Finding the right real estate investment is hard. Many factors influence the profitability of rental properties, and what matters most in a real estate investment is the bottom line. You need to know you’ll make money on the investment.
But how do you know whether a rental property will produce positive cash flow?
The 1% rule was created to help real estate investors answer that question. It serves as a quick analysis of a rental property to help weed out poor investments. It isn’t a definitive tool, but it can help guide your decisions when comparing potential rental properties.
What Is The 1% Rule In Real Estate?
The 1% rule in real estate investing is an easy screening tool that can be used to eliminate poor investment properties. It isn’t a hard and fast rule, but more of a guideline that will help direct your real estate investment decision.
The 1% rule of real estate investing states that the gross monthly rent should be at least 1% of the purchase price of an investment property. Meeting the 1% rule indicates a rental property will be profitable but does not guarantee it. The best use of the 1% rule is comparing potential real estate investments.
Because the 1% rule only considers the price of the property and the gross rent, it omits other important factors that impact the cash flow of a rental property. Expenses, for example, are completely missing from this formula and may be significantly higher on one property than another. Relying solely on the 1% rule can lead you to poor investments.
So, the 1% rule shouldn’t be used alone, but in conjunction with other tools like cash flow analysis.
How To Calculate The 1% Rule
Calculating the 1% rule is simple; you just divide the gross monthly rent by the purchase price of the property. If the number is greater than or equal to 1% (0.01), the property passes the test.
For example, let’s consider a property that costs $250,000 and has a gross monthly rent of $2750. The rule would yield $2750 / $250,000 = 0.011 or 1.1%. This property would pass the test.
If the same property instead had a gross monthly rent of $2000, the rule would be $2000 / $250,000 = 0.008 or 0.8% and would not pass the test.
Does this mean you should purchase the property if it had the $2750 rent and not if it had the lower $2000 rent? Nope. That’s not the purpose of the 1% rule. You still have to consider many other factors before buying a rental property.
Does The 1% Rule Work Today?
If you have spent any time looking at real estate investments, you probably see very few, if any, properties that satisfy the 1% rule. This is because the price of real estate has outpaced the price of rent, especially since the collapse of the last housing bubble in 2008. The Federal Reserve Bank has a good article showing the change in price to rent ratio if you want to learn more. The price to rent ratio is essentially the inverse of the 1% rule.
In addition to the overall rise in price to rent ratios across the US, each city or state differs. If you live in a large metropolitan area, you’ll see a much higher price to rent ratio than say, Diller, Nebraska.
The 1% rule was created when the cost of housing was much cheaper compared to rent. There was even a time when the 2% rule was used. But these days are gone, at least for now. So the 1% rule doesn’t apply today as it was written, but there is a concept used in the rule that does work no matter what housing or rent prices are doing.
That concept is a comparative analysis of the price to rent ratio. As a general rule, the lower the price to rent ratio, the more potential cash flow returned to the investor. Just like the 1% rule, however, this does not account for expenses so should be used as a screening tool rather than a deciding factor. If you’re looking at a handful of properties, the price to rent ratio can be used to screen out the less desirable choices.
Real estate investors commonly use the concept of price to rent ratio when calculating gross rent multiplier. Gross rent multiplier is the same as the price to rent ratio except it uses annualized rent instead of monthly average rent.
How To Use The 1% Rule
While the 1% rule doesn’t hold up to its original intent, it can still serve as a valuable tool for real estate investors. Rather than looking only at real estate that satisfies the 1% rule, an investor should use this rule as a comparative tool for different investments.
If you’re looking at similar properties in the same geographical area, the 1% rule can be used to compare these properties. For instance, if you’re looking at a selection of properties that are 0.8%, 0.7%, 0.55%, and 0.3%, you can probably focus on the properties with the higher percentage and ignore the 0.3% and maybe even the 0.55%.
Remember that the price to rent ratio (the inverse of the 1% rule) varies depending on the real estate market, both in terms of geographical area and time. So you may see very different results depending on what part of the country you want to invest in.
What’s important is that you use the 1% rule only as a screening tool for potential investments. The 1% rule isn’t a substitute for a full financial analysis of the rental property.
Once you have refined your list of properties using the 1% rule, you should move on to a more detailed analysis of the cash flow.
Summary
The 1% rule was created in a time with much lower price to rent ratios and was an effective tool to screen for real estate investments at that time. While the 1% rule doesn’t hold up in today’s real estate market, it can still be useful to real estate investors.
Real estate investors can use the 1% rule to compare different investment properties across a city or metropolitan area. But investors should be cautious against relying too heavily on this comparison because there are many other factors to consider in real estate investing.
What other rules do you use when considering a real estate investment?