Is the one percent rule a hard and fast guideline every investor must follow to be successful? It depends. While it's a useful tool for evaluating the cash flow of a property, it doesn’t necessarily tell the whole story of investment potential.In this article, we pull the curtain back on what the one percent rule looks like in real estate investing, and when it may (or may not) make sense to follow it.
What is the one percent rule?
The one percent rule is a guideline frequently referenced by real estate investors when evaluating potential property purchases. This rule of thumb states that the monthly rent should be equal to or greater than one percent of the total purchase price of an investment property. Keep in mind, the one percent rule doesn’t account for other property expenses, such as loan and acquisition fees, closing costs, repairs, maintenance, insurance, property taxes, etc.
Here’s how to calculate whether a property passes the one percent rule:
Rent / purchase price x 100
Here’s an example with an investment property that costs $100,000, and rents for $900 a month:
$900 / $100,000 x 100 = .9% (This property comes in just under the one percent rule)
While the one percent rule isn’t a make-or-break-it benchmark for all investors, it can be a useful screening tool to quickly estimate how a property will cash flow. It can also serve as a target for setting rental rates if the property is currently unoccupied.What does the one percent rule look like in practice?
The one percent rule is more of a guideline than a rule, and not one you should follow blindly. Think of it as a screening tool or benchmark in a multi-step evaluation process that also takes property quality, location, and tenants into consideration.
For example: Let’s say you purchase an investment property for $50,000 in Detroit that rents for $500 per month.
Does this satisfy the one percent rule? Yes.
Does that mean it’s a great investment opportunity? Not necessarily.
It depends on your personal goals and criteria as a real estate investor, and how many of those boxes the property checks (we dig into that more here).
Our point is, properties that come up short of the one percent threshold can still have upsides in investment potential. So if you’re eyeballing an investment home that doesn’t quite meet the one percent rule, don’t write it off without considering other fundamental factors that influence overall rate of return.
These include (but are not limited to):
- The local market
- Neighborhood quality and amenities
- The current renters
- Property condition
- Forecasted home price appreciation
- Projected rent growth
- Demographic and socioeconomic trends
- Foreclosure rates
- Vacancy rates
- Days on market
Below, we’ll dive in to just a few of these factors.
Tip: Roofstock provides much of this essential information up front for every listing on its marketplace.
Fundamental factors that influence overall rate of return
Population & employment growth
You know what they say about a rising tide. If a market is experiencing above-average population or employment growth, it may be a great time to get your foot in the door before housing demand spikes and the competition heats up.
Of course, it’s important to consider barrier to entry, or affordability, as well. Don’t bank your decision solely on the hope you’re buying in the next Denver or Seattle.
We explore this more, as well as how to identify population trends, in our blog post how to spot an up-and-coming real estate market.
Consider how comfortable you are with the risk/return tradeoff of a certain investment property. Oftentimes, lower-priced homes will be a little bit riskier due to location, property condition or renter turnover, but typically generate higher current or cash-on-cash money returns.
Alternatively, if you’re focused on safety and security, “consider exploring low-risk investment homes that generate steady, reliable yield,” explains Roofstock CEO Gary Beasley. “An example of this may be a more expensive investment property (think $150-$250K) in a good school district. You’re going to get a lower yield, but on the flip side you may see better downside protection and less volatility.”
Property 1: An investment home in Douglasville, GA comes in slightly under the one percent rule. However, there are many other factors that make it appealing from an investment standpoint:
- Strong 6.3% cap rate
- Located in a 4-star neighborhood
- Attractive commuting distance from a major metropolis (about 35 minutes from Atlanta, a very strong real estate market)
- Above-average expected appreciation: Douglasville home values have gone up 12.4% over the past year, and Zillow predicts they will rise 6.9% within the next year (this is above Zillow’s forecasted national average of 6.4%)
- Recently renovated/new fixtures and appliances
Property 2: An investment home in Chicago, IL comes in above the one percent rule, with a very high cap rate of 9% and gross yield of 16.1%. For some investors, strong cash flow is the top priority. They may be willing to assume a little more risk due to the following:
- The property is located in a two-star neighborhood
- It’s an older home (built in 1910) and may have more maintenance/upkeep needs
- There are significant expected capital expenditures that must be completed next time the property turns
In the case of these two properties, neither is necessarily better than the other. It all boils down to your investing style, goals, and risk tolerance. The point is, using a single metric like the one percent rule doesn’t paint the entire picture of investment potential.
