Hello my friends and welcome to another episode of Ask Marco where I answer your investing related questions. So today we get a question coming in from Dave and it is related to the ask Marco episode I did last week about the rent to value ratio and this one is actually a little bit more specific cause he’s referring to it as the 1% rule, which a lot of people refer to it as and he says, Hi Marco, I’ve been a fan of your podcast for years now you provide great investing insight and knowledge in a trustful non objective manner. Thank you for that. As you being in the turnkey business, can you explain why the 1% rule seems to be the baseline in the rent to value ratio? Sometimes it’s a little over and under but usually close when looking at the turnkey listing. Nine Times out of 10 I can guess the rent based on the asking price, which is close to 1% do turnkey providers typically mark up the price to hit the 1% mark?
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Thanks Dave. Okay, great question. So as you can see, this question is very closely related to the topic we had last week about the rent to value ratio because the 1% rule is about the rent to value ratio and as I mentioned last week, generally speaking we want a target of about 1% it can go as low as about 0.8% and as high as 1.1 1.2% when you’re outside of that range, you have to start asking some pretty important questions such as where is it located? More specifically, what type of neighborhood is it in? If it’s on the outside of a range, being in the upper A-class neighborhoods or the lower sees and below, it’s going to skew that rent to value ratio just naturally because of its location and how the purchase price in those areas relate to the typical or average rent in those areas.
They start to separate tremendously as you get outside of that bell curve outside of that range. So the 1% rent to value ratio or what they refer to as the 1% rule is in the sweet spot. It’s in the range of what works for most investors, meaning that we’re looking at buy and hold rentals that we want to produce cash flow and generate a reasonable rate of return. Often these are cap rates or capitalization rates in the six to 9% range, so you got to understand that when you have a target and a criteria for an investment property that works, meaning that it’s located in a good area and generates a reasonable rate of return, it’s naturally going to fall in that range. And this is why the 1% rule keeps coming up time and time and time again. So number one, it works for investors.
Number two, you see it often because it’s in within an hour range and within our criteria, meaning that what we typically work with and look for as a company, helping our clients, our investors identify and purchase these portfolio properties. It’s going to be in that range because we expect the builders and the providers that we work with to provide us with that inventory that meets a list of criteria and one of those items happens to be that 1% rule, so we’re okay if a property is 0.8% ish, a plus or minus or higher, you’re going to find those lower numbers with often the new construction properties at the duplexes, even single family homes, and fourplexes that it just naturally is lower and there’s a give and take there. The give and the take is that you typically will have a lower rent to value ratio, a lower, in other words, rent to price ratio, but what you’re getting typically is sometimes equity in the transaction right upfront or you are in an area that has strong growth and is strongly expect it to continue so you make it up in that appreciation over the next year, two, three again, there’s no guarantees here and there are no crystal balls.
Just understand the give and the take theirs. There’s an ebb and a flow. Nothing has ever in equilibrium. If you give up something somewhere, you tend to gain it elsewhere. And the third point I’m going to make about this 1% rule and this ratio is that providers, whether they’re professional rehabbers and or builders, they don’t mark up the property. Often what they’ll do is in order to make sure that they’re in the right areas and meeting the cash flow expectations or requirements of an investor is they’ll work the numbers backward. So if they find inventory or distressed properties in a particular area that is known to be a desirable and good place to invest, they’re going to say, okay, if I acquire that property and I fix it up, what is it going to be worth? What is referred to as the ARV after repair value?
So if that after repair value is let’s say 150,000 and that property in that area, we’ll typically rent for about $1,500 a month, maybe 1400 but somewhere in that neighborhood. Then we know that quick litmus test shows us that that property is a good candidate as an investment property. Now they just have to work their numbers backward to make sure that if they acquire it, pay the carrying costs, funded the scope of work, which is the renovation and budget for a profit in there, and they can walk away from that property, having it fully renovated and turnkey and making a profit to stay in business. At the same time, being able to sell it to an investor who was also going to make a profit and be able to buy hold and cash flow that property over time, then it becomes a win-win.
But you see they’re working it backward from the after repair value backward. They’re not looking at it from, okay, what can we add onto it in order to meet our numbers and hit the 1% ratio? Maybe some providers do that, but typically it works the other way around. And the fast and quick and dirty way to look at it is what’s the after repair value? What is the market rent in that neighborhood? Those two numbers right there will tell you if it’ll meet the 1% rule or come even close to it. So anyway, I don’t want to overcomplicate something that is fairly simple and that is really the answer to your question. So Dave, thanks for submitting that question. If you have a question about real estate investing or finance that you’d like me to answer on the show, simply go to passive real estate investing.com and click on the ask Marco Button. And if you haven’t already, remember to subscribe, help us share this show with other like-minded people who can benefit from it as well. So visit us on Itunes, and leave us a rating and review. Again, thanks for listening and we’ll see you on our next episode.
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