Have you heard of the 1% rule for real estate? If you’re looking to invest in real estate, it’s basically your guideline for evaluating that potential for a property purchase. This rule of thumb can be pretty handy when it comes to making smart investment decisions in real estate.
Basically, the monthly rent of that property should be at least equal to (ideally greater than) 1% of that total purchase price. If it’s not, it’s probably not a smart way to invest your money, not to mention your time too.
Of course, this isn’t a hard and fast rule. There are times when going with the 1% rule will certainly be the right path, but there are also times when you shouldn’t use it. Not to worry though, I’ll cover all of that below as well as everything else you need to know so keep reading!
How the One Percent Rule Works
All it takes is a little bit of math to make this simple calculation. You multiply the purchase price of the property in question and add in any necessary repairs you’d need to make all by 1%. The number you get is the base level you should charge for monthly rent. It’s basically to give you a better understanding of how much cash flow you can generate per month on the property.
But it’s a quick estimation method for it doesn’t factor in all those other costs that come with owning a property as such. There’s the insurance, the upkeep, and the taxes too that will all come into play.
It really just serves as a jumping-off point for you to determine if the property is feasible for you to invest in. There might be so many repairs that need to be made that it would be foolish to invest in. Conversely, you might determine something is a relative steal.
However, just because the 1% might work out in your favor in numerical terms doesn’t mean it is always the logical choice. If you were to invest in a property in a declining neighborhood, this decision might not bode well. Conversely, going for an up-and-coming area that’s going through a renaissance might make your choice a wise one.
An Example of a Property That Meets the One Percent Rule
Talk is talk though. Let’s go with a speculation in terms of numbers to illustrate this point.
Imagine you find a duplex that costs $400,000 which includes all the closing costs and repairs. So, you invest your own $80,000 into it (a standard 20% investment) and then borrow the remaining $320,000 for 30 years at 5% interest. This gives you a monthly payment of $1,730.
Therefore, the gross rent for this property meets the 1% rule as it would be $4,000 per month. You’ve also got to factor in operating expenses which include maintenance, taxes, insurance, management, and vacancy, among others which, for this example, are $1,600 per month or roughly 40%. That amounts to $28,800 per year for your net operating income which is what you get before making the mortgage payments. The cap rate of 7.2% puts it at $28,800 over $400,000.
To put it another way, the pre-income tax income you’ll be putting in your own wallet will be $8,040 per year. So, it returns you roughly 10% on that $80,000 down payment or your investment. That’s a good chunk of money you can take to the bank to save for making another investment purchase.
You can use it to pay the debt on this property or any other properties you hold, though I don’t recommend that so much for paying off your mortgages. You have a great interest rate and the property is really paying its own way in the world. Paying off a property early would be foolish. Even the behemoth that is Disney, leas their island Castaway Cay in the Bahamas. Why? Because it’s a smarter investment move.
You might not be Disney but you can still make a smart investment move for yourself. Use what you generate to fund your living expenses or make more investments.
And by the way, you’re about to be getting $5,900 in equity that first year and every year to come so really, you will be benefiting even more from the property as it appreciates from here on out.
An Example of a Property That Does NOT Meet the One Percent Rule
My last example was for a property that was ideal. But if you’re new to investing in properties, you should know how to spot what happens when you find a property that doesn’t meet that 1% rule.
Again, we’ll go with a duplex for the example. But let’s say this one is cheap at $200,000. The price includes those closing costs and repairs like my other example. You give the standard 20% investment of your own cash (in this case it’s $40,000) and you then borrow $160,000 for 30 years at 5% interest, bringing the monthly payment to $859 a month.
The gross rent on this property comes in at $1,000 a month which means it’s not in that 1% rule. For this example, you still have those operating expenses (management, insurance, taxes, etc.) but the cost is $400 a month. So now, your net operating income is just $7,200 per year, giving you a cap rate that’s only half as good as the other one – 3.6% for $7,200 over $200,000 (unless you’re investing in large multi-family property in an extremely wealthy area, that cap rate is too low).
Before income taxes, your rental will be generating -$3,108 every year. You’ll have to pay the fees associated with this property from either your own job earnings or any positive cash flow you’re generating from another property. As you can see, it’s not a good deal.
