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You’re determined to break into real estate investment, and your first instinct is to field your options. But as you click through property listings, there’s only one question on your mind: “How am I supposed to know which properties are good investments?”
The 1% rule is a quick and easy measurement that helps establish whether a property is worth a closer look. It also helps set a baseline on what to charge for rent.
What Is the 1% Rule in Real Estate?
In real estate investing, the 1% rule is used to calculate the cost of an investment property against the income it can likely generate. In short, a property’s monthly rent must be 1% or more of the purchase price to pass the rule. It’s one of the first things any new investor learns, and it becomes second nature with time.
While the 1% rule is good for quick, back-of-the-envelope math, purchasing property for investment purposes is complicated, and the 1% rule isn’t a hard-and-fast rule. There are situations where a property doesn’t pass the 1% rule, but it could still be a wise investment.
How Is the 1% Rule Calculated?
To calculate the 1% rule, multiply the purchase price of the property plus the cost of any repairs by 1%.
For example, if you’re thinking of investing in a single-family rental home that’s selling for $150,000 and needs $20,000 in repairs, the true cost of the property is $170,000. Multiply $170,000 by 1% and you get $1,700. If you can charge $1,700 in rent, congratulations, the home meets the 1% rule.
Testing the 1% rule
You don’t need to speculate on rental income relative to cost to understand the 1% rule. You can test it out by applying it to a property that’s already rented.
Let’s say a tenant is living in a home you want to buy. Once you’ve added in repairs, the home is valued at $130,000. When you multiply $130,000 by 1%, you get $1,300. If the tenant is paying $1,200 in rent, the property doesn’t pass the 1% rule.
But, before you pass on the property, it might be helpful to understand why a tenant is paying the amount they’re paying in rent. Perhaps the tenant is a friend or relative of the owner or maybe the neighborhood is on the cusp of a rental boom that hasn’t arrived yet.
This is where the 1% rule starts to break down a little. This is why it’s important to know the pros and cons of using the rule.
What Are the Pros and Cons of the 1% Rule?
When it comes to real estate investments, if a rule is quick and easy, it definitely has some pros and cons. Before you start building a real estate portfolio based on the 1% rule, you need to be aware of what those pros and cons are.
When the 1% rule works
The 1% rule typically works well when you want to invest in smaller single-family homes in neighborhoods with relatively stable property values. When property values are stable, rental rates are likely to stay in line with property values.
When the 1% rule doesn’t work
If you’re investing in markets where property values and rental rates aren’t in alignment, the 1% rule may not be as helpful. For instance, in major cities where real estate is extremely expensive compared to the average price to rent, it may be harder to find a renter who is willing to pay a rental rate that would provide enough return on your investment.
You also shouldn’t use the 1% rule as your sole determiner of investment decisions. Always pay attention to the other variables associated with investing. The property’s location, the neighborhood and current market trends play much bigger roles.
1% rule pros
- It’s quick and easy to use: That’s why investors love it. As you gain knowledge and experience in real estate investing, you’ll develop an instinct for good and bad properties and whether they’ll pass or fail the 1% rule. But the rule still provides a lightning-fast baseline to work from.
- Helps narrow down a pool of properties: The speed and simplicity of the 1% rule is useful when you’re vetting a large pool of properties. If you’re looking at 50 properties, apply the 1% rule to trim the fat. If half the properties on your list pose a risk to positive cash flow, it’s likely a wiser choice to focus on the half that doesn’t.
1% rule cons
- It’s not comprehensive: The rule doesn’t take into account ongoing repairs, property taxes, operational expenses or any other unexpected or irregular expenses. While it’s good for establishing a baseline, it’s not useful for making sound investment decisions.
- Often fails in expensive cities: In bigger, more expensive real estate markets, the 1% rule tends to fall apart completely. In cities like San Francisco, Oakland and New York City, the price-to-rent ratios are much wider, meaning property prices far exceed any reasonable number you’ll get from the 1% rule.
