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.
Calculating the 1% rule doesn't involve any complex math. It is pretty straightforward. Just multiply the purchase price of the property by 1%. The result should give you an idea of the minimum amount you should charge in monthly rent. In addition, if there are any extra costs needed to get the rental property, you should include them in the purchase price.
For example, you’re looking to purchase a rental property with a purchase price of $220,000:
$220,000 x 0.01 = $2,200
Using the 1% rule, you need to get a mortgage that requires you to pay a maximum monthly payment of $2,200 or less and charge your tenants a minimum monthly rent of $2,200.
Let's say the home required $12,000 worth of home improvements. In this case, you would need to add the cost of the improvements to the house's purchase price for a total of $232,000. Then, you'd multiply that total by 1% to get a minimum monthly payment of $2,320.
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.
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.
- 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. So, 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.
Using the 1% rule can be a great way to determine if a piece of real estate is a good potential investment. However, it is important to remember that the 1% rule is just one guideline and is unsuitable for every scenario and property. You should still consider other factors such as location, property condition, and local rental market conditions when evaluating the potential profitability of a rental property.