Airbnb make it easier for guests to book the home they want to stay in.
With this software, you can manage rental channels. These include HomeAway, Expedia, and Airbnb using one app or platform to reduce management time and increase profits. This means that you can manage your property without having to enlist the services of a professional management firm.
Are Vacation Rentals Really Profitable?
Investing in vacation rentals is an excellent way to earn passive income.
A survey done by HomeAway, which is a short-term rental marketplace, found something interesting. People who rent out second homes earn more than 33,000 dollars annually in rental revenue. On the other hand, at Airbnb, the average vacation rental owner collects yearly rental revenue of about 11,000 dollars.
Most of the vacation rental owners using the Airbnb platform don’t perform as well. They may only rent out only a single bedroom or rent out their homes irregularly. They do not treat their homes as true vacation rentals.
I’ve spent the last 10 years developing my systems and growing my business until now I have over 480 units of rental property.
It’s no joke and I’m not pulling your leg…and I started with just one small rental property.
I’ve put together and outlined the simple 5-Step System that I used to get from broke student to retired by 30, and it’s yours now, totally free!
Do the Math
It is not that straightforward to figure out the amount of money your vacation home can bring in. However, online tools can enable you to calculate the potential cash flow to your property.
You can use these tools to calculate the average daily rental rates, revenue, and occupancy rates. By using these projections, you can then subtract items such as interest, PITI, management fees and maintenance expenses. Then you’ll get a cash flow forecast.
Evaluate the Location
The other factor that will determine the amount you will earn as rental revenue is the location. If you buy a vacation home, which is close to a popular destination like a ski resort or beach community, then it is likely that it will bring in a higher rental income. An excellent location close to a major airport or a vacation spot that people visit year round will have the best impact.
Assess the Scene
Apart from the accessibility and popularity of a destination, you also need to consider the setting. For instance, it is more cost effective to invest in a vacation home located in the mountains compared to a beachfront vacation home. However, such a home is not likely to bring in as much income as a beachfront property can.
The peak season for vacation rentals lasts about 12 weeks.
The trick is trying to rent the vacation home during the off-peak periods or when you do not want to live in the house. Try your best to keep your vacation home occupied by advertising it on platforms like HomeAway and Airbnb. You can even seek advice on the best ways to keep a property occupied from a property management firm that manages vacation homes.
Set the Price Right
To maximize occupancy, you should price your vacation home well. You can price your propertyslightly lower than similar properties so that it will be occupied more frequently. Furthermore, you should keep an eye on events like festivals and conventions that occur close to the location of your vacation home. When the demand is high, take advantage of it and adjust your rental charges accordingly so that you will not miss out on revenue.
Vacation homes are unique in that they are both an investment and a lifestyle upgrade. While they perform equally as well as conventional rental properties, they offer the benefit of having a place to stay for your own vacations.
A vacation home can bring in a good return on investment if you can keep it rented out most of the year. If you hold the vacation rental for many years, then you will make a return, which is comparable to or greater than you would have made if you had invested in stocks.
What is Debt Service Coverage Ratio and Why it’s Important?
There are few numbers more important in commercial real estate than the debt service coverage ratio.
It’s one of the first things and one of the last things that any commercial lender or broker will talk about. It’s first and last because it’s simply that important!
A lot of people toss this term around without explaining it while others are using it without fully understanding it. It’s a lot more than just a simple formula and when you understand the debt coverage ratio, you’ll be able to control it to get maximum financing.
Let’s dive into it.
Why the DSCR is Important
Imagine finding a commercial property worth $400,000 and you need to put 25% down.
You think, “alright, I can afford that!” and move forward with the deal, expecting $300,000 in loan proceeds.
As you approach closing, your mortgage lender calls you to say “The maximum loan we can give you is $225,000 because the debt coverage ratio is too low.”
Now what do you do?
This is real and happens every day. To avoid a situation like this, you need to fully understand the debt service coverage ratio before you make offers.
The fact is that it’s regularly used by banks and loan officers to determine if a loan should be made and what the maximum loan should be. If you don’t have the extra money laying around, you won’t be able to close the deal and you’ll lose a lot of money.
