• Table of Contents

  • Is the 1% Rule Obsolete? Why Building May Outshine Buying
  • Understanding the 1% Rule
  • Origins and Purpose
  • Limitations of the 1% Rule
  • The Changing Real Estate Landscape
  • Rising Property Prices
  • Low Rental Yields
  • Changing Demographics
  • Why Building May Outshine Buying
  • Customization and Control
  • Cost Efficiency
  • Tax Benefits
  • Appreciation Potential
  • Case Studies: Building vs. Buying
  • Case Study 1: Urban Infill Development
  • Case Study 2: Suburban Expansion
  • Challenges of Building
  • Financing and Capital Requirements
  • Regulatory Hurdles
  • Construction Risks
  • Market Timing
  • Strategies for Successful Property Development
  • Thorough Market Research
  • Partner with Experienced Professionals
  • Secure Favorable Financing
  • Plan for Contingencies
  • Conclusion

Is the 1% Rule Obsolete? Why Building May Outshine Buying

The 1% rule has long been a guiding principle for real estate investors. It suggests that a property should rent for at least 1% of its purchase price each month to be considered a good investment. However, as the real estate market evolves, many are questioning whether this rule still holds water. In this article, we will explore the relevance of the 1% rule in today’s market and delve into why building properties might be a more advantageous strategy than buying existing ones.

Understanding the 1% Rule

The 1% rule is a quick and straightforward way to evaluate the potential profitability of a rental property. For example, if a property costs $200,000, it should ideally generate at least $2,000 in monthly rent. This rule helps investors quickly filter out properties that may not provide sufficient cash flow.

Origins and Purpose

The 1% rule originated in a time when property prices were relatively stable, and rental yields were predictable. It served as a simple heuristic to ensure that rental income would cover mortgage payments, property management fees, maintenance costs, and other expenses, while still providing a reasonable return on investment.

Limitations of the 1% Rule

While the 1% rule is useful for quick assessments, it has several limitations:

• Market Variability: Real estate markets vary significantly by location. What works in one city may not work in another.
• Property Condition: The rule does not account for the condition of the property, which can significantly impact maintenance costs and rental income.
• Financing Terms: Interest rates and loan terms can vary, affecting the overall profitability of the investment.
• Economic Factors: Changes in the economy, such as inflation or unemployment rates, can impact rental demand and property values.

The Changing Real Estate Landscape

The real estate market has undergone significant changes in recent years, making the 1% rule less reliable. Here are some key factors contributing to this shift:

Rising Property Prices

Property prices have been on the rise in many markets, outpacing rental income growth. According to the National Association of Realtors, the median existing-home price for all housing types in the U.S. was $359,900 in August 2021, a 14.9% increase from the previous year. This rapid appreciation makes it challenging to find properties that meet the 1% rule.

Low Rental Yields

In many high-demand areas, rental yields have not kept pace with property price increases. For instance, in cities like San Francisco and New York, rental yields are often below 4%, making it difficult to achieve the 1% rule. Investors in these markets may need to rely on property appreciation rather than rental income for returns.

Changing Demographics

Millennials and Gen Z are increasingly favoring renting over buying, leading to higher demand for rental properties. However, this demand has also driven up rental prices, making it harder for investors to find properties that meet the 1% rule.

Why Building May Outshine Buying

Given the challenges of adhering to the 1% rule in today’s market, many investors are turning to property development as a more viable strategy. Here are some reasons why building may outshine buying:

Customization and Control

When you build a property, you have complete control over its design, layout, and features. This allows you to tailor the property to meet the specific needs and preferences of your target market, potentially commanding higher rents and reducing vacancy rates.

Cost Efficiency

Building a property can be more cost-effective than buying an existing one, especially in high-demand areas. By purchasing land and constructing a property, you can often achieve a lower cost per square foot than buying a comparable existing property. Additionally, new buildings typically require less maintenance and have lower operating costs.

Tax Benefits

Property development offers several tax advantages, including depreciation deductions, which can significantly reduce your taxable income. Additionally, many governments offer incentives for new construction, such as tax credits and grants, further enhancing the financial viability of building over buying.

Appreciation Potential

Newly built properties often appreciate faster than older ones, especially in growing markets. By developing a property, you can capitalize on this appreciation potential, increasing your overall return on investment.

Case Studies: Building vs. Buying

To illustrate the advantages of building over buying, let’s examine two case studies:

Case Study 1: Urban Infill Development

In a rapidly growing city like Austin, Texas, property prices have skyrocketed in recent years. An investor looking to buy an existing property in a desirable neighborhood may struggle to find one that meets the 1% rule. However, by purchasing a vacant lot and developing a multi-family property, the investor can achieve a lower cost per unit and command higher rents due to the property’s modern amenities and prime location.

Case Study 2: Suburban Expansion

In suburban areas experiencing population growth, such as the outskirts of Atlanta, Georgia, building new properties can be a lucrative strategy. An investor who buys land in a developing suburb and constructs single-family homes can benefit from lower land costs and strong demand from families seeking affordable housing options. This approach can yield higher rental income and appreciation potential compared to buying existing properties in the same area.

Challenges of Building

While building properties offers numerous advantages, it is not without its challenges. Here are some potential obstacles to consider:

Financing and Capital Requirements

Property development requires significant upfront capital and financing. Securing construction loans can be more complex than obtaining a mortgage for an existing property, and lenders may require higher down payments and stricter terms.

Regulatory Hurdles

Building a property involves navigating a complex web of zoning laws, building codes, and permitting processes. These regulations can vary significantly by location and may cause delays and additional costs.

Construction Risks

Construction projects are inherently risky, with potential issues such as cost overruns, delays, and unforeseen complications. Managing these risks requires careful planning, budgeting, and project management.

Market Timing

Developing a property takes time, and market conditions can change during the construction period. An economic downturn or shift in demand could impact the property’s profitability once completed.

Strategies for Successful Property Development

To mitigate the challenges of building properties, investors should consider the following strategies:

Thorough Market Research

Conduct comprehensive market research to identify high-demand areas with strong growth potential. Analyze factors such as population trends, employment opportunities, and infrastructure developments to ensure your property will attract tenants and appreciate in value.

Partner with Experienced Professionals

Collaborate with experienced architects, contractors, and project managers to ensure your development project runs smoothly. Their expertise can help you navigate regulatory hurdles, manage construction risks, and deliver a high-quality property on time and within budget.

Secure Favorable Financing

Work with lenders who specialize in construction loans and understand the unique requirements of property development. Shop around for the best terms and consider alternative financing options, such as private investors or joint ventures, to reduce your capital requirements.

Plan for Contingencies

Develop a detailed budget and timeline for your project, including contingencies for potential delays and cost overruns. Regularly monitor progress and adjust your plans as needed to stay on track and minimize risks.

Conclusion

The 1% rule has served as a valuable guideline for real estate investors, but its relevance is waning in today’s dynamic market. Rising property prices, low rental yields, and changing demographics have made it increasingly difficult to find properties that meet this rule. As a result, many investors are turning to property development as a more viable and profitable strategy.

Building properties offers numerous advantages, including customization, cost efficiency, tax benefits, and appreciation potential. However, it also comes with challenges, such as financing requirements, regulatory hurdles, and construction risks. By conducting thorough market research, partnering with experienced professionals, securing favorable financing, and planning for contingencies, investors can successfully navigate these challenges and capitalize on the opportunities presented by property development.

In conclusion, while the 1% rule may no longer be the gold standard for real estate investment, building properties can outshine buying in many cases. By embracing this strategy, investors can achieve higher returns and create valuable assets that stand the test of time.