Are you looking to make money in real estate but unsure how to find the right investment property? The 1 percent rule in real estate can be a helpful starting point and is pretty straightforward: it suggests that the monthly rent of a property should be at least 1% of its purchase price.
For example, if you buy a house for $200,000, you’d want to rent it for at least $2,000 monthly. Simple, right?
This rule of thumb has gained popularity among real estate investors, as it helps them determine potential returns. It’s:
- Quick and easy to calculate
- A great initial filter for potential investments
- Useful for comparing different properties at a glance
Many investors swear by this rule because it often indicates that a property will generate positive cash flow – the holy grail of rental property investing. While the 1% rule is a handy starting point, relying on it alone is like trying to navigate a ship with just a compass. In today’s complex and ever-changing real estate market, you need a full suite of navigational tools to chart your course to success.
This guide will explore alternative strategies and metrics to give you a more comprehensive toolkit for evaluating properties. Ready to take your real estate investing to the next level? Let’s dive into how the 1% rule can help you invest in real estate!
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Table of Contents
The 1 Percent Rule in Real Estate: What It Is and How to Calculate It
What Is The 1% Rule In Real Estate?
The 1% rule of real estate investing measures the price of an investment property against the gross income it can generate.
For a potential investment to pass the 1% rule, its monthly rent must equal at least 1% of the purchase price.
For example, if you buy a $300,000 investment property, you should earn at least $3,000 a month in rent to satisfy the 1% rule in real estate.
You may need to keep searching if that rent price doesn’t seem realistic due to the property’s location or size. Remember that the 1% rule is a good place to start, but you should consider other factors when determining how much rent to charge your tenants.
Limitations of the 1% Rule
While the 1% rule can be helpful for quick assessments, it has its limitations:
- Oversimplification: It doesn’t account for the full range of costs associated with property ownership.
- Geographic Differences: The rule may not apply in high-cost or low-cost markets, where property values and rents fluctuate significantly.
- Changing Market Conditions: Mortgage rates, economic shifts, and local market factors can make the 1% rule less effective.
How To Use The 1 Percent Rule In Real Estate Investing
To apply the 1% rule, multiply the property’s purchase price by 1% or move the decimal point in the purchase price two places to the left. The result should be the minimum you consider charging in monthly rent.
Purchase price × 1% = Monthly rent
If the property requires any repairs, factor them into the equation by adding them to the purchase price and multiplying the total by 1%.
Examples Of The 1% Rule In Real Estate
Here’s an example of a property selling for $150,000:
$150,000 × 0.01=$1,500
Based on the 1% rule, you should charge your tenants $1,500 monthly. Let’s say you need to make about $10,000 in repairs before renting the home. Add the cost of repairs to the home’s purchase price for $160,000. Then multiply the total by 1%. You’ll get a $1,600 minimum monthly rental rate.
Purchase price+Repair costs×0.01=Monthly rent\text{Purchase price} + \text{Repair costs} \times 0.01 = \text{Monthly rent}Purchase price+Repair costs×0.01=Monthly rent
Beyond the 1 Percent Rule: Comparing Investment Criteria
Real estate investors use various rules and benchmarks to evaluate potential investments beyond the 1% rule. Here, we will explore the 2% Rule, the 50/50 Rule, the Gross Rent Multiplier (GRM), and the 70% Rule. Each offers a different perspective on profitability and risk, allowing investors to tailor their approach based on specific market conditions or investment goals.
The 2% Rule
The 2% rule suggests that a property’s monthly rent should equal 2% of its purchase price to be considered a good investment.
Formula: Monthly Rent≥Purchase Price×2%
For example, if a property costs $150,000, applying the 2% rule, the rent should be at least $3,000 per month to meet the gross annual expectations.
150,000×0.02=3,000
The 50/50 Rule
The 50/50 rule proposes that 50% of your rental income should cover the property’s operating expenses (including property taxes, maintenance, and insurance), while the remaining 50% should cover your mortgage payments and contribute to your cash flow.
Formula: Remaining 50% = Mortgage Payments + Profit
For example, suppose a property generates $2,000 per month in rent. In that case, the 50/50 rule suggests $1,000 should go toward operating expenses (e.g., maintenance, taxes, insurance), while the other $1,000 can cover mortgage payments and provide profit:
Operating Expenses=2,000×0.5=1,000
This rule ensures a balanced allocation between expenses and profitability.
Gross Rent Multiplier (GRM)
Gross Rent Multiplier (GRM) is calculated by dividing the property price by its annual gross rental income. GRM helps investors quickly compare properties without delving into operating costs.
Formula:
For instance, if a property is priced at $200,000 and the annual gross rental income is $24,000, the GRM would be calculated as:
The lower the GRM, the better the investment. This metric helps investors quickly compare properties based on rental income relative to price.
