As you dive into the world of real estate investing, there are a few rules that you should use to evaluate deals. The 1% rule in real estate is a useful calculation to help you determine whether or not a property will be a good choice for you.
Today we will take a closer look at the 1% rule and how it will affect your real estate plans.
What is the 1% rule in real estate?
The 1% rule in real estate is a rule of thumb that can help you determine whether or not a property will be a good deal. The rule outlines that your monthly gross rent should be equal to at least 1% of the total investment in the property. The total investment of the property will include the purchase price, plus any upfront renovations that you have to do.
You should think of the 1% rule as a starting point. It is a good way to weed out properties that aren’t going to be very profitable. As you scan listings, you should be looking for deals that satisfy the 1% rule.
How to calculate the 1% rule in real estate
Don’t worry! Calculating the 1% rule will not require any complicated math. In fact, you’ll find that it is extremely easy as a back of the envelope calculation.
In order to calculate the 1% rule, you’ll need to multiply the upfront cost of the property by 1%. Here’s the formula to do that:
(Purchase price + upfront renovations) X 1% = 1% of the purchase price
1% of the purchase price < gross monthly rent
For example, let’s say you buy a home for $95,000 and conduct $5,000 in upfront renovations. That would lead to a total cost of $100,000. With that, 1% of the purchase price would be $1,000 in gross monthly rent.
Ideally, you want the gross monthly rent that you would expect the property to bring in to be higher than the 1% rule. For example, let’s say you bought a house for $150,000. If you are only able to rent that house out for $1,000 per month, then the property would not satisfy the 1% rule. However, if you were able to rent out the property for $1,600, then you would more than satisfy the 1% rule.
What is the 2% rule?
The 2% rule is very similar to the 1% rule. However, you’ll look for a property that is able to gross 2% of your upfront investment on a monthly basis. It can be more difficult to find properties that are able to satisfy the 2% rule.
In order to calculate the 2% rule, use the formula below:
(Purchase price + upfront renovations) X 2% = 2% of the purchase price
2% of the purchase price < gross monthly rent
Let’s look at an example in which you buy a property for $150,000. In order to meet the 2% rule, you’d need to rent out the property for at least $3,000 per month. If you were only able to rent out the property for $2,000 per month, then you wouldn’t be able to satisfy the 1% rule. However, you would be able to satisfy the 1% rule in that case.
Is the 1% rule realistic?
It is important to note that the 1% rule in real estate is a rule of thumb. With that, it is absolutely not a hard and fast rule. In some markets, the 1% rule is not feasible at all. In other markets, you can easily find properties that will satisfy the 2% rule.
Let’s explore a few markets around the country that may or may not satisfy the 1% rule.
- In Los Angeles, California, the median sale price is $760,200. But the median rent price is $3,500. With that, you would have difficulty satisfying the 1% rule in this market.
- In Miami, Florida, the median sale price is $336,400. But the median rent price is $2,450. You would still have trouble finding properties that satisfy the 1% rule, but it would be a more manageable gap.
These are just a few examples in which you can see that the 1% rule might not always be feasible. If you are sticking to the 1% rule in those markets, then you might never be able to pull the trigger on an investment purchase. After all, you might be waiting a long time for the right property to come along at the right price.
Since it’s not a useful calculation in all markets, then you might be wondering why so many real estate investors talk about this rule. That’s because it is a great starting point. You can use the 1% rule to quickly assess the cash flow opportunities of a property. Based on the market conditions in the area you want to invest in, you can adjust the rule to reflect a realistic rate of return.
The other option is to look for areas to invest in that would allow you to hit the 1% rule. You might look to become a long-distance landlord in order to capitalize on the promise of the 1% rule.
Pros of the 1% rule
The 1% rule is used commonly by real estate investors in markets across the country because it allows them to easily assess the profitability of a property quickly. With the 1% rule, you can make quick comparisons to the market rental rates of the property. You’ll quickly be able to determine whether or not the property is a good fit for your real estate portfolio.
If you are sifting through properties, it can be a good way to sort through your options. If you have a set rule in mind, then you are more likely to stay on track with your investment goals.
Cons of the 1% rule
The problem with the 1% rule is that it doesn’t paint a complete picture of the investment. Although you can make some quick assumptions through this quick math, you’ll still need to investigate the property further to assess its profitability.
Beyond the 1% rule, you should consider other details such as the location, condition, net rental income potential, repairs, expected costs, and more. As you move forward with a real estate decision, make sure to consider all of the factors. Don’t move forward simply because a property satisfies the 1% rule.
