Lazy Man and Money

Can You Rely on Real Estate Investing’s 1% Rule

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You’d think that after 15 years of being a landlord and reading about personal finance, I’d know all the rules of thumb. However, I recently came across the 1% rule of real estate investing and had to look up the definition. Perhaps I knew in the past and just forgot about it. We’re accidental landlords, our rentals are homes that we already lived in. The exception was an investment property that was insanely cheap. It was in great condition – no repairs necessary. We didn’t have to do a single calculation on it, because we already had a condo in the same complex. We knew everything about the neighborhood already.

I love rules of thumb because they help me verify that I’m on track. So…

What is the 1% Rule in Real Estate Investing?

It’s a quick estimation of whether you are getting value when you buy a rental property. The monthly rent should be 1% of the purchase price plus any necessary repairs. For example, a $200,000 home (with no repairs) should rent at $2000 (or more) to cover the mortgage payments.

Similarly, you could do the reverse and multiple an expected rent by 100 to figure out how much you should pay for a property.

When to Use the One Percent Rule

The best time to use the rule is early in the search as a prescreening tool. That’s what the experts say at least.

I was looking at the properties we have and I thought, “What if we sold them to another investor?” Or if I were an investor today, would I buy the rentals all over again?

Property 1

Our oldest property currently has a Zillow estimate of $200,000. That makes figuring out the 1% rule very easy because we just finished that example. Zillow’s Rent Zestimate is a little less than $1800. The rent we’re making is $1350. We’ve kept it low for a long time because our tenant is an elderly widow living there on a fixed income and we don’t have to do anything. Keeping the vacancies minimal is also important to us.

We’re losing money on the property as condo fees keep going up. It’s starting to be an older property and the expenses will go up to maintain it.

It wasn’t bought to be a rental in the first place. However, if someone bought it now and got a tenant in it, perhaps it would be close to 1%.

Property 2

My old condo is worth $358,000 now according to Zillow. However, the rent Zestimate is a little less than $2300. For it to follow the 1% rule, we should be collecting $3,580 a month in rent. Zillow says we couldn’t get close to that. It’s true, we have it rented for only $1900. We’ll look to raise this rent too because the condo association has had a couple of fires and the insurance has gone up.

Fortunately, we bought the condo a long time ago, so the mortgage is lower. Unfortunately, that’s not enough to generate positive cash flow.

So far no investor should buy either of our properties.

Property 3

Our newest property was bought in 2013 and it was a great deal at $95,000. We sold it for nearly double at the end of 2019. We did a 1031 Exchange, which allows us to roll the money into a new property without paying taxes on the sale. We did all this because it is easier to manage property closer to where we live.

We paid about $200,000 for the new property and it jumped to $265,000 as prices have skyrocketed in the last year. We’ve only been able to get $1600 in rent though. Zillow says that we may have been able to get $1800, but the $1600 was fair for the market. In the last couple of months, Zillow has jumped the rent estimate to $2500.

If an investor about the property from us for $265,000 and tried to rent it out to someone new, I doubt it would get $2,500, much less $2,650.

Property 4

This is actually our primary residence instead of a rental property. However, it used to be rental property. We lived in California, but in 2011 we bought a house in Rhode Island. The real estate market was still down and we figured we could get a price and rent it out to a military family until we retire in it. We only rented it for one year.

We bought it for $400,000 and we were able to rent it for $2,600. That’s not near 1% either. Zillow says it is worth nearly $700,000 now, but the rent would be a little more than $3,400. That’s only about 0.05% – very far from 1%.

Throw out the 1% Rule?

I think our area of New England makes the 1% rule very difficult to do. There might be some properties that are 1%, but it’s very hard. Perhaps if we bought a 3-family house, we could get enough rent.

Another “problem” is that the housing market has exploded in the last year. Rents have gone up too, but it seems like that they haven’t gone up fast enough to make hitting the 1% rule easier.

One way to get to the 1% rule is to wait. Rents go up over time, but your mortgage should stay the same. Let’s review the first property again. The purchase price of the property was around $140,000, so the current rent of $1350 is very close. If we charged a market rate, we’d finally have over the 1% rule.

What’s better than the 1% Rule?

Many real estate investors prefer to use the rent multiplier over the 1% rule. It’s very similar, but rather than just giving you a decision to move forward or not, it can be used to quantify how good or how bad a deal is. You simply divide the price of the property by the rent. So, we can use the very first example above with the $200,000 price and $2000 rent to come out with a rent multiplier of 100. That means it will take 100 months of rent to break even. Of course, you wouldn’t really break even because there are other expenses such as property taxes and repair costs. It’s just a good guideline to compare properties.

