What is the 1% Rule in Real Estate?
REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
The 1% Rule Explained
The 1% Rule is more of a rule-of-thumb than a hard-and-fast rule. It’s one of the many metrics that real estate investors can use when analyzing deals.
The idea behind the 1% Rule (sometimes referred to as the 2% Rule) is that the rent an investor should collect on a property should be between 1% and 2% of the total cost of the property’s purchase price plus any costs to improve the property.
For example, if a property costs an investor $200,000 to purchase and improve, the 1-2% rule implies that the investor should expect to earn between $2,000 (1%) and $4,000 (2%) from the property in monthly rent.
If a property is projected to earn that amount, it will typically be one an investor will look into further. If not, the investor might move onto another property.
The 1% Rule Is Overly Simplistic
The 1% rule is a very simple way to analyze a real estate deal, which makes it easy for real estate investors to quickly run this figure before doing a deeper dive on a property. It’s useful in the sense that it offers a quick estimation of whether a property makes sense as an investment.
The shortfall of such a simplistic metric is accuracy. The 1% rule’s weakness is that it does not account for the many additional costs involved with an investment property, such as maintenance costs, insurance, property taxes, HOA fees, vacancy rates, and utilities. Those additional fees contribute to the bottom line of a real estate deal, and the 1% rule does not factor in any of these expenses.
The 1% Rule and 2% Rule Are Often Unrealistic
The 1% rule represents what the investor should or would like to make on a property. But depending on the price of the property, it might not be realistic to expect a property to generate 1%, let alone 2% of its purchase price.
Using the above example of a $200,000 home, it may be difficult in some markets to find a $200,000 property that will bring in $4,000 (2%) a month for rent. Even $2,000 (1%) can be a stretch in some cases.
The Location Factor
Location plays an important role when using the 1-2% rule. The more expensive the area, the more difficult it will be to make 1-2% in rent. In high-priced real estate markets where the median home price can be upwards of $600,000, it is probably unrealistic to expect to get 1-2% of those prices in rent. But in less expensive markets where the median price of a home is under $100,000, getting 1-2% of a home’s price for rent becomes more achievable.
The Market Determines Price
Just as the market determines the price of homes, it also determines the price of rent. Market rate rent on comparable homes is usually a good indicator of what an investor can expect to charge for rent. Using that knowledge, the 1% rule makes a good comparison guide regarding the goal rent and the likely rent.
In an area where rents are around $1,700 for a $200,000 home, for example, $1,700 is less than 1%.
Would this be a bad investment? Maybe, but maybe not. Receiving less than 1% of a home’s price in rent might be a deal-breaker for some investors, but the property might still make for a good investment. There would need to be more analysis than just the 1% guideline to determine this.
The 1% Rule and 2% Rule for Fixer Upper Properties
Getting 2% of a property’s purchase price in rent is generally more likely to happen with cheaper properties. A property purchased for $50,000 could very well bring in $1,000 a month, depending on the location. Cheaper properties, however, often require repairs and renovations, which then brings the cost up.
Buying a property for $50,000 might seem like a good deal at first, but because repairs and renovation costs are included when determining the 1% or 2% figure, once those costs are accounted for, this could turn out to be a bad investment, one that doesn’t pass the 1-2% rule.
Another important factor to consider with less-expensive properties is the neighborhood. The 1-2% rule doesn’t consider location, which is a very important (possibly the most important) factor when buying an investment property. It’s generally more difficult to get or keep renters in neighborhoods where properties are extremely cheap, usually due to a lack of renter interest if the area is undesirable or because of evictions. If the deal works on paper but there is a high vacancy rate, the property might turn out to be a bad investment.
Mortgage Payments Are a Consideration
Positive cash flow is typically very important to investors. The exception, however, is if there is good reason to believe a property will appreciate, allowing the investor to sell quickly and make money that way. Otherwise, positive cash flow is the primary goal.
If there will be ongoing debt service for an investment property, the rent collected will need to be at least equal to the mortgage payment, and obviously, a higher debt service coverage ratio is even better.
If the rent collected is less than the mortgage payment, the investment will produce negative cash flow (more money going out each month than coming in). By using a mortgage calculator and the 1-2% rule, an investor can better understand whether the investment is a good deal.
Common Mistakes With the 1% and 2% Rule
Calculating how much rent to charge using the 1% rule or 2% rule is generally not the best way to determine a property’s rent price.
Here’s an example: People who are selling their home after having made improvements might think their home is worth more because of the improvements. While this might be the case, the true determinant of what a house will sell for is what someone will pay, not the improvements the seller made to it.
The same holds true for the 1-2% rule. Just because an investor thinks they should get 1% or 2% of the home’s price for rent doesn’t mean anyone will actually pay that amount. In an area where comparable properties are renting for $1,600 – $1,700 a month for homes with similar square footage and the number of bedrooms and bathrooms, for example, it would probably be unlikely for a tenant to pay $2,000 if there are similar properties available to rent for less.
In most cases, pricing a rental property solely on the 1% rule or 2% rule would be a mistake.
1% Rule Summary
The 1% rule is one tool investors can use to help determine whether a property might make a good investment. It provides a quick and easy starting point.
The 1% rule is most useful when combined with a variety of other investing factors, such as cash-on-cash return, potential cash flow, capitalization rate, the gross rent multiplier, location of the property, condition of the property, and area appreciation rates.
Using only the 1% rule will not give an investor a complete sense of whether a property will make a good investment. This rule also favors cheaper properties. Although cheaper properties will be more likely to hit the right numbers under the 1% rule, cheaper properties might not make a good investment overall.