Other factors that will influence your return
In addition to the 1% rule, you should consider other factors when evaluating the viability of a real estate investment.
A few that you should consider include:
What is the population like in the area? Are there plenty of employment opportunities? Or is there a particularly volatile industry that employs the majority of residents?
Take some time to do your research about the area. You want to make sure that your investment has the potential to grow in value over time.
So much of investing will boil down to your personal risk tolerance. If you have a lower risk tolerance, then you’ll likely want to seek out properties that absolutely meet the 1% rule. If you are comfortable with a little bit more risk in your portfolio, then you may move forward with properties that don’t satisfy this general rule of thumb.
Beyond cash flow, appreciation is another way to make money with real estate.
Simply put, appreciation is the rise in the value of a property over time. For example, let’s say you bought a property valued at $100,000 today. Over the next five years, you add an extra bedroom and make some cosmetic tweaks. In addition, the real estate market in your area becomes a very hot commodity. At the five year mark, you may notice that your property is now worth $150,000. With that, your property has appreciated by $50,000 in the last 5 years.
It is easy to see how appreciation could be a potentially viable way to grow your net worth through real estate investing.
You can and should seek out areas that are poised to allow for an increase in property values over time. Of course, you cannot predict the future in terms of which properties will appreciate. But it can be a good idea to keep an eye out for properties that are on track to appreciate over time.
PRO TIP: One of the biggest ways people lose money in real estate is to do an appreciation only investment play. They buy a property that needs work and doesn’t have cash flow, all in the hopes that the market will go up enough so they make their money on the appreciation. This is how so many people went bankrupt back in 2007 & 2008.
Even with a beautiful space to rent out, you will likely encounter vacancies at some point. The turnover between tenants can cut into your bottom line. Not only will you have to cover any turnover costs, but also do so without any rental income.
The goal is to get new tenants into the unit as quickly as possible. But sometimes it can take longer than you would like.
PRO TIP: It is generally cheaper, and better for your bottom line to keep an existing tenant than have them move out and deal with a vacancy. The longer you can keep your tenants, the lower your vacancy rate. And this means more money in your pocket.
Repairs can also make a dent in your bottom line. Although some repairs are something that you can plan for, not everything will go according to plan. For example, you can plan for your roof to wear out at the end of its useful life. But storm damage could require you to move up that repair date. Plus, other repairs throughout the house will likely pop up throughout your ownership of the property.
In order to prepare for vacancies and major repairs, it is a good idea to build an emergency fund for that exact situation. You never know when a major repair will pop up. You’ll need to find a way to fund that emergency. But it can be stressful without an emergency fund available.
Each of these factors should play a part in your decision to purchase a property.
Is it possible to still make money if a property doesn’t meet the 1% rule?
It might be easier to make money on a property that satisfies the 1% rule. But it is still absolutely possible to make money on a property that doesn’t meet the 1% rule.
When you are looking to make money on a property that doesn’t meet the 1% rule, you should expect to rely more heavily on the appreciation. You will need the property to appreciate nicely in order to make a solid return on your investment.
For many investors, they consider the idea of relying on appreciation to be speculative investing. In many cases, investors view the idea of speculative investing as a bad option. However, the strategy is not necessarily bad but it does pose more risk.
The good news is that you can increase the value of a property through a variety of creative solutions. You could make some updates to the space to make it more appealing such as cosmetic upgrades or adding an extra bedroom. Plus, if you are a buy and hold investor, then you’ll have decades of appreciation potential to allow your property to become profitable for you.
So yes, you can make money even if a property doesn’t meet the 1% rule in real estate. Just be prepared to explore different options for profitability.
Should you use the 1% rule?
The bottom line is that it is possible to purchase a profitable property even if it doesn’t satisfy the 1% rule. However, you’ll be relying more on appreciation than cash flow for your returns. Before you decide to exclusively work with the 1% rule in real estate, or not, decide what your investment goals are.
If you are trying to build a portfolio that will generate a relatively passive income through positive cash flow, then the 1% rule might be very useful. If you are attempting to build wealth through appreciation of real estate assets, then the 1% rule might not be the best guideline for you.
As you know, personal finance and real estate investments involve very personal decisions. You need to make sure that you are comfortable with your decision to move forward with the 1% rule. Make sure that the rule fits into your real estate goals and then use it as a starting point when you are evaluating future properties.
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In 2018 FI by REI was created with the purpose of helping individuals that want a better life. We share articles on personal finance, house hacking & real estate investing, and more.