If you have another property that costs $100,000 and the rent is $1,500 that’s a much better deal as it would pay off in 66 months or five and a half years. Again, it’s important to note that about half the rent will go to other things over the long term.

Even though both properties pass the 1% rule, you can see how much better the second property is. Or, in the case of my property examples above how much worse they are.

Some people use the Gross Rent Multiplier (GRM), which just means that it uses the gross rents or the rent for a whole year. The math isn’t different, it’s only a matter of whether you want the answer in terms of months or years.

Final Thoughts

The 1% rule works to show you if a property is a good investment. It isn’t perfect though. Some locations are expensive and the 1% rate may not be possible. When that happens you may have to look at investing in another location, which can create its own set of management headaches. Or, you may decide to get as close as you can by minimizing the GRM and counting on appreciation to add value.

For us, the toothpaste is already out of the tube. We’re far enough along where we may be able to pay off the mortgages soon and have a real monthly cash flow. If we can raise the rental rates to be a little competitive it will certainly help. However, this is a tough time due to COVID, so staying with lower rents for a while longer may make the most sense.

The Most Expensive Vacation Ever?

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I’m away on vacation this week (and it is expensive), but here’s frequent contributor Kosmo with an article about his last vacation.

No, we didn’t go to Disney World.

In 2017, we made our first trip to Door County, Wisconsin.  For those who aren’t familiar, it’s the “pinky finger” on the eastern border of Wisconsin – a peninsula with Lake Michigan to the east and Green Bay to the west.  After the initial trip, we decided that we’d definitely make a return trip.  We planned a trip in 2019, but it was derailed by a family health situation.  Last year, it was postponed because of COVID.  This year, we finally made a return trip.  Even with a somewhat limited set of activities (because our 11-year-old isn’t old enough to be vaccinated), it was great.  We’ll definitely be back.

A funny thing happened.  We started looking at homes on Realtor.com.  Just goofing around at first.  What would we do with a second house?  Especially a house that’s considerably more expensive (per square foot) than our primary residence.  That’s just crazy.

Maybe?

The idea percolated and eventually turned into a new idea.  Perhaps a rental property that we use for a couple of weeks per year, plus some sporadic weekends.

Financially, we’re in a position where we could try this.  I’m 46 years old.  We have about 75% equity in our house and have a bit of money in an investment account.  We would swing the down payment and setup, and even get through some lean years with limited rentals, if worst came to worst.  I actually don’t think we’d have trouble renting a place, because it’s a very high-demand area.

The hard part

The bigger factor is the fact that we live 400 miles away.  Even if we bought something that didn’t require a lot of maintenance, trying to get things set up on weekends would cause the setup to stretch longer than we’d like.  Setting up a short-term rental takes a bit more work than setting up a long-term rental.  You need to furnish virtually everything.  Not just beds, a couch, table, chairs, and TV, but things like spatulas, corkscrews, and frisbees.  And, of course, toilet paper.  Nobody wants to check into an Airbnb and realize there’s no Charmin.

We would also have to hire a local cleaning service, as well as have some sort of arrangement with a local maintenance person to handle any acute issues that arise.  If there’s a leaky pipe on a Wednesday, I wouldn’t be able to jump in the car and go fix it, since I have a day job.  Nor could I mow the lawn every week or clear snow in the winter.  Naturally, paying locals to assist would cut into the profitability of the venture.

Does it make sense?

Of course, the venture doesn’t actually need to make a profit.  We’d be getting some personal use out of the property, plus the likely appreciation in property values.  We could lose a bit of money every year and wouldn’t cry about it.  If we could simply defray a decent chunk of the costs, that would be great.

We’re going to dip our toes in the water.  My wife (a CPA) and I are both the type to plan things.  We’re putting together a list of the furnishings we’d need, so that we can get our arms around the potential cost.  Everything from bed frames to pizza cutters.

We have a local realtor that we’ve used to buy two houses and sell one.  We’ve always enjoyed working with him.  It seems like a longshot that he’d know some realtors 400 miles away, but we asked.  Yep, he knows a couple of people.  He’s going to get their information to us today, and we’ll engage with them very soon.

Your thoughts?

Do any of you own and remotely manage short-term rentals?  What has your experience?  Is it worth the cost and effort?  Are there potential pitfalls that I should be aware of?

Should I Put My Investment Property in an LLC?

