When you are buying a property, it’s a good idea to keep in mind the following ratios that can help you in judging whether this is a good investment or not.
Price/Rent Ratio
Look at the median price and median rent for the area in which you are considering buying a property. You will want to favor lower ratios versus higher ones.
The 50% Rule
The 50% Rule is just a shortcut to estimate the Net Operating Income or NOI of a rental property.
The 50% Rule says that you will only keep 50% of the rent you collect on an average rental after paying for vacancy, management, taxes, insurance, and maintenance.
The 50% Rule and NOI exclude mortgage costs.
Capitalization Rate
The 50% Rule allows us to quickly determine a cap rate so that we can decide to pursue the deal or not.
A capitalization rate is a tool experienced investors use to compare the performance of one property to another.
In some neighborhoods, a 6% cap rate will be a great deal. In other neighborhoods (usually lower-priced ones) a 12% cap rate or more might be needed to make it worthwhile.
The 1% Rule
The 1% Rule states that your gross monthly income from the rent of a property must equal or surpass 1% of the total investment in that property. By total investment, I mean the purchase price plus fees and expenses to refurbish the property before putting it onto the rental market.
As an easy example, if your total investment into a property was €100,000, then you would want to get at least €1,000 a month in gross rental income.
The 2% Rule
This is exactly the same as the 1% Rule, except this time we are looking for a 2% gross return in monthly rent versus the total investment.
When To Apply Each Rule
The obvious question is, therefore: when should we apply each of these rules. The answer is that it is totally dependent on the area you’re considering. There are some areas where a 2% deal is possible from time to time, and other areas where even a 1% deal would be a real stroke of luck.
The key here is to know the yields being produced in the area and the investments needed to produce those yields. Armed with that information you can then decide whether to apply the 1% or 2% rule to your investment options.
Rule Limitations
Like every shortcut, these rules have limitations. The major limitation you should be aware of is that what matters most in buy-to-let is the net rental income.
Here are a few costs that will eat into your gross monthly rental:
- Taxes
- Insurance
- Maintenance
- Management
- Vacancy/Turnover
- Condominium Fees
Some of these costs will inevitably be equal for all properties in a particular area (taxes is one such example), but others may not (for example maintenance). An older building might meet the 1% Rule criteria while a new building wouldn’t, however, the older building will probably have significantly higher maintenance costs. It might therefore very well be the case that the newer property might end up outperforming the older property even though at first glance and based on the 1% Rule the old building looked like a better investment.
Using the Rules
Given the additional intricacies we discussed, the best use of these rules is for quick filtering and comparison. If you’re using crowdfunding property platforms, for example, you’re likely to have several options to consider every month, and having a few quick rules to sort out the wheat from the chaff will be useful in saving precious time. Once you narrow down your options to a handful of properties, you can then dig deeper until you find your perfect investment.
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