Wednesday, March 3, 2021

Knowledge is Key: Rules for Rental Real Estate

Recently, we've highlighted the value of thinking outside of our original plan which flowed into a discussion about real estate and using a 1031 exchange to trade one rental property in for another one without incurring a tax bill in the process.  This really got me thinking about how important knowledge is in the flow of our money-lives.  I believe in the flow of money.  I also believe in using inspired actions in order to keep things flowing to our maximum benefit.  Those of us practicing the Law of Attraction utilize our inner guidance systems to aid in the decision-making process,  knowing that knowledge is still one of the critical pieces of the puzzle because knowledge is the fuel for inspiration that eventually flows into action.

A couple of recent examples that even fit within the real estate arena come to mind.  

Friend A and her husband sold a rental property they owned.  After the fact, she approached me.  She didn't know what to do with the proceeds and wanted to make a wise decision.  She was also nervous about the tax bill that would result in the sale of this property.  Unfortunately, she had never learned anything about a 1031 exchange and had already sold the property.  So, that tax bill would certainly be coming.  I didn't know that she was selling a property either.  She was certainly under no obligation to tell me about it ahead of time, but since I didn't know, I did not bring her attention to this strategy.   Interestingly, she and her husband were leaning toward trying to buy another rental property that had better cash flow for them.  This is a wonderful move to make no doubt, and had she known previously about the benefits of a 1031 exchange, they might have saved thousands in taxes.  Consequently, they'll end up with the tax bill and have less money to put toward a new purchase.

Friend B learned about a 1031 exchange when she spoke with a real estate professional in her life (and me) prior to the sale of a rental property show owned.  Since she had a little time with the information to absorb it and what it might mean for her situation, she was able to meditate on it and gain a vision for how using this strategy would allow things to flow in her financial life.  She started looking around at new property opportunities as a result and became inspired to pursue the 1031 exchange.  She's still in process with it, so we don't know how this story wraps up quite yet, but the point remains that a little knowledge has inspired her to take an action that will save her from a hefty tax bill and help her to increase her passive income pushing her across the threshold into financial independence.    

Now, both of these friends have a little bit of experience in rental real estate, but only a little.  What they don't know much about is what data to look at when purchasing a new rental property.  This little bit of knowledge can not only increase confidence in the purchaser's ability to assess an investment for themselves but also create an environment that will allow them to become inspired about a particular property or subsequently allow them to avoid buying a lemon.

When you are working with a realtor to purchase a property, they should be able to send you a certain amount of data with regards to any listings you may be interested in pursuing.  One number to look at is the Cap Rate, which helps you assess the profitability of a property, which I've written about previously.  There are a couple more pieces of data that your realtor can provide you that you can use to assess a rental property and they aren't terribly difficult.

Gross Rent Multiplier (GRM)

The Gross Rent Multiplier tells you how many years it will take the property to pay for itself based on the gross rents.  In order to calculate this number, you will take the purchase price and divide it by the amount of gross rent collected annually.   

So, if you paid $800,000 for a building that has gross annual rents totaling $60,000, the Gross Rent Multiplier is 13.33.  So, it would take roughly 13 years for the property to pay for itself.  

What is a good GRM?  This is the tough part.  This can vary from place to place.  You may want to ask your realtor if they have this information on your city or county.  The GRM on my property is 5.69, though recently I've seen others in the same area with GRM ranging from 10-17.

I like the GRM because it's a pretty straightforward number.  The Cap Rate is also useful, though it is more complex.  It's good to look at both of them because the Cap Rate accounts for expenses, where the Gross Rent Multiplier does not.

The 1% Rule

This is a super simple rule of thumb used by many real estate investors.  This rule suggests that the monthly rent should be equal to (or greater than) 1% of the total purchase price of the property.  This can also help people to understand how much they'd need to be able to rent a property for in order for it to cash flow the way they'd like.

If a property is purchased for $100,000 the 1% rule indicates that it should rent for $1000 or more.  If it rents for $900, it comes in just under 1% because 900/100,000 = .9%. However, if that same property rents for $1200 (1200/100,000 = 1.2%), it comes in just above that benchmark.  My rental property comes in at 1.75%.

Now, this isn't a rule that should make or break your real estate purchase, and you should absolutely ask your realtor how this applies to your local area.  However, this is a really nice way to evaluate possible investments and compare them to each other.

You know, I absolutely love learning these little guidelines and rules because for me they're fuel for inspiration.  When we first bought our house, we didn't buy it as a rental, we lived in it.  When we changed directions, we realized our home would make a good rental.  We didn't know all of these little data points before, and things turned out really well.  When we look at our Cap Rate, Gross Rent Multiplier, and the 1% rule, we realize just how wonderfully we did.  Now, should we become inspired to make another real estate move, we will be able to duplicate our success with confidence.

Are you currently looking at any real estate?  Would it (or your current home) make a good rental using the 1% rule or GRM?


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