Debt Service Coverage Ratio Defined
The debt coverage ratio is a simple ratio that tells a lender how much of your cash flow is use to cover the mortgage payment. It’s known as the debt service coverage ratio, debt coverage ratio, DSCR, or DCR.
Debt Service Coverage Ratio Calculation
In general, it’s calculated as:
Net Operating Income = Gross Income – Total Operating Costs
Debt Service = Principal + Interest
To calculate the debt coverage ratio of a property, first, you need to calculate the NOI. To do this, take the total income, subtract any vacancy, and also deduct all operating costs.
Remember, operating costs do not include debt service (principal and interest), or capital expenditures. Insurance and taxes are operating costs, so don’t forget to include them.
Next, take the Net Operating Income and divide it by the annual debt service, which is the sum of all principal and interest payments during the year.
To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.
How The Debt Ratio is Used
A Debt Coverage Ratio below 1 means the property does not generate enough revenue to cover the debt service while a debt ratio over 1 means the property should, in theory, generate enough revenue to pay all debts.
It’s very common for lenders to require a 1.2 DSCR, give or take.
If your debt coverage ratio is too low, the only way to make it work out better is to reduce the loan balance. Your NOI is the same but now your principal an interest decreases, making the ratio go up.
And that’s how you can get your loan proceeds cut dramatically.
Debt Coverage Ratio Example
Let’s say there is a property that generates $10,000 in revenue, has total operating costs of $4,800, and yearly debt service of $4,000
NOI = $10,000 – $4,800 = $5,200
In this example, the debt coverage ratio is above 1.2, so this would be a good risk for the bank and they’d likely give the loan.
Let’s say that interest rates change and the bank gives a slightly higher rate, causing a new debt service of $4,500.
Notice how a small change can suddenly change everything!
The Bank Will Reduce Your Loan
In this situation, the bank probably won’t reject the loan. Instead, they will reduce the loan balance until the payment comes in line with their minimum DSCR requirements.
In this situation, the lender will simply reverse the formula and determine what the maximum debt service can be. We can plug in the variables we know to solve for the allowable debt service
1.2 = $5,200 / Max Debt Service
Max Debt Service = $5,200 / 1.2
So, the maximum debt service can be $4,333. Now they just need to figure out what loan balance that will be based on their interest rate and loan term.
…and you’ll be stuck trying to squeeze some quarters out of your couch to pay for the extra down payment.
How the Debt Ratio Affects Returns
In the example above I showed how a loan can be adjusted down before the lender will give the loan. This can significantly reduce your cash on cash returns.
Let’s say you are buying a property in the example above costs $100,000 and requires a down payment of $25,000.
Let’s also say that it generates $10,000 in cash each year and has an NOI of $5,200.
Originally the debt service was supposed to be $4,000 per year, leaving $1,200 in total cash flow.
Now, let’s calculate our cash on cash return. We know that it’s calculated as:
Cash on Cash Return = Total Cash Flow / Total Cash Invested
CoC = $1,200 / $25,000 = 4.8%
This means that for every $100 you invested, you get back $4.8 every year, cash in the bank. This is not to be confused with the overall return on investment.
But due to some fluke, the terms changed and now the debt service will increase. Let’s say that the interest rates increase so your $75,000 loan is at 4.5% now and your debt service goes up from $4,000 per year to roughly $4,560/year. You can see that the new debt service coverage ratio is well below the 1.2 minimum.
I’ll spare you the math, but when I punch it into a calculator I find that the maximum loan value is now roughly $71,000. This creates a yearly debt service of $4,320, bringing you back to 1.2
Comparing The Two Scenarios
Since you’re loan has gone down, you will need to invest an extra $4,000. You’ll also have a lower cash flow because of the higher debt service.
Cash Flow = $5,200 – $4,320 = 880.
Now let’s compare two scenarios. Imagine if you were still able to get 25% down, your cash on cash would look like:
CoC = $880 / $25,000 = 3.5%
Not very good, right? But, that’s because of the increased interest rates.
Now, let’s see how the change in the loan amount affects your return. Remember, your down payment is no longer $25k because it became $29k.
CoC = $880 / $29,000 = 3.03%
Never Neglect the Debt Coverage Ratio
You can see how important this simple ratio is to banks. It can change your returns, your down payment requirements, and it can even kill your deal.