Tip: See how the Roofstock Neighborhood Rating helps you measure real estate investment risk
Neighborhood attributes such as local school quality, the “walkability” factor, commuting distance and proximity to amenities/services all play a role in the attractiveness of an investment property — and its potential for overall return. Take stock of nearby amenities like public parks and spaces, transportation hubs/systems, shopping plazas, restaurants and employment concentrations, for example.
“Look out for new retail developments and special economic zones, as their presence may help home price appreciation. It’s smart to buy within close proximity to these areas,” advises Jason Green, Roofstock Enterprise Account Executive. “For example, in Atlanta, they are expanding MARTA stations throughout the city. The neighborhoods near these future stations will become more desirable, and therefore may increase in value faster as the area sees an increase in demand. Get in ahead of the curve to participate in the most upside.”
Understanding historic and projected home price appreciation rates is another piece of the puzzle when looking at the potential ROI on investment properties. Depending on the area you buy in, a property that doesn’t quite meet the one percent rule could still be a lucrative longer-term investment opportunity based on how it appreciates.
To see how different markets stack up against national averages, check out Zillow’s home value index.
For example, in Kansas City, MO — where you can still find affordable investment properties — home values are forecasted to appreciate by nearly 8% in October 2019. This is above Zillow’s forecasted national average of 6.4%.
Like the one percent rule, appreciation is a factor that should be considered when evaluating investment properties, “but it shouldn’t be the only factor driving your decision, depending of course on your investment goals and priorities,” notes Green. “If higher monthly cash flow isn't as critical and you care more about building up equity over time, you might focus on properties with higher appreciation potential.”
Rental demand and vacancy rates
Getting a sense of local rental demand and rental vacancy rates in a given market will help you better gauge the potential profitability of your investment.
A few primary drivers of overall rental demand include proximity to employment, home prices/affordability, commuting patterns and homeowner/renter profiles.
Tenant turnover also impacts your bottom line. Costs can range anywhere from $1,000 to $5,000, with estimated averages landing in the ballpark of $2,500. For reference, national vacancy rates in the third quarter of 2018 were 7.1% for rental housing, according to the U.S. Census Bureau.
Adds Green, “When comparing different properties in different locales, it’s helpful to assume that turnover and vacancy rates will typically be greater for a higher-yielding home in a lower-rated neighborhood, versus a lower-yielding home in a higher-rated neighborhood. This may negatively impact your ROI.”
Sleuthing out this information may seem overwhelming for people who are out-of-town real estate investors, but don’t hesitate to call up a local property manager (or two) in the market you’re interested in. Ask about local rental vacancy rates, rental demand and turnover frequency.
Alternatively, you can also get market insight and perspective by speaking directly with a Roofstock advisor or one of our vetted property managers.
Like we mentioned earlier, the one percent rule doesn’t account for a number of other expenses. You might be looking at a listing that meets the one percent threshold, but has high taxes or needs a brand new roof next time the property turns.
Here is a list from our post on how to calculate investment property ROI, which outlines several of the costs owners typically assume when purchasing an investment property.
- City taxes
- Property taxes
- Property insurance
- Property management fees
- HOA fees (if applicable)
- Landscaping (if applicable)
- Capital expenditures (bigger renovations, additions, etc.)
- Vacancy costs (this is typically calculated as a percentage and factored into your projected expenses as a conservative oversight, in case the home sits empty between tenants)
At the end of the day, there is no one metric you should look at when evaluating investment properties. Know your investing criteria, and look at a blend of factors to help guide your purchasing decision.