The 70% Rule
House flippers and short-term investors often use the 70% rule. It suggests that you should pay no more than 70% of a property’s After Repair Value (ARV) minus the cost of repairs.
Formula: Maximum Purchase Price=After Repair Value (ARV)×70%−Repair Costs
For instance, if a property has an ARV of $200,000 and requires $30,000 in repairs, the 70% rule suggests the maximum price you should pay for the property is:
Maximum Purchase Price=200,000×0.7−30,000=140,000
House flippers primarily use this rule to ensure they leave enough room for profit after covering repair and unexpected costs.
Pros and Cons of Different Investment Rules
| Rule | Pros | Cons |
|---|---|---|
| 1% Rule |
– Simple and quick for initial screening. – Works well for rental property evaluation. |
– Doesn’t account for all costs (e.g., mortgage rates, taxes). – Less applicable in high-cost markets. |
| 2% Rule |
– Targets higher returns. – Better suited for markets with lower property costs. |
– Difficult to find properties that meet this rule, especially in competitive markets. |
| 50/50 Rule |
– Accounts for operating expenses. – Ensures balanced cash flow allocation. |
– May oversimplify costs; unexpected expenses could affect profitability. |
| Gross Rent Multiplier (GRM) |
– Easy to calculate. – Useful for comparing multiple properties quickly. |
– Doesn’t consider operating expenses or other costs like vacancies. |
| 70% Rule |
– Helps house flippers secure profit margins. – Protects against overpaying for properties. |
– Primarily used for flips, not long-term investments. – May not work well in hot markets. |
These rules offer various strategies to evaluate real estate investments. Your choice will depend on your investment goals, the type of property you’re dealing with, and the specific market conditions you face.
Evaluating the 1 Percent Rule In Real Estate Across Different Property Types
Regarding real estate investing, not all properties are created equal. Let’s break down how the 1% rule applies to different types of investments and the challenges you might face.
Single-Family Homes vs. Multi-Family Properties
Single-family homes are often the go-to for new investors. They’re easier to understand and manage, but how do they stack against the 1% rule?
- Single-Family Homes: In many markets, hitting the 1% rule with single-family homes can be tough. These properties often have lower rent-to-price ratios, especially in high-value areas. However, they may offer better appreciation potential and attract long-term tenants.
- Condos: Condos can be tricky. While they might have lower purchase prices, don’t forget those pesky HOA fees that can affect the overall return for the property owner! These extra costs can affect your returns, making it harder to achieve at least the 1 percent rule.
- Multi-Family Properties: Here’s where things get interesting. Multi-family properties often have an easier time meeting (or exceeding) the 1% rule. Why? Higher total rent relative to the purchase price. Plus, you’re spreading costs (like land and major systems) across multiple units.
Challenges in Applying the Rule
One of the main challenges is the variability in rental rates for different property types, which the 1% rule states must be considered in any investment strategy. Single-family homes typically command lower rents per unit than multi-family properties, condos, or micro-unit apartments. This makes the 1% rule less effective for evaluating certain asset classes.
Adjusting the 1 Percent Rule for Current Market Conditions
Impact of Changing Mortgage Rates
Mortgage rates can make or break your investment. Here’s how they affect the 1% rule:
- Rising Rates: Your monthly mortgage payment increases significantly when rates go up. This means you might need a higher rent-to-price ratio to maintain profitability. In this case, you might need to aim for a 1.2% or 1.5% rule instead.
- Falling Rates: Lower rates give you more wiggle room. You might be able to make a property work even if it doesn’t quite hit the 1% mark.
Pro Tip: Use an investment property mortgage calculator to run different scenarios. It’s like a crystal ball for your investments!
Market Fluctuations
Economic trends and local market conditions can wrench your 1% rule calculations. Here’s what to watch out for:
- Property Value Fluctuations: In a rapidly appreciating market, a property that doesn’t meet the 1% rule today might do so in a few years as rents catch up. Conversely, today’s 1% property might not be tomorrow’s winner in a declining market, which local real estate trends can help to clarify.
- Rental Market Trends: Keep an eye on local rental demand. A hot rental market might allow you to exceed the 1% rule, while a saturated market might make it hard to hit that target.
- Economic Indicators: Job growth, population trends, and local development projects can all impact your property’s performance beyond the 1% rule.
Remember, the 1% rule is a snapshot. Your job as an investor is to see the bigger picture and anticipate changes.
Factoring in Additional Costs Beyond the 1% Rule
Here’s where many new investors get tripped up. The 1% rule doesn’t tell the whole story regarding your returns. Let’s uncover those hidden costs and learn how to factor them in.
The Hidden Costs of Real Estate Investing
Don’t start celebrating just yet when you’re eyeing that property that perfectly hits the 1% rule. Here are some costs that might lurk in the shadows, including those that affect gross annual rent.
