Rental properties build wealth…if you choose them wisely.

We all agree that one of the main goals of real estate investing is passive income, and you can only generate that through owning rental properties. Rental properties can generate multiple income streams. But, assuming you don’t have the leverage to buy a multi-million dollar apartment community, how do you know if a house will make a good rental property? I have a few simple guidelines that let me know.

• The Affordability Guideline
• The 1% Rule
• The Appreciation Guideline
• The Market Appropriateness Guideline

In this post, I’ll go over each of these guidelines and then show you how we applied them to two of our current projects.

Median single-family home prices in Austin proper climbed to $380,000 this May.
Source: Austin Board of Realtors^®

The Affordability Guideline

You can have the most beautiful house in seven counties, but it will sit empty if people can’t afford to rent it. Similarly, you’ll go broke if you have to rent a house for too much less than it costs to own it. The Affordability Rule helps you determine upfront if a property is affordable as a rental. I didn’t come up with it. I stole it from Chris Clothier of Memphis Invest.

Simply put, the affordability rule states that you want your rental property to be around three times the median income for the community. If the median income for a community is $50,000 according to the Census Bureau, your all-in cost for purchasing a rental home should not exceed $150,000. That gets challenging in “hot markets” like Austin, where the median income is about $55,000 but the median sales price of a single-family home in May was about $380,000, according to the Austin Board of Realtors^®. This conflict between price and income is driving many potential buyers (and renters) out of the market. To compensate, we’ve been focusing most of our activity in outlying areas and San Antonio.

The beginning monthly rent should be about 1% of the acquisition cost, including rehab.

The 1% Rule

The 1% Rule isn’t a statement about income inequality in this country. It’s a quick-and-dirty derivative of an ideal rent ratio. I want the monthly rent to be about 1% of the all-in cost of the house. If I’m paying $150,000 for a house, I want it to generate at least $1500/month in rent. Conversely, if I know a house can generate $1000/month in rent, I don’t want to spend more than about $100,000 on its acquisition, including rehab.

The 1% rule should help you get about a 10% cap rate, which is the laziest I want my money to be. It will pay back the initial investment in 10 years. Chris Clothier recommends a rent ratio of between .8% and 1.2%. If you can get 1.2% from the start, do it! But the .8% is just a little too risky for me to be interested…unless there are other factors that sweeten the deal. At much less than 1%, the risk of negative cash flow is just too great.

But Chris does have a good point. If you execute you rehab well, the rent ratio will only improve over time, thanks to our old frenemy Inflation.

“Appreciation” is a euphemism for “inflation” in housing terms. If you had purchased a $150,000 Austin home in 2004, it would be worth more than $300,000 today. 
Source: Austin Board of Realtors^®

The Appreciation Guideline

I know people usually think of inflation as a bad thing. That’s why investors often use a different word: appreciation. The houses we hold will continue to appreciate over time because inflation will continue over time. The appreciation curve isn’t smooth. It can be really bumpy, but home values have always gone up over the long term. But as Norman Greenspan once quipped, the problem is that, “in the long run, we’re all dead.” Nonetheless, real estate investing is a long-term game.

The Appreciation Guideline is simple. You want to invest in appreciating areas. When you factor in the other guidelines and the 1% Rule, you probably won’t find anything in the trendiest areas. That’s a good thing. People pay top dollar for trendiness, and investors are looking for value and income. Trendiness and value are often mutually exclusive concepts.

For example, there are areas of Austin that have appreciated more than $25% per year for several years. While it would have been nice to buy a $100,000 house in one of those areas three years ago and have it appreciate to just over $195,000, the truth is the rents don’t usually support that growth, because the entry point for those areas is usually well above the Affordability Guideline and the 1% Rule. While you would make money at the point of sale, you’d probably have to pour additional money into the house every month instead of  letting someone else pay your taxes, mortgage, and upkeep.

While these houses are appropriate to the neighborhood, I’m still not certain I’d invest in them.

Market Appropriateness

The final guideline is really just a catch-all of several factors.

• A balance of rentals and owner-occupied homes to keep up property values
• Square footage in the lower to middle of the homes in the neighborhood to maximize appreciation
• An established neighborhood with little new construction to compete with

Smaller houses have a couple of other advantages. They appeal to older couples who are done with child raising, which results in less damage to the house. They are less expensive to make ready between tenants.

Application

If you apply these guidelines to some of our current projects, it’s easy to tell which ones would be good to hold onto as rentals and which wouldn’t. I’ve summarized in the following table.

Just going down these factors shows why we chose our primary exit strategies for each of these two houses. We plan to lease Meadow Arbor 2 and sell Roadrunner. Of course, plans aren’t results. As my dad used to say, “We’ll see….”