The 1% rule isn’t set in stone. It’s a guide. And, as a guide, it can be useful in helping you determine whether a property might be a good investment or not. In short, use it to screen properties and narrow your list, but don’t accept any result as the final word on the matter.
What Else Should You Consider When Real Estate Investing?
Despite its cons, the 1% rule is still a great tool for setting baselines and taking a broad look at potential investment opportunities. But once you’ve narrowed down your list, you’ll need to dive deeper to understand the true investment potential of the properties that made the cut.
For starters, you’ll need to understand the nuances of location.
Let’s compare two neighborhoods in the same area. The property values in both may be stable, but if the first neighborhood has less crime and more amenities compared to the second, it may be harder to find a renter in the second neighborhood willing to pay enough to provide a return on your investment.
But if the second neighborhood is expected to start booming, snatching up a property that fails the 1% test now could be a smart investment for the future.
Other factors the 1% rule doesn’t account for are the gross income of a property (the total income you can collect from renting) and its net income (the total income you can collect minus expenses). Gross income is important, but without net income, it’s meaningless. If you want to understand a property’s true potential cash flow, you’ll need to factor in what you’ll need to spend to maintain it.
You’ll also need to consider property taxes, maintenance and repairs. And you’ll probably want to hire someone to manage the property unless you plan on managing it yourself.
The 50% rule
The 50% rule is helpful here. The 50% rule states that all operating expenses, except for the mortgage payment, should be no more than half your gross rental income. Like the 1% rule, it’s more of a guideline. But if your expenses are higher than half your gross rental income, you may want to reconsider your approach.
How Does the 1% Rule Compare to Other Real Estate Investing Calculations and Rules?
The 1% rule is a tool that helps you narrow down your options. But it isn’t the only one. There are other tools you can use to make quick determinations about whether you can and should invest in a piece of real estate.
The 2% rule
If you’re in a less expensive market or you’re looking at properties that might need expensive repairs sooner rather than later, the 2% rule is a good filter. It’s simply a doubled-up version of the 1% rule. The gross monthly rent must be equal to or greater than 2% of the property’s price.
The 70% rule
The 70% rule is for fix-and-flip properties. These properties typically require significant repairs before they can be sold for a profit. The rule simply states that investors shouldn’t pay more than 70% of the property’s after-repair value (ARV) after they’ve paid for repair costs.
Gross rent multiplier
The gross rent multiplier (GRM) helps you determine how long it’ll take to pay for your investment property. By dividing the price of the property by the gross annual rent, you’ll get a number that indicates how favorable of an investment the property is.
For example, if a property valued at $150,000 passes the 1% rule, with a rent of $1,500, the annual rental income is $18,000. The property cost divided by the income is a gross rent multiplier of 8.33 which means it will take roughly 8 years and 4 months to pay off.
As a rule, the GRM should roughly fall between 4 and 7 years. The lower the gross rent multiplier, the better. The more rental income you have relative to the purchase price, the more profit potential the property has.
But be wary, like the 1% rule, the gross rent multiplier doesn’t account for operating expenses or capture the nuances of a particular investment.
An alternative to the gross rent multiplier is the cap rate. This calculation divides net operating income (total rental income minus all expenses except the mortgage payment) by the property’s purchase price.
The result is a percentage you can use to compare to other properties in the area. The higher the cap rate, the better the return on the investment.
It’s a useful calculation. And one you’ll definitely want to factor in before making a final decision on a property.
Compared to the 1% rule and GRM, cap rate factors in operating expenses. It takes a little more work to calculate all the expenses you’ll pay, but it’s a much better indicator of investment potential than either of the other tools.
1% Closer to Investing
If you’re beginning your real estate investment journey, you now have a few principal tools to help you determine whether a property is a smart investment. While you shouldn’t make any final or costly decisions based on the 1% rule, it’s a useful tool that also serves as an entry point into the wider world of real estate investment.