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That’s a question I asked myself years ago. I wish I was wise enough to answer it…

… NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO, NO!!!

Or as Al Bundy from Married… with Children once said, “Run hard, run now, run silent, run deep, run like Mexican water through a first-time tourist, but the key word here is ‘run!'”

I could go on about how I feel, and I will, but before I go any further I need to pause and stress something. Much of this is an account of my situation and how I personally feel. Your situation may be different… and your answer may be different. Perhaps you’ll be smarter than I was and get professional advice before jumping in.* In any case, I wish this was one of the 1.31 million personal finance articles I’ve read over the last 15 years or so.

I was going to suggest that no one should put their investment property in an LLC, but I talked with a few people and it seems like there may be some valid reasons to do it. Let’s cover a few of those reasons first.

Why Put Your Investment Properties in an LLC?

My wife and I were looking to simplify our finances. Whenever we needed money for repairs it would come from our checking account or a credit card. Since I love to rack up credit card bonuses, I put the expenses on a few different cards. We’re not the most organized people when it comes to having receipts. Come tax time, it’s a nightmare to put together all the numbers.

It turns out that organizing your finances is NOT a good reason to put your investment properties in an LLC. It can work well for internet publishing like Lazy Man and Money, but real estate is unique. I’ll explain why in the next section.

One reason why people may put investment properties into an LLC is that it can afford some legal protection in the event of a lawsuit. What kind of lawsuit? I’m not sure, but I’ve read that it can be someone visiting the property falls over a deck railing and gets injured. (Presumably, if it is someone living at the property, they have their own insurance and you have landlord insurance.) Because this involves lawyers and specifics of the law, I’m going to defer to your legal counsel to help you with how this can work. The people I know simply get umbrella insurance. One more thing that I’m looking into is protection from liability claims.

While I like legal protection and insurance as much as the next person, I have a limited budget for it. Umbrella insurance is fairly cheap and that’s about where my budget is.

Another reason to put investment properties in an LLC is that you can give some of it away in pieces. Maybe somewhere down the line, we’ll give the properties to our kids. I think we could give away a little at a time, so they wouldn’t have to deal with a big estate tax bill. That’s something that we’d have to tackle with our financial advisor(s). Once against see the “*” citation below. For now, we’re not interested in this. Our 6-year-old lacks the maturity to manage real estate… and probably will for at least the foreseeable future.

Finally, if you are investing in some commercial properties it may be easier if you are a corporation. (We’re not interested in this.)

Why Not to Put Your Investment Properties in an LLC?

I never figured there would be a negative to putting real estate in an LLC. Lazy Man and Money essentially works the same if it is in an LLC or not. My earnings are the same. My hosting costs are the same. I have two additional costs. At tax time, I have to pay more to the tax preparer. I also have to pay the state filing fee. I have a lawyer who automates most of this (at additional cost) and it’s about $1000 a year more than when it was a sole proprietorship. That’s not insignificant, but I’ve learned to live with it.

Real estate investing is different than internet publishing. It often depends on lenders and banks. Banks and lenders complicate things. For example, we’re in the middle of buying a new property, the first since we put it in the LLC, and it is a mess. I couldn’t work with the typical bank lenders because I need to use the “corporate division.” That process is a lot more difficult. It’s harder to track down the lender. They want incorporation documents. It’s a lot more hoops to jump through (which is significant because getting a mortgage is already a hoop-jumping intensive process.)

The first surprise was when we got our lending term sheet. Mortgage rates for 15-year-fixed loans can be as low as 2% now. We know that as investors we going to have to pay an extra 0.75% more. That’s just how it works with investing. What we didn’t know is that the LLC triggering the corporate loan adds another 1%. The rate jumps up to 4%. It’s still decent, but the “LLC tax” that doesn’t give us any real benefit is starting to get costly. In addition to that higher rate, the loan is not fixed. It readjusts every 5 years. What does the lending market look like in 5 or 10 years? I don’t know, maybe the rate will be 6% or 8%. We are very fortunate that we aren’t borrowing much money and can hopefully pay it down quickly.

The LLC nightmare gets worse. We registered our LLC in Massachusetts even though we live in Rhode Island. That may sound odd, but all the properties are located there and my lawyer practices there. We’re trying to manage properties closer to Rhode Island, so we are selling them off there and buying here when it makes sense. Our Rhode Island bank at the last minute decided that we need to register with Rhode Island which is an additional annual filing fee. It also almost caused the deal to collapse.

