If you’re an active real estate investor, then you’ve probably heard of the 1% rule. This tool is a guideline to help you determine whether the monthly income you earn from a rental property will exceed your monthly mortgage payment.
But is the 1% rule accurate or are there better strategies you can use to assess a rental property’s value? That’s exactly what this article will discuss.
What Is The 1% Rule?
The 1% rule is also sometimes written as the 1 rule in real estate or 1 percent rule. But regardless of how it’s spelled, the underlying principle is still the same.
The 1% rule is a strategy used in real estate investing to determine your cap rate. It states that when evaluating properties, investors should calculate monthly rent to be at least 1% of the total purchase price.
Here is the formula for the 1% rule in real estate:
Monthly Rent ≥ 1% of Total Investment
The idea being that if you can meet the 1% rule, you should be able to meet your monthly expenses and generate a positive cash flow on the property.
How To Use The 1% Rule
So how does the 1% rule work out in real life? Well, let’s say you’re looking at investing in a rental property that costs $150,000.
Using the 1% rule, you should be able to charge $1,500 in monthly rent. From there, you can focus on obtaining a mortgage payment under $1,500. This ensures that you can meet your monthly payments and earn some money on the side.
Is The 1% Rule Realistic?
Many people find the 1% rule helpful, but there are some shortcomings with using this strategy. For one thing, properties that fail to meet the 1% rule are not necessarily bad investments.
And likewise, properties that do meet the 1% rule are not automatically good investments either. And you can’t necessarily use this formula across all real estate markets.
Let’s look at a few examples of when the 1% rule can work for you, and when it doesn’t.
When It Works
The 1% rule can be useful as a tool for prescreening rental properties. If you’re evaluating many different properties, then using the 1% rule can help you quickly narrow down your list of properties and identify the ones that may be a good investment. From there, you can do additional research on those properties.
When It Doesn't Work
The 1% rule shouldn’t be used as the determining factors as to whether or not you’ll invest in a property. Before buying a rental property, you should always consider the neighborhood, the condition of the property, and current market trends.
And the 1% tool is best used when you’re looking at smaller single-family homes. If you’re looking at high-priced markets or multifamily units, then 1% rule may be too small.
Alternatives To The 1% Rule
Let’s look at a few other metrics investors commonly use to evaluate real estate purchase decisions.
Gross Rent Multiplier
The gross rent multiplier is a calculation you can use to determine how long it will take to pay off a rental property. It compares your annual rental income to the fair market value of a property.
Here is the formula you’ll use:
Gross Rent Multiplier = Property Price / Gross Annual Rental Income
You’ll typically use the gross rent multiplier in addition to the 1% rule, but not necessarily as a replacement. It’s another tool to help you determine the profitability of a rental property.
The 70% rule states that an investor should only pay 70% of the After Repair Value (ARV) of a property, subtracting the cost of repairs. This is a formula used by investors who actively flip houses.
It will help you determine the maximum price you can pay for a property while still earning a profit. However, you may need to adjust your calculations depending on the market you’re in.
For instance, you may be able to raise the percentage to 80% in a high-end market. Whereas you’d probably need to lower the percentage in low-end markets.
According to the 50% rule, you should assume your operating costs will make up 50% of your gross income. So, for instance, if a property generates $12,000 per year in rental income, you should expect that $6,000 will go toward expenses.
And these expenses don’t include the monthly mortgage payments. Instead, it refers to things like property taxes, maintenance, and utilities. This can help you determine what your monthly cash flow will look like.
The 2% rule is similar to the 1% rule. It states that if your monthly rent is at least 2% of purchase price, you should be able to generate a fair amount of cash flow.
The problem is, many investors have a hard time meeting the 1% rule, so finding property that meets the 2% rule is even harder. In order to do this, you’ll likely have to invest in a less-expensive market. And you’ll need to think outside of the box and find unique strategies for boosting the rental income.
The Bottom Line
The 1% rule isn’t foolproof, but it can be a good tool to help you whether a rental property is a good investment. As a general rule of thumb, it should be used as an initial prescreening tool to help you narrow down your list of options.
If you’re just getting started in real estate investing, it’s important to find a mortgage that fits within your long-term investing goals. If you’re not sure where to start, consider talking to a Home Loan Expert at Rocket Mortgage®.