- Property Taxes: These can vary wildly depending on location. A property in a high-tax area might look great under the 1% rule but fall short in real-world returns, emphasizing the importance of local real estate conditions.
- Insurance: Don’t forget this one! Costs can be higher for rental properties, particularly in areas prone to natural disasters. In my article, “The Importance of Rental Property Insurance,” I delve into how rental property insurance can help mitigate these higher costs and provide crucial protection, especially in high-risk regions.
- Maintenance and Repairs: The 1% rule doesn’t account for that 3 AM call about a burst pipe. A good rule of thumb is to set aside 1-2% of the property value annually for maintenance.
- Vacancy Rates: No property is rented 100% of the time. Factor in some vacancy, typically 5-10% of the time, depending on your market.
- Property Management: If you’re not managing the property yourself, these fees typically run 8-12% of the monthly rent. Using property management software can help streamline operations and potentially reduce costs, offering an efficient alternative to traditional management fees.
- Capital Expenditures: Big ticket items like a new roof or HVAC system must be factored into your long-term calculations.
Modifying the 1% Rule Based on Expenses
So, how do you account for all these extras? Here are a couple of approaches:
- The 50% Rule: This rule suggests that your operating expenses will be about 50% of your rental income. So, if a property meets the 1% rule, half of that 1% goes to expenses, leaving you with a 0.5% return on your gross annual investment. Under this rule, you might aim for a 2% property to achieve the same returns as a true 1% property without expenses.
- The Gross Rent Multiplier (GRM): This metric looks at the property’s price relative to its gross rental income. A lower GRM generally indicates a better investment. It’s calculated as: GRM = Property Price / Annual Gross Rent For example, a $200,000 property renting for $2,000 a month ($24,000 annually) would have a GRM of 8.33.
- Cash-on-Cash Return: This metric looks at your actual cash investment and the cash flow it generates, giving you a more accurate picture of your returns.
Remember, successful real estate investing is about looking at the whole picture. The 1% rule is a great starting point, but it’s just one tool in your investor toolbox. By understanding its limitations and knowing how to adjust for different property types, market conditions, and hidden costs, you’ll be well on your way to making smarter, more profitable investment decisions.
When the 1% Rule Works (and Doesn’t) in Real Estate Investing
When The 1% Rule Works In Real Estate Investing
The 1% rule can be a valuable guideline for real estate investors in certain scenarios, particularly when you’re evaluating rental properties. Here’s when the 1% rule proves most effective:
- Emerging or Cash Flow Markets: The 1% rule works well in markets where property prices are low relative to rent. These markets are often emerging or have strong rental demand, allowing you to meet or exceed the 1% threshold more easily.
- Single-Family Homes: For single-family rental properties, especially in areas with stable rental demand, the 1% rule can help ensure that the rental income covers your mortgage and basic expenses.
- Quick Screening Tool: The rule best works as a first-pass filter when analyzing multiple properties. Applying the 1% rule early in your search can quickly eliminate properties that won’t generate sufficient rental income, saving you time and effort.
- Long-Term Investors Focused on Cash Flow: Investors prioritizing steady cash flow over long-term appreciation might find the 1 percent rule helpful in identifying properties that generate at least 1 percent cash flow from the start.
When The 1% Rule Doesn’t Work In Real Estate Investing
Despite its usefulness, there are many scenarios where the 1% rule falls short. Here’s when it might not be the best tool for evaluating an investment:
- High-Cost Markets: In expensive markets like New York, San Francisco, or Los Angeles, finding properties that meet the 1% rule is nearly impossible. Property values far outpace rental income, and relying solely on this rule can lead to missed opportunities in markets with significant long-term appreciation potential, as many real estate agents noted.
- Appreciation-Focused Investments: If your strategy focuses on long-term appreciation rather than immediate cash flow, the 1% rule becomes less relevant. Properties in appreciating markets may not meet the 1% rule but could offer substantial returns over time through property value growth.
- Short-Term Rentals (Airbnb/VRBO): The 1% rule doesn’t account for the unique economics of short-term rentals. While the rule is based on long-term rental income, short-term rental properties often generate higher income per night but also come with higher costs for management, cleaning, and maintenance, impacting the gross annual return.
- Properties with Significant Rehab Needs: The 1% rule excludes upfront capital expenditures for properties requiring substantial repairs or renovations. You’ll need to factor in the costs of renovations and how they will affect both the rent and the property’s future value.
- Ignoring Expenses: The 1% rule doesn’t consider additional expenses like insurance, property management fees, vacancies, maintenance, or property taxes. If these expenses are high, a property that meets the 1% rule could still be unprofitable.