Finally, it’s looking like we’ll have to pay our tax preparer to file in two states now doubling the tax preparation fees. The annual fees to states and tax preparation are going to be around $2000, I believe. We used to pay a nominal fee when it was included as part of our normal taxes.

Some people may say that $2000 isn’t a big deal, but I’m a person who celebrates finding chicken at $0.69 a pound. I save up for years to buy a $1300 television. It’s significant especially with the potential of more expensive loan terms.

Lesson learned: a real estate LLC can cost you.

* Whenever I try to get professional advice it doesn’t go well. I’ve spent the last month trying to get a CPA who can help with some advanced future tax-planning questions. Most seem to want to manage all your finances at a cost of hundreds of dollars a month. I had a few ask about my investable assets because taking over that aspect is part of the core of what they do. Maybe I just haven’t found the right people.

Further reading: Bigger Pockets – Why You Should Skip the LLC When You’re House Hacking

Should I Move?

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Should I move? That’s the question that many people are likely asking themselves these days. If not, maybe they should be asking themselves that question.

Nearly 8 years ago, my family moved from the San Francisco Bay Area (aka Silicon Valley) to Rhode Island. We had lived there for 7 years and it was a difficult decision to leave all those friends behind and start a new life. I had never lived in Rhode Island, but I lived in Massachusetts for the first 30 years of my life, so I figured it would be relatively easy. I won’t get into all the specifics, but it hasn’t been easy at all.

[Editor’s Note: This article was started last week. The focus is on a move within the United States. After the death of Ruth Bader Ginsburg, I’ve seen some talk on social media about moving outside the United States. That’s a topic that I won’t be covering here at this time.]

I’ve been talking with some friends from San Francisco and they’ve sent me some crazy pictures about the wildfires there. The sky was simply red all day. Their rooms were dark orange. My memory of the area couldn’t be more different. The Bay Area had the best climate in all of America. It was about 75-80 and sunny almost every day. No one needed air conditioning because it only got hot for 2 weeks in the summer. My only complaint was that you didn’t get all the seasons. You’d have to drive a couple of hours to Lake Tahoe to go skiing.

Nowadays, I don’t regret our decision to move across the country. In fact, some of my friends are looking to move to New England as well. I don’t blame them. Who wants to live in fear of wildfires and extremely poor air quality?

Of course, the wildfire problem isn’t only in the Bay Area. It’s millions of acres in multiple states all along the west coast… and of course, that’s just the fires. I hope they prepared for an emergency ahead of time.

I’ve been talking with another friend of mine (who writes as Kosmo on this website) about a natural disaster that hit close to his home. The Midwest derecho leveled Iowa in August. He was lucky to have missed most of the damage, but millions of people lost utilities. Last week he told me that they cleaned up 250 million pounds of tree debris and it was still going on.

It barely made the news as this Washington Post article notes.

This made me reach out to a couple of other friends (completely tapping out my network):

  1. I have a friend in Jacksonville, Florida, who roughly represents the southeast portion of the US that has to deal with hurricanes. This year the storms are so bad, they literally ran out of names and had to start going with Greek letters of the alphabet. I asked about her long-term plans. As I guessed, she has plans to move in the future. The hurricanes are just too much.

    If you live in Alabama, Lousiana, or another state in the southeast, perhaps you’ve had similar thoughts?

  2. Arizona has always been a very hot state. However, it seems to just get hotter and hotter with more and more days over 100 degrees every year. I contacted Abigail from I Pick Up Pennies who lives in Arizona to see if she is thinking of moving. While she isn’t a fan of the extreme heat, good friends and a low cost of living make it bearable.

To spare you any further gloom and doom, I won’t skip over thoughts of flooding and rising sea waters.

All of these thoughts are presented in much greater detail in Propublica article on climate change. It is a long read, but well worth it.

It’s hard to read that article and come away with any conclusion other than people in the United States will start moving to Maine and Vermont. While those states typically get feet of snow at a time nowadays, the snow may be more moderate over years of climate change.

What does all of this have to do with personal finance? There are a lot of places with expensive real estate that may not make sense over the long term. In my own area, Newport, Rhode Island has many million-dollar

Should I move?
If your city looks like this, it is time to move.
properties on the coast. It’s not like we have the money to buy them. However, if we did, we’d have to think long and hard about whether it would make long-term sense.

What are your thoughts on climate change? Do you think you’d consider relocating in the next decade or two due to climate change? Let me know in the comments.

Reviewing the Profit/Loss of Our Condo Sale (and Subsequent Purchase)

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rental property investmentThis is a continuation of yesterday’s reveal: our tenant texted us that she is breaking the lease.

