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The 1% Rule Test

I've heard many California investors buy out of state because they think better returns can be found.

So, what is the 1% rule? This is a common test many investors use to determine if the property is worth keeping as a rental or not. You'll especially see it quite often on investing forums such as Biggerpockets. The rule is: 1% of the purchase price should be the minimum amount of rent you collect from the property each month. That equates to a gross 12% return on the asset. I don't know who came up with the rule or why it is used as a measuring stick for a deal. I think it is better to be able to get a 20%+ return on the cash you have into the deal. I didn't write the rule, but since many follow it, let's run with it.

Can this be found in California? The prices are so high!! Well, as long as you don't pay retail, yes, you can absolutely find great rentals locally. The problem with most people is that they find what they are looking for. If you think it can't be found, you'll find properties all day long that don't meet the rule. If you think it can, like I do, you'll find a few here and there that do meet and exceed the1% rule.

I got a call from a seller in late June. She had a house she previously lived in, but had to move out. She purchased it in 2009 for $90,000 and said she was into it for about $112,000 due some upgrades she said she had done. She put a new A/C on the roof 5 years ago and had done some interior work. Unfortunately, she could no longer live in the house and had moved away.

I generally don't go see properties I buy, but since I own 4 other rentals all right around this property I did a drive-by when I was out dealing with one of my other houses. I thought the value was about $163K. When I got back to the office, I phoned her up. We spoke for a bit and I made her an offer of $100K. She agreed and I opened escrow. This is nice 3 bedroom, 1.75 bath, single story tract house with a 2 car garage. It is the perfect rental property. 

About a week into escrow, the seller called me up and said there was some minor interior damage to the house and since I'm buying it as-is, she didn't think it would be fair not to disclose it. She said she wanted to pay for the repairs after we closed escrow. I asked what she thought it might cost, but she didn't know. I threw out, "$500?" She said no. I then asked, "Would $1,000 cover it?" She thought that might be enough. I then said there was no reason to wait until escrow closed. She could just call escrow and give me a $1,000 credit towards repairs. She thought that was a great idea. Escrow sent her out an amendment which she signed and sent back.

Now I had to figure out how I was going to fund this deal. I visited my local hard money lender's website, The Norris Group, and completed their online loan application. As part of the loan application, I had to have an appraisal done. It came in at  $169,000. I emailed the appraiser to let him know I mailed out his check and that I was surprised it came in at that price. He replied that he would have appraised it at $180K if I intended to do a full rehab!

The lender decided to fund $100K towards this purchase and said they were going to hold $5,000 for rehab since I hadn't seen the inside and they couldn't verify condition. I was talking with my wholesale buyer of July's D.O.T.M. who owns quite a few rentals in that market and told him about this house. He said I should be able to get $1,200-$1,300 in rent for it.

The closing statement has $111,939.55 as the total due. Of this $5,000 is being held by the lender, so in points, fees & closing costs, I'm into the deal for $5,881.45. My loan is $100,000 at 7% interest only. My payments will be $583.33. Taxes and insurance will run less than $200/month. If I rent the house for $1,250, that leaves me with about $467 a month in cash flow. Disclosure: I may have to put more money into the rehab. This is the unknown factor in this deal. I am also evicting the occupant so that is another $700 I have already spent.  If I end up being into this deal for $15,000 in cash, my return will be 37% cash on cash. That beats both the 1% rule and my 20% cash on cash return. And I found this deal right here in California.

Please leave any comments below and head over to my blog for more insights on investing in real estate.