One of the most challenging things about being a real estate investor is deciding which property to invest in out of all of the choices available. The 1% rule is a shortcut investors use to quickly narrow down investment options to help find the right property before another buyer steals the deal.
But is it the right way to analyze a property? Let’s learn more about this “rule” and the pros and cons of using it.
- The 1% rule states that the gross monthly rent should be equal to or greater than 1% of the property purchase price or value in order for it to be deemed a cash-flowing property.
- To calculate the rent-to-price ratio to see if a property meets the 1% rule, divide the monthly rent by the purchase price.
- One of the drawbacks of the 1% rule is that operating expenses are not taken into account.
- In addition to the 1% rule, real estate investors use the 50% rule and cap rate calculation to gain a better idea of potential returns.
What is the 1% rule in real estate?
The 1% rule is an easy, back-of-the-napkin calculation real estate investors use when analyzing rental property. According to the rule, the gross monthly rent must be equal to or greater than 1% of the property purchase price in order for it to have positive cash flow.
Because there are other metrics such as operating expenses, cap rate, and long-term appreciation to consider, the 1% rule isn’t set in stone. In other words, if the rent is 1% or less of the purchase price, the property may still be a good option depending on an individual investor’s goals. Dividing the rent by the purchase price is also known as the rent-to-price ratio.
With that in mind, the rule can be a good way to initially screen potential investments by ballparking what the cash flow from a property could be.
Using the 1% rule for rental property
To calculate the 1% rule, simply multiply the property purchase price by 1%. The result is the minimum monthly rent that the home should generate. If a property needs immediate updating, such as new appliances or carpeting, the cost of improvements should be added to the purchase price.
Assume an investor is thinking about purchasing a single-family rental (SFR) home with an asking price of $125,000. Based on the 1% rule, the home should generate a monthly rent of at least $1,250:
- $125,000 purchase price x 1% (0.01) = $1,250 gross rent per month
If the home requires immediate repairs, the cost of the needed work would be added to the purchase price before using the 1% rule. If needed repairs total $15,000, the property should rent for at least $1,400 per month:
- $125,000 purchase price + $15,000 repairs = $140,000 x 1% (0.01) = $1,400 gross rent per month
The 1% rule also can be used on rental property that is already rented to a tenant. For example, let’s say a single-family home priced at $150,000 is generating a gross monthly rent of $1,400 per month. By rearranging the 1% rule, an investor can quickly tell whether the property passes the test:
- Property price or value x 1% (0.01) = Gross monthly rent
- Property price = Gross monthly rent / 1% (0.01)
- $1,400 gross monthly rent / 0.01 = $140,000 property price or value
In this example, a home rented for $1,400 with an asking price of $150,000 does not pass the 1% rule. That could be due to a variety of reasons. Maybe there is room to raise the rent, the property is overpriced, or the home is in a seller’s market where there are more buyers than there are homes available for sale.
Pros and cons of the 1% rule
As with any other quick and easy financial calculation, there are pros and cons to be aware of when using the 1% rule.
One of the advantages of the 1% rule is that it is a good formula for prescreening and comparing rental properties to one another. If an investor is analyzing 10 potential rental properties to invest in and 8 pass the 1% rule, those 8 homes may be worth a closer look and the 2 that don’t pass the test might be set aside.
There are also times when an investor may look at a property even if the home doesn’t pass the test. For example, an investor focused more on appreciation than cash flow may find that homes in rapidly appreciating real estate markets don’t always meet the 1% rule because it might take up to a year for the fair market rents to catch up.
One of the drawbacks of the 1% rule is that there are a variety of factors that the rule doesn’t take into account, such as repairs and maintenance, property taxes, homeowner association (HOA) dues, or the neighborhood ranking. The Roofstock Neighborhood Rating index is a good free tool to use to better understand the potential risks and rewards of different neighborhoods.
Items like these may have a significant impact on potential return on investment (ROI) even when a property generates enough rent compared to the purchase price to pass the 1% rule.
To illustrate, let’s look at two similar SFR homes:
|SFR #1||SFR #2|
|Gross monthly rent||$1,250||$1,100|
At first glance, SFR #1 appears to be the better investment. After all, it has a higher monthly rent compared to the purchase price and passes the 1% rule.
However, operating expenses are significantly greater, maybe due to higher property taxes or an older home requiring a lot of ongoing repairs. Based on the potential cash flow before paying the mortgage, SFR #2 may be the more profitable investment based on this example.
Other real estate calculations to know
In addition to the 1% rule, there are several other real estate calculations an investor can use when analyzing a rental property:
The 2% rule is a more stringent version of the 1% rule. In order to pass the 2% rule, the gross monthly rent must be equal to at least 2% of the property value or purchase price. The 2% rule may be a good calculation to use in less expensive markets, or for a home that will need a significant amount of repair in the next few years.
The 50% rule assumes that operating expenses, excluding the mortgage payment, will run about half of the gross rental income. Looking back at the 2 SFRs in the previous section, SFR #2 meets the 50% rule, while operating expenses in SFR #1 run 64% of the gross rent.
Investors who fix and flip homes or purchase property that needs a significant amount of repairs and updating use the 70% rule. The rule states that an investor should pay no more than 70% of the after repair value (ARV) of a home, less the cost of repairs.
For example, if the projected ARV of a home is $150,000 and the estimated repairs are $25,000, the maximum purchase price based on the 70% rule would be $80,000:
- $150,000 ARV x 70% = $105,000 - $25,000 estimated repairs = $80,000 maximum purchase price
Gross rent multiplier
The gross rent multiplier or GRM forecasts how long it will take to pay for a property based on the gross rental income. As a rule of thumb, the lower the GRM is, the more gross rent there is relative to the purchase price, and the more profitable an investment could be. To illustrate, let’s look at the GRMs of 2 single-family rentals:
- SFR #1: $125,000 purchase price / $15,000 gross annual rent = 8.33 GRM
- SFR #2: $125,000 purchase price / $13,200 gross annual rent = 9.47 GRM
On paper, SFR #1 appears to be the better investment based on the GRM. However, one of the biggest drawbacks of the GRM is that it doesn’t factor in operating expenses. As the previous section illustrated, even though SFR #1 passed the 1% rule and has a lower GRM, SFR #2 generates a larger amount of potential cash flow due to lower operating expenses.
The cap rate calculation overcomes the drawbacks of the 1% rule and GRM by taking into account a property’s operating expenses. Cap rate is the percentage rate of return calculated by dividing net operating income (NOI) by the property purchase price. NOI is determined by subtracting operating expenses (excluding the mortgage payment) from gross rental income. The higher the cap rate is the greater the return will be, everything else being equal:
- SFR #1: $15,000 gross annual rent - $9,600 operating expenses = $5,400 NOI / $125,000 purchase price = 0.043 or 4.3% cap rate
- SFR #2: $13,200 gross annual rent - $6,600 operating expenses = $6,600 NOI / $125,000 purchase price = 0.053 or 5.3% cap rate
Based on the cap rate calculation, SFR #2 is the better buy in this example, even though the home didn’t pass the 1% rule and has a higher GRM.
The 1% rule in real estate is a quick and easy calculation investors use to help decide which potential investments are worth taking a closer look at. However, the 1% rule doesn’t take into account property operating expenses that can have a significant impact on returns. That’s why, in addition to the 1% rule, investors also use calculations such as the 50% rule and cap rate calculation to estimate operating expenses and potential return.