For example, the median list price in San Francisco is about $1,100,624. Using the 1% rule, you should charge $12,906 as your minimum monthly rent. But the median rent in San Francisco is close to $3,000 per month. To match the 1% rule to the median rent in San Francisco, you’d need to find a $300,000 property – and that’s only a quarter of the median list price in the city.
Exploring Alternative Investment Strategies Beyond the 1% Rule
While the 1% rule is a great starting point, it’s time to add more tools to your real estate investment toolkit.
Cap Rates
The capitalization rate, or cap rate, is like the 1% rule’s more sophisticated cousin. It tells you the potential return on your investment, assuming you bought the property with cash. Here’s how you calculate it:
Cap Rate = (Net Operating Income / Property Value) x 100
For example, if a $200,000 property generates $16,000 in annual net operating income, the cap rate would be 8%. Generally, a higher cap rate means a better deal, but remember – higher returns often come with higher risk!
Leveraging Good Cap Rate in Real Estate For Smart Investing
Cash-on-Cash Return
If you’re planning to use a mortgage (and let’s face it, most of us are), cash-on-cash return might be your new best friend. This metric looks at the cash you’re investing and the cash flow you’re getting back. Here’s the formula:
Cash-on-Cash Return = (Annual Cash Flow / Total Cash Invested) x 100
Let’s say you put $40,000 down on a property and your annual cash flow (after all expenses and mortgage payments) is $4,000. Your cash-on-cash return would be 10%.
What is Cash on Cash Return? The #1 Real Estate Cash Flow Metric
Investment Diversification: Don’t Put All Your Eggs in One Basket
You’ve heard it before, but it bears repeating – diversification is key in real estate investing. Here’s why:
- Risk Reduction: By spreading your investments across different types of properties or locations, you’re less vulnerable to market fluctuations in any one area.
- Increased Opportunities: Different types of properties perform differently in various market conditions. A diverse portfolio gives you more chances to succeed.
- Balanced Cash Flow: Some properties might provide steady income, while others offer potential for appreciation, which a savvy real estate agent would help you to determine. A mix can give you both immediate returns and long-term growth.
So, how can you diversify? Consider mixing residential and commercial properties or investing in different neighborhoods or cities. Real Estate Investment Trusts (REITs) can also be a great way to diversify without the hassle of direct property management.
Unlock 7 Investment Alternatives Beyond Traditional Assets
When to Use the 1% Rule vs. Other Strategies
The 1% rule is great for a quick, initial screening of potential investments. But when should you stick with it, and when should you dig deeper? Here are some guidelines:
| Use the 1% Rule When: | Use Other Strategies When: |
|---|---|
| You’re just starting and need a simple way to filter properties | You’re in a high-value market where the 1% rule is rarely achievable |
| You’re in a market where the 1% rule is commonly achieved | You’re considering properties with significant appreciation potential |
| You’re looking for properties that will cash flow immediately | You want a more comprehensive understanding of your potential returns |
Remember, the best investors use multiple strategies and metrics to evaluate properties. The more tools in your toolkit, the better equipped you’ll be to find great deals!
FAQ: Beyond the 1 percent Rule in Real Estate
Is the 1% rule always accurate?
Not always applicable, especially in markets where the one percent rule is not feasible. The 1% rule is a rule of thumb, not a guarantee of profitability. It doesn’t account for all expenses or market-specific factors. Always do a thorough analysis before investing.
How do mortgage rates affect the 1% rule?
Higher mortgage rates can make achieving the 1% rule harder, as they increase your monthly expenses. In high-interest environments, you might need to look for properties with higher rent-to-price ratios to ensure profitability.
Can the 1% rule be applied to commercial real estate?
While you can apply the 1% rule to commercial properties, it’s often not the best metric. Commercial real estate typically involves more complex leases and expenses. Cap rates and cash-on-cash return are usually more appropriate for evaluating these investments.
How do I know if my rental property is profitable?
Calculate your net operating income (NOI) to determine profitability by subtracting all operating expenses from your total rental income. Your property is profitable if your NOI is positive after accounting for your mortgage payment.
How do I calculate additional costs when using the 1% rule?
The 1% rule doesn’t account for additional costs, which is one of its limitations. To get a more accurate picture, factor in expenses like property taxes, insurance, maintenance, vacancies, and property management fees. A good rule of thumb is to set aside about 50% of your rental income for these expenses.
The Bottom Line: Know The Rules Of Investment Properties
When considering an investment property, you must assess the return on investment a home can provide. In other words, know what you’re getting into before throwing money at it. Successful real estate investing requires knowledge, analysis, and adaptability, which many property owners need to consider. By diversifying your portfolio and continuously learning about the market, you can increase your chances of achieving long-term financial success.
Now that you have a few strategies to help you make this critical decision, it may be time to start your real estate investment journey.