Almost exactly 7 years ago we purchased our investment property. Our oldest child was almost a year old and our other child would be born 4 months later. It was quite an interesting time in our life.

Now we are looking to sell the condo. Today I thought I’d take you through the numbers.

We ended up paying $95,000 for the condo. My wife had previously bought in the same complex, so we knew that they typically range from $140K-175K. However, this was 2013, and there was still a big housing slump. When the market got hotter, we were able to get $16,000 a year in rent, which is extremely good for a $95,000 property.

During that time, we were paying condo fees. We also got a condo assessment of around $15,000 – ouch. While the condo looked great on the inside, the whole exterior of the property needed replacing. At least it looks great now. We had to do the typical maintenance inside, but it was all minor stuff.

In the end, we put $23,750 (or 25%) as a down payment. We are expecting it to sell for $170,000. It may go for less, but that’s what the comparables are. It seems that the properties move fast, within a couple of days. We started ours a little higher and haven’t gotten any bites in the first few days. I don’t expect the final numbers to change too much, so I feel fine with using these as projected numbers.

I’m terrible at keeping track of all the expenses that we had to put in for maintenance. I could pull taxes for seven years, but I’m much too lazy. For the most part, we’ve been able to cash flow about $200 a month while paying down a 15-year mortgage. We’ll have to use that as rough measure of ongoing costs.

(Side Note: Thanks to 2020 being what it is and COVID, there’s a war brewing between landlords and tenants. The full story on our three rental properties is that this the only good one. The other two my wife and I bought when we were single to live in. My wife’s military transfer and housing collapse made landlording the best viable option for us. Those properties have recently only matched the price we paid after 15 years. So I view the numbers of this probably as representing a successful attempt at dollar-cost averaging.)

I’m hoping we can get about 172K, which would give around 160K after closing costs. If it sells for less and we get $155K that not a big deal. We owe the bank $45,000 for their part in financing the property. That would mean that we paid $23,750 for around $110K-115K of profit. However, as I mentioned above, we did have a big condo assessment. We took a loan on that and it seems that will be the buyer’s responsibility. We may end up needing to make a concession at a lower price because of that.

Hopefully, we’ll be able to roughly say we spent around $25K to make $100K. That’s a good rate of return. Thanks to the Rule of 72 (done twice), we can see that quadrupling is about a 22% annual return (72/3.5 for the first double, and the same for the second double).

The stock market has done well in the last 7 years too. It was certainly more passive (as it always is.) However, it “only” averaged 9.5% over the same time. That’s was enough to double your money, but I’ll take a quadruple to a double any day.

What will we do that with that $100K in profit? If you read yesterday’s article, we plan to buy another condo. This allows us to use a tax vehicle called a 1031 exchange. A 1031 exchange allows you to sell one property and buy another and avoid paying taxes on the profits.

We have a property in mind, but we couldn’t move forward before we listed the current property. We also have to rope in some lawyers, especially a 1031 exchange specialist, and our mortgage company. Each of these steps has about 5 sub-steps of paperwork and red tape that is simply tedious. It would be nice to make an offer, but all those pieces take several days, or even a week to get in place. It’s slower in a COVID world.

If we are able to get the condo we have our eyes on, we’ll pay around $205K for it. We’d put the $100-110K net proceeds towards it and get a 15-year mortgage on it. That would give us a mortgage similar to what we have now, but hopefully able to get $1800 a month in rent. The numbers would be much better at the old place, but this place would be closer and easier to maintain. That’s a lot less stress for us, which is the big driver to sell.

I’m disappointed to have to go back to waiting for 15 years to be mortgage-free when we were 8 years away. We could get a 10-year mortgage or make larger payments to be mortgage-free faster. The 10-year mortgage rates don’t seem enticing. It’s painful for me to pay off a mortgage at 3.5%. That’s the kind of interest rate that I want to keep long term.

At the same time, I’m excited to move to a property that I feel has more room to appreciate and will be easier to manage.

There’s one additional x-factor of all of this to consider. Our kids are able to be a part of the process. At ages 6 and 7, almost all of this is going over their heads. However, this is a review of a Teen Titans Go! episode that they’ve seen many times. So far, they are dreading everything about this process. I don’t blame them – it’s adult stuff and not fun for kids. However, sometimes kids need to suck it up and do things that aren’t fun. I like them getting some exposure to this now. It builds character, right?

Perhaps someday they find this article and realize that real estate investing is exciting after all.