As you can see, the 1% rule can be handy when computing simple math about how to make a smart decision for properties that can make you money. Now that we’ve gone over a couple of examples, let’s delve into when you should use this rule.
When to Use the One Percent Rule
This rule of 1% is best to be used to prescreen properties and save you time (not to mention money). You’ll use this as you pursue good investment opportunities. It can help you cut through the clutter, especially if you have a list of 20 properties from your real estate agent. You’re not going to buy all of those. And while some of them might LOOK good, they might not be worth your time. The converse of that can also be true.
So, with this list, you’d look at the list of asking prices to see what that 1% would be for each. You can even do it in seconds by just sliding the decimal point over two spots to the left. So, $100,000 in a listing price would be $1,000.
Once you get that 1% number figured out for each property, you’ll want to compare it to the market rent for this property. If that rent number is close to that 1% asking price, it’s worth your time to look into the property a little further. If it’s far below that 1% then you can simply skip that option completely.
When you’re first getting into real estate investment, you will need to put more time forth to making a smart buy. Reading over the sources to find the market rent is the best way. Eventually, it becomes intuitive, but initially, be prepared to study up on it. Places to look are Zillow, Trulia, and Loopnet, but do keep in mind they aren’t always fully accurate. It should give you a ballpark for what to expect for rent prices in the area though to help you separate your potential opportunities.
When Not to Use the One Percent Rule
Remember, that 1% rule is only meant to help you narrow down your list of available properties to invest in. Once you’ve narrowed it down, you shouldn’t rely on the 1% option anymore. You should get down to it with a more in-depth analysis. It certainly requires more of you to make an offer and close on the property than this simple rule.
See, the 1% rule only uses the gross income for a property, or rather, what you’re going to net from any tenant. However, your bottom line for rental investing is that net income which is what you have left after all those expenses. So if you want to understand the cash flow of a property, you have to deduct y our other expenses. We touched on this in the examples above but because it’s not a real property and there are so many variables, these costs can fluctuate.
Things like the insurance, maintenance, management, taxes, vacancy, capital expenses, and of course, the mortgage payments, will all come into play. One way to go about figuring this all out is to set a goal for your property’s cap rate and the net income generated after financing. You might find that a property that passed the 1% test also meets these criteria. You may also find that it won’t.
The other time the 1% rule might not benefit you is with certain properties. Small residences make sense with it, like the duplexes mentioned above, preferably in A or B neighborhoods. Lower-priced C neighborhoods, multi-unit buildings, and commercial property will in some cases need to have a better income than the 1% allows to make it worth your time, money, and effort.
Is the One Percent Rule Even Possible in Some Markets?
Real estate investing is definitely something to be locally-tuned to. The numbers and trends always vary in every location. In some places, big cities in particular, it’s almost impossible to see any properties that even fall into that 1%.
Take a look at some of the hottest markets for real estate in the country. There’s San Francisco, one of the most notoriously expensive markets. With a median sales prices at $1,289,300 by 1%, it’s $12,893 with a median rent of $4,285 per month. Denver’s median sales price is $391,300. That’s $3,913 for the 1% and a median rent of $2,047. That means you’ve had to buy an average home at nearly half its value to qualify that 1% rule in Denver. And in San Fran, forget it! That would be one-third of its value for the 1%.
Of course, these are primitive examples that would likely never happen in these hot markets so you need to either buy in another area outside that market or in lower-priced areas of the same market, or drop your criteria down, perhaps to a 0.5% rule.
Most investors go with the first option and stick to buying properties in other markets from afar. But you can also go with the second option and lower your criteria. You could still pull it off if you bring in money from other sources like appreciation by buying a fixer upper.
However, there’s still a bit more to know here so keep reading on my special rule that could really help you invest wisely.
Why I combine the 1% rule with the Fifty Percent Rule
There’s also the 50% rule. It’s ideal to do a quick analysis to see if a rental property qualifies for your intentions. Basically, the total expenses associated with the operation of a rental property should be roughly 50% of the gross rents and the expenses are 50% (taxes, repairs, insurance, management, and the whole shebang).
