For example, if you want to buy an investment property, the 1% rule can be a helpful tool for determining the approximate difference in a rental property's rental income potential and monthly mortgage obligations. You can use the 1% rule to quickly determine the property's cash flow, or you can use the rule to help determine how much monthly rent to charge.
Table of Contents
How To Calculate The 1% Rule
Example Calculations of the 1% Rule
Advantages of the 1% Rule
Limitations of the 1% Rule
When To Ignore the 1% Rule in Real Estate Investing
Alternatives To the 1% Rule
Real Estate 1% Rule Bottom Line
How To Calculate The 1% Rule
1. Determine the Purchase Price
Calculating the 1% rule starts by determining the purchase price. Be sure to include the total cost to acquire the property, such as the purchase price, closing costs, and any necessary repairs or renovations.
2. Calculate 1% of the Purchase Price
Multiply the total purchase price by 1% (or 0.01).
3. Compare the Purchase Price to the Expected Monthly Rent
Next, you will need to estimate the potential monthly rental income the property can generate and compare it to the purchase price. If the expected monthly rental income is equal to or greater than 1% of the purchase price, the property passes the 1% rule. If it is less than 1%, the property may not generate sufficient cash flow to be a good investment.
Example Calculations of the 1% Rule
Example 1: An Investment Property That Passes The 1% Rule
Let's say you're looking to purchase a rental property with a sale price of $300,000. However, the rental charges $3,500 for monthly rent. Going by the 1% rule, the monthly rent should be equal to or greater than $3,000 per month. Since this property charges $3,500 per month, it passes the 1% rule.
Example 2: An Investment Property That Does Not Pass The 1% Rule
Let's say the same property, listed for $300,000, has historically charged $2,600 for monthly rent. This property would not pass the 1% rule because the monthly rent is less than $3,000 (or 1% of the purchase price). In this situation, you should continue searching for a more profitable rental property or offer no more than $200,000 - $240,000 to purchase the home.
Advantages of the 1% Rule
1. Quick and Easy to Calculate
The 1% rule allows investors to quickly evaluate multiple properties without extensive analysis.
2. Cash Flow Focus
The 1% rule emphasizes properties that are likely to generate positive cash flow, which is essential for long-term profitability.
3. Risk Mitigation
By focusing on properties that meet the 1% rule, investors may reduce the risk of overpaying for properties that will not generate sufficient income.
Limitations of the 1% Rule
1. Oversimplification
The 1% rule is a rough guideline and does not account for all factors that can impact profitability, such as property taxes, insurance, maintenance, vacancy rates, and local market conditions.
2. Market Variability
In some high-cost or high-demand markets, properties that do not meet the 1% rule may still be good investments due to the potential for appreciation or other income streams.
3. Neglecting Other Metrics
Relying solely on the 1% rule can cause investors to overlook other important financial metrics, such as the cap rate, cash-on-cash return, and internal rate of return (IRR).
When To Ignore the 1% Rule in Real Estate Investing
As important as the 1% rule can be, there are several instances where you may have to ignore the 1% rule when purchasing a rental or investment property. While most real estate investment experts hint at the importance of the 1% rule, it may be wiser to invest in a rental property that doesn't meet the 1% rule.
You should consider investing in a property that doesn't meet the 1% rule only if the property is:
- Currently rented at below-market rates
- Forecasted to appreciate quickly
- Located in an up-and-coming neighborhood
- Determined to be an exceptionally low-risk investment
- Situated in a special economic zone or an improving school district
Aside from evaluating the location, property condition, and neighborhood amenities, below are several metrics real estate investors may employ when looking to invest in a rental property.
Alternatives To the 1% Rule
- 50% Rule
- 70% Rule
- 2% Rule
- Gross Rent Multiplier Rule
1. 50% Rule
Your expenses for a property (not including mortgage expenses) should be 50% of the rental revenue. For instance, if a property generates $30,000 per year in rental income, you should expect that $15,000 will go toward expenses.
2. 70% Rule
The investment made in a purchased property should be less than 70% of the property's after-repair value if flipping the property. To calculate the 70% rule, take the estimated ARV (After Repair Value) of the home and multiply it by 0.7 (or 70%). Once you have that total, subtract your estimated repair costs. This will be the amount you should pay for the property.
3. 2% Rule
The 2% rule is quite similar to the 1% rule – it just uses a different number. The 2% rule states that the monthly rent for investment property should be equal to or less than 2% of the purchase price.
4. Gross Rent Multiplier Rule
The ratio of a property's value to its annual rental revenue. The gross rent multiplier (GRM) gauges the time to pay off the investment. To calculate the GRM you'd divide the purchase price by the gross annual rent. For example, if you purchase an investment property for $250,000. You charge $3,000 per month for rent. Your yearly gross rental income is $36,000 (3,000 x 12).
$250,000/$36,000 = 6.9
The GRM of this property is 6.9, which means that it will take you around six years and nine months to pay off the property using your gross rental income.
Real Estate 1% Rule Bottom Line
Using the 1% rule in real estate investing can be a great way to quickly identify properties that have the potential to generate positive cash flow. However, it is important to remember that the 1% rule is just one guideline and is unsuitable for every scenario and property. Investors should perform a comprehensive analysis that includes a detailed examination of all expenses, local market conditions, and other financial metrics to ensure a property aligns with their investment goals and risk tolerance.