Definition and Examples of the 1% Rule
The 1% Rule is a guideline for real estate investing that states that the monthly rent of a property should equal or exceed 1% of the total investment in the property.
The 1% Rule is a guideline that real estate investors can use to evaluate potential rental properties for monthly cash flow. By multiplying the total investment (purchase price plus repair costs) by 1%, it gives investors a target number they should aim to achieve as monthly rent. If 1% of the total investment results in a competitive rental rate that also covers costs and produces monthly cash flow, investors can feel more secure.
Properties that meet or exceed the 1% Rule have a good chance of being profitable. Properties that do not meet the 1% Rule may struggle to generate monthly profits. However, investors should use other methods to evaluate potential rental properties over the long term before dismissing a property based solely on the 1% Rule.
How the 1% Rule Works
Applying the 1% Rule to the purchase of a property involves a relatively simple formula that investors can use in two different ways:
Total purchase price × 1% ≥ monthly rent
Monthly rent × 100 ≥ total investment
You can use this simple formula to get a general idea of the rents that will work for a price point of an investment property. For example:
A property valued at $100,000 should generate at least $1,000 monthly
A property valued at $200,000 should generate at least $2,000 monthly
A property valued at $400,000 should generate at least $4,000 monthly
Generally, investors can use the 1% Rule for two purposes:
To evaluate the profit potential of a property before purchasing it
As a guideline for how much rent should be charged
You should keep in mind that the 1% Rule is a general guideline and often does not apply to properties in more expensive areas like New York, San Francisco, Boston, and San Jose. In fact, investors can afford any property they can pay for. What the 1% Rule helps to determine is whether the property will generate enough rent to cover costs and produce monthly cash flow. Real estate investors using the 1% Rule apply this guideline to properties they are considering holding for the long term.
Jim Fitzgibbons, a licensed investor and real estate agent at Ledge Real Estate Solutions based in Florida, stated in an email to The Balance that he uses the 1% Rule to evaluate properties.
“If the house can adhere to the 1% Rule, I keep it in my rental property portfolio,” Fitzgibbons said.
He purchased and renovated a home in Winter Garden, Florida, that adheres to the 1% Rule. The total investment in the property was $200,000 and it rents for $2,150, which exceeds 1% of his investment.
Limitations of the 1% Rule
The 1% Rule is not the only factor to consider when evaluating potential rental properties for long-term profit.
Mark Ferguson, an experienced real estate investor with InvestFourMore in Colorado, stated in an email to The Balance that investors should use the 1% Rule only after determining that it will work in their favor.
“Real estate is very unique,” Ferguson said. “Every property is different, every state is different, every city is different. Even neighborhoods and streets vary within the city. While the 1% Rule can provide a broad overview of properties in a certain area, I do not believe it should be used to determine whether the rent will be a good investment or not.”
Explanation
The 1% rule limitations, which include:
Property taxes, insurance rates, vacancy rates, maintenance costs, interest rates
“Those costs will vary by area. Property taxes in New Jersey can be 10 times higher than those in Colorado, yet the 1% rule ignores this,” he said.
Interest rates are also lower now than they were a decade ago when investors started using the 1% rule. “With interest rates being as low as they are, an investor can make the same amount of money, or more, by purchasing properties that don’t meet the 1% rule just as they could have done 10 years ago with properties that did meet the 1% rule,” Ferguson said.
Investors may find other limitations as the 1% rule works better for lower-cost properties that may not be in good condition (known to investors as “class B properties”).
“A property’s ability to meet the 1% rule will vary significantly depending on the class of property,” said Serena Barton, co-owner of Azalea Home Buyers based in Alabama, in an email to The Balance. “Generally, lower-class properties are more likely to meet this rule.”
Advantages and Disadvantages of the 1% Rule
Advantages
Easy to calculate: The 1% rule can be easily calculated without the need for a calculator or formal training in business, accounting, or finance.
Conservative analysis can help an investor choose a profitable property: Properties generating 1% monthly rent will be able to cover at least the monthly mortgage payment.
Disadvantages
Ignores interest rates: With falling interest rates, investors can benefit from properties that do not meet the 1% rule and still achieve profits.
Does not account for local conditions, vacancy, and maintenance costs: Every real estate property is unique, and all the different interrelated factors must be considered. Many investors using the 1% rule consider it a starting point. It should not be the only factor or even the most important factor when selecting potential long-term rental properties.
Ignores property taxes: Property taxes can vary significantly across the country. Taxes in New Jersey are entirely different from taxes in Nevada, which is a cost not accounted for when analyzing properties using the 1% rule.
Works best for lower-cost property class: Properties that can generate 1% of monthly rent work best for lower-cost properties.
Alternatives to the 1% Rule
The 1% rule is not the only way to evaluate a property’s potential profits. Here are some commonly used calculations to help real estate investors make property decisions:
50% Rule: Set aside 50% of the monthly rent you receive to cover monthly expenses, excluding the mortgage.
70% Rule: Do not spend more than 70% of the after-repair value on the property.
Gross Rent Multiplier: Divide the market value of the property by the gross annual income. The resulting number is the number of years it will take for the investment to pay for itself.
Return on Investment Rate: Also known as “cash on cash return,” it is calculated by dividing the net cash flow by the amount invested. A general rule is to achieve a return on investment of at least 8%.
Internal Rate of Return: It is the annual return rate of your investment. It is used to compare investments with expected returns within the company.
Takeaway
Real estate investors use the 1% rule to determine if the amount invested in the property will generate enough monthly income to cover costs. Not every house can meet the 1% rule. Investors can use the 1% rule as a starting point, but other factors should also be considered. Investors have other tools to analyze properties.
Source:
https://www.thebalancemoney.com/what-is-the-one-percent-rule-5193932
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