Understanding the 1% Rule in Real Estate Investing

Understanding the 1% rule in real estate investing is crucial for anyone looking to maximize their returns and make informed decisions in the real estate market. Properties that meet or exceed the 1% rule are more likely to be profitable investments in the long run, providing a steady stream of passive income and building wealth over time. It is important for investors to carefully evaluate potential properties based on this rule to make sound investment decisions and achieve financial success in real estate.

What is the 1% Rule in Real Estate Investing?

The 1% rule recommends that the monthly rent of a property should be at least 1% of the original purchase price of the property. While it’s just a rule of thumb, many real estate professionals believe the 1% rule can deliver a solid return on investment (ROI) over time.

This rule is considered a good benchmark for rental income because it supports positive cash flow. It’s thought to be a good formula for earning cash while covering insurance, taxes, mortgage payments, maintenance and other operating expenses.

Many perceive rental properties priced on the 1% rule to be stable investments. It’s also simple to calculate. However, it must be emphasized that the 1% rule may not be suitable for every rental property. Depending on the property’s type, location and condition — plus the state of the real estate market — investors may determine that another formula is better for reaching their financial goals. Still, the 1% rule serves as a reasonable starting point.

How Does the 1% Rule Work?

With the 1% rule, real estate investors just have to make a simple calculation to estimate whether a specific property might turn a profit. The investor determines the total purchase price of the rental property, adding the cost of repairs or renovations. The monthly rent rate is then set for at least 1% of the total.

Generally, the 1% rule allows for a monthly rental rate that equals or exceeds the owner’s monthly mortgage payments on the property. Of course, various other factors come into play in this decision. While some property owners find the 1% rule acceptable for their purposes, others use it as just one of multiple formulas.

How to Calculate Rent Using the 1% Rule?

Here’s how to price monthly rent with the 1% rule:

• Enter the cost you paid to purchase the property
• Add the costs of renovations or repairs
• Multiply the sum by 1% (0.01)

For example, suppose you paid $150,000 to acquire a rental property. Then, you had to make upgrades and repairs that cost a total of $20,000. This establishes your total acquisition cost as $170,000. To determine monthly rent, multiply that total by 0.01:

$170,000 x 0.01 = $1,700

Therefore, $1,700 is the minimum you’ll charge tenants as monthly rent. You may decide to price it a little higher depending on your financial goals and the local rental market.

Example of Using the 1% Rule in Real Estate Investing

Suppose you’re considering purchasing a three-bedroom house for $400,000 and intend to rent it out. It has been unoccupied and on the market for a year. While there are no foundational problems, several fixtures and appliances need upgrades that will cost a total of $15,000.

You look for comparable rental units in the area. You notice another owner is charging tenants $3,500 a month for a similar property. Using the 1% rule, you determine that that rental price would be insufficient for your property; instead, you want to try to rent it for at least $4,150 per month.

A similar home one mile away rents for $8,000 per month, which would be more than enough to make a profit. However, that home may be in a particularly desirable area where people happily pay more to live.

Before making an offer on the home, you’ll have to carefully weigh the home’s location, its condition and trends in the local rental market.

Simplicity is the beauty of the 1% rule. Real estate investors can establish a range of acceptable rental payments with relatively little effort. It shouldn’t be used exclusively because additional factors need to be accounted for.

1% Rule vs. Other Real Estate Calculations

The 1% rule is just one standard property owners use to establish monthly payment rates. To compare, here are a few more.

2% Rule

The 2% rule recommends that monthly rent payments equal or exceed 2% of the total acquisition and renovation costs of the property. Fewer properties qualify for this rule, but those that do could bring in a healthy income stream.

50% Rule

The 50% guideline suggests property owners set aside half of their monthly gross rental income for maintenance and operational expenses. For example, if a property owner earns $2,800 in rental income, $1,400 should be reserved for expenses and not counted as profit.

Gross Rent Multiplier (GRM)

The GRM is used to assess the viability of a certain rental property by dividing its purchase price by annual rent. For example, if a property that costs$300,000 earns its owner$40,000 in annual rent, its GRM is 7.5%. Properties with lower GRMs are considered good investment opportunities.

Rent-to-Income Ratio (RTI)

This general rule of thumb is used by both renters and property owners. It states that rent payments should be about 30% of a tenant’s monthly income. Landlords may use the RTI ratio to screen for tenants, while prospective tenants use it to find properties they can afford.

What the 1% Rule Doesn't Take Into Account with Real Estate Investing

With the 1% rule, real estate investors have a handy guideline. However, the rule doesn’t consider certain important factors that relate to the profitability of an investment property. Here are a few factors that don’t come into play with the 1% rule.

Mortgage Rates

Interest rate fluctuations play a huge role in the profitability of any enterprise. Higher rates could eat into your cash flow; however, the 1% rule does not consider how interest rates affect mortgage payments.

Maintenance and Upkeep

The 1% rule assumes the property under question is in rentable condition. It does not factor in monthly operating expenses for maintenance and upkeep of the property. Rental homes that need extensive repairs may not be appropriate for the 1% rule.

HOA Fees

Condominiums, townhouses, co-op developments and homes in planned or gated communities usually fall under the guardianship of homeowner associations (HOAs). HOAs charge fees to take care of common areas and amenities for the general community. These fees are not included in the 1% rule calculations.

Atypical Markets

Another assumption of the 1% rule is that the current real estate market is relatively stable. However, if the local market is experiencing an atypical fluctuation, the 1% rule likely won’t be effective in calculating rental payments. During market booms, for example, 1% may be too high for typical renters.

The 1% Solution: A Valuable Tool for Property Owners

The 1% rule in real estate is just one of the methods rental property owners have at their disposal. It helps them decide on rental rates that are fair to tenants but also cover their expenses and earn revenue. While it should be used in combination with other methods, it’s a reliable principle that has served property owners well for decades.

Frequently Asked Questions