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.
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 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.
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.
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.
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.
|Meadow Arbor 21||Roadrunner|
|Affordability Guideline||All-in cost is just over twice median income. After Repair Value (ARV) is still under three times median income for Universal City.||All-in cost will be just over six times the median income for Bryan, twice our guidelines for a good rental candidate. ARV is more than seven times median income.|
|1% Rule||The expected rent rate is 1.1% of our all-in cost.||We would have to get about 1.5 times the market rent to satisfy the 1% rule.|
|Appreciation Guidelines||Median home prices are up 12% year-over-year and 29% over the last five years.||Median home prices are up more than 8% year-over-year and more than 40% over the last five years.|
|Market Appropriateness||All-in costs will be about half of the median home price in the market and well-below ARV for the neighborhood.||All-in cost will be $50,000 over median home price but within reason for the neighborhood, which is at the high end of the Bryan market.|
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….”
1 The San Antonio Board of Realtors and Bryan College Station Board of Realtors do not publish market data in the level of detail we’re used to seeing in Austin. Bryan data is available city-wide, but San Antonio data is only available at a system level.