Real estate investors use a variety of metrics to analyze potential investment opportunities, and one of those measurements is the 1% rule. Here we take a deep dive on what the 1% rule in real estate investing is and how it’s used, so you have a better idea of when you should or should not follow it.
What is the 1% Rule in Real Estate Investing?
The 1% rule in real estate is a guideline that’s used to evaluate potential properties based on their cost and rental revenues. According to the rule, the monthly rental revenue of a property should be equal to or greater than the property’s total purchase price.
When performing this calculation, investors consider all sources of rental revenue, along with the actual sale price. For instance, they may consider monthly parking space fees and storage unit fees, in addition to unit rental payments in an apartment building. However, the sale price doesn’t include closing costs, loan origination fees, insurance premiums or property taxes. In addition, repairs and maintenance costs are also not included (see 50% rule below).
The formula for applying the 1% rule is simple: Divide the monthly rent by the sale price, and multiply it by 100 to attain a percentage. In order to see how this calculation works with different types of rental properties, consider a single-family home that sells for $85,000 and a multifamily apartment complex that sells for $10 million. According to the 1% rule, the single-family home should be rented for at least $850 per month — and between all sources of rental revenue — the multifamily apartment complex should bring in approximately $100,000 per month.
How to Use the 1% Rule in Real Estate Investing
Less of a hard-and-fast rule that must be followed in every situation, the 1% rule in real estate investing is more of a guideline that can prove useful when evaluating properties. When it is used, the rule can help in three distinct ways.
First, the 1% rule can be a good general measure of a property’s cash flow. A property that brings in at least 1% of its purchase price in monthly rent will probably have a relatively positive cash flow, aside from any unusual considerations, such as excessive repair costs. By contrast, a building that doesn’t generate at least 1% of its purchase price in rent will likely have negative cash flow.
Second, investors who are focused primarily on cash flow sometimes use the 1% rule as a litmus test to determine whether a potential property is worth investing in. So if a property doesn’t meet the 1% rule, they may automatically pass on investing.
Finally, investors can use the 1% rule as an estimate for what the rent price of a vacant building should be. Any estimated rental price must be measured against the area’s going rates for comparable rental units, but 1% of a property’s sale price can serve as a starting point when setting rents.
When to Ignore the 1% Rule in Real Estate Investing
As useful as the 1% rule can be, there are legitimate instances when you should break the rule. It may be appropriate to invest in a property that doesn’t meet the 1% rule if the property is:
- Currently rented at below-market rates
- Forecasted to appreciate in value quickly
- Located in an up-and-coming neighborhood
- Determined to be an especially low-risk investment
- Situated in a special economic zone or in an improving school district
Considerations for the 1% Rule in Real Estate Investing
The 1% rule is most useful when it’s considered alongside other rules in real estate investing, as various calculations can help investors more comprehensively evaluate a potential property. In addition to general assessments of a property’s condition and neighborhood, these numerical calculations should also be taken into account before investing:
- The 50% Rule:
The expenses associated with a property (not including mortgage expenses) should be 50% of the rental revenue.
- The 70% Rule:
The investment made in a new property should be no higher than 70% of the property’s after repair value if flipping the property.
- Gross Rent Multiplier Rule:
The ratio of a property’s value to its annual rental revenue.
How to Carefully Evaluate Potential Investment Properties
As you or your property syndication team evaluates potential investment properties, carefully consider the 1% rule in real estate, along with the rules mentioned above. Together, they’ll provide an accurate picture of what type of return you can expect a property to provide.