Again, I’m a numbers guy so I’d like to illustrate this rule with a little example.
Surprise! You’ve found a property to invest in that’s going for $100,000. And even better, your research of the local area leads you to conclude that you can rent that property for just $1,000 per month. When you use the 50% rule, the operating expenses would be about $500 per month. In other words the expenses equal the gross rents of 50% of $1,000 which is $500.
What you’re left with at the end of the month to pay the mortgage and your profit (the NOI, or net operating income) is $500. Under the assumption that you’d put 20% down, have a 30-year fixed interest mortgage (6%), then you would have a mortgage payment of $480 per month which comes to $20 in profit.
Yes, $20 per month is nothing to jump up and down for. But the potential to negotiate the price down from there and lower your monthly payment might be worth it. If you could talk your way into buying it for $85,000 then your monthly payment falls to $408 per month and that comes to $100 in profit. It’s still a tight squeeze but there’s potential.
However, if you plan to manage the property yourself, the fees that would go for that will go to you so you’ll actually be bringing more in per month on this investment. While it’s not wise to use these basic rules as your full deciding factor, it can help you see if making time to figure out the more intricate details is worth your time and money.
How to Break the One Percent Rule and Still Come out Ahead
When talking about properties that don’t meet the 1%, like in our example, the principal on that mortgage reduces by nearly $2,400 in the first year. When you’re doing this basic computation, it doesn’t seem so bad with a loss of -$708. Plus, if that property appreciates by 3% in the same year, things could really be looking up. When there’s a 3% price increase on a $200,000 property, that’s $6,000. That means you’d move ahead by $5,292.
Remember, the example-you put down $40,000 for this property. That means you’d get a 13% return on your investment. Basically, this is how most real estate investors still get money even though it doesn’t measure up to the 1% rule. They have to rely more heavily on the appreciation of the property to make that happen.
Keep in mind though, price appreciation is very subjective. There are no guarantees now what the future will hold. It could work in your favor or you could wind up kicking yourself. Hard.
The return you get above in the example is just what it comes out to on paper until your property is sold or you refinance. With illiquid investments, this isn’t an easy task. Still, the speculations that mount don’t necessarily have to be a bad thing.
One of the best aspects of real estate to generate profit is to force appreciation. In other words, add some value. Improve on the property in some way, and believe me, there are so many ways to do this. Make it more beautiful, add on another room, convert an otherwise unused space like a basement so it can be used as a rental unit, raise the monthly rent, and other tactics like this and you’ll start making more money.
Patience also pays. Investors that hold onto rental properties for longer where the neighborhood itself is appreciating can stand to make lots of money down the road. You’ll need to be prepared to feed into the property in the short term but it will all catch up if you make wise investments. It takes some staying power and extra cash, but it can be done.
What you need to sort out is this speculation for the properties you consider and how much rental income you can generate. So if you’re buying properties that don’t meet the 1% rule or any other measure for income generation, then you’re going with speculation to chase those profits. If you’re comfortable with it and have a plan to bring it all to fruition, it can be a great thing for you.
But not everyone is comfortable with this level of risk. You might feel best if you have a more balanced combination of profit from the rent and that speculation. If so, choose properties in quality locations that fit that 1% rule or another measure for income to feel more secure in your choices.
Investing is risky after all, but it can net you quite a bit of money when you do it right. Study what those successful before you have done and attempt to emulate that strategy for yourself.
Even if you come out $20 ahead, it’s still a success, though I advise aiming much, much higher than that!
Conclusion
The 1% rule can be very helpful for determining which investment properties are worth your efforts. It’s not something that can help you see your exact income potential from the investment, but rather, helps you have a basic point of reference to work with. This is what you’ll use to whittle down a massive list of properties to consider.
But this rule doesn’t always apply. You may find a property that doesn’t meet this rule but because you plan to do your property management yourself, then you’re not expensing it to someone else. Finesse your numbers and get all the projections for the area first. Just because it’s not there yet doesn’t mean it won’t be the hottest neighborhood in 5 or 10 years.
By thinking with forward vision and focusing on a little math, you can find a real estate investment opportunity that will have you profiting hugely from simply signing on the right line.
