The 1% Rule in Real Estate: Is This a Realistic Way to Evaluate Rentals?
I have something to admit to you here. It is something I spent four years in college studying. It is something that gets tossed around in the real estate world all the time. Yet, I really don’t pay much attention to it. I may look back on this and feel it was quite unintelligent to admit, but I want to be honest.
Here it is:
I really pay very little attention to the “acronyms”: cash-on-cash return (COC), return on investment (ROI), et cetera (ETC).
Have you ever listened to someone who is just raining down acronyms on you? If that’s not how you always go about analyzing deals either, you are not alone. While this next gauge is certainly not embedded in years of financially charged research and development, I do find it to be a good quick-use calculation when analyzing a property.
I’m referring to the 1%, 2%, and even 3% rule (and beyond). This type of calculation effectively considers the price of the property versus the gross rental income it can generate.
How to Use the One Percent Rule
Here’s the quick-and-simple math behind the 1%, 2%, or 3% rule when evaluating potential investment properties.
Example 1: Joe purchases a house for $100,000 and believes he can rent it out for $1,000 per month. This purchase allows Joe to reach the 1% rule as $1,000 in rent is 1% of the $100,000 purchase price.
Example 2: Suzy buys a triplex for $225,000 and rents out each unit for $1,500. Her total gross income is $4,500 per month. Suzy has reached the 2% rule. $225,000 times 2% is $4,500.
Example 3: Ryan purchases a triplex and fixes it up. He is into the triplex for $160,000 with a hard money loan. On average, each bedroom rents for approximately $525. Each of the three units have three bedrooms. Therefore, each unit earns about $1,575 ($525 times 3 bedrooms). The entire triplex earns $4,800 ($1,575 times 3 units, plus $75 per month for the leasing of the garage on site) gross rent each month. Ryan reaches the 3% rule with this property as $4,800 is 3% of $160,000.
A few points on this rule. I do believe it is area-specific. As you can see, in the third example, I am personally able to reach the 3% rule. A few factors go into this, however. First, I am renting out by the room, which boosts my cash flow dramatically. Second, the market I am in allows for purchase of a small multifamily property for a relatively low price.
For places like Hawaii, San Francisco, Washington, D.C., New York City, etc.—place that are extremely expensive to buy in—investors are outrageously excited to even touch the 1% rule.
With all that being said, I do believe it is very possible to still hit this metric. Here are a few ways to help you get there.
How to Meet the One Percent Rule
Here are a few ways to ensure an investment property will generate monthly rent equal to or greater than 1% of the total purchase price.
1. Invest in a market that is not expensive.
I invest from 1,500 miles away and self-manage, too. It is possible.
2. Employ a unique strategy to boost rental income.
I personally accomplish this by renting by the room. Alternatively, you could rent out extra spaces like a garage or buy coin-operated washers and dryers.
3. Buy in an area with strong rental demand.
This theoretically allows for incremental increases in rental rates each year.
4. Buy off-market.
Most properties on the MLS are overpriced in my area. Try working with wholesalers to get a better deal. Or start a marketing campaign targeting property owners in your chosen area.
5. Buy a property with under-market rent and deferred maintenance for a lower price.
Make the necessary repairs, and raise the rent to the appropriate level.
The Bottom Line
For someone who usually takes a pass on using a lot of these investor metrics, I do enjoy this particular rule.
As mentioned, it’s not a “carved in stone” sort of guideline. Meaning, if you’re shooting for the 2% rule and a property of interest is at 1.9%, just buy the property. Do not pass just because it does not hit or exceed this metric.
It is more of a gauge than a rule, in reality. I particularly enjoy using it when I am taking a quick look a possible investment property.
I happen to be good at math, but for those of you that are a little shaky on your multiplication tables, this is an easy way to swipe left or swipe right on a property. You can make a fast judgement call as to whether it is worth really digging into the numbers or whether you should just move on to the next one.
Lastly, know your area, and set a range for yourself. I am looking for something right around 2.5% or so—2% is the minimum and 3% is a home run.
While at this point, we know this not to be the end all, be all rule, be sure to know how to calculate it on the fly.
Gross Rent/Purchase Price
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This way you can look like a pro when analyzing or passing on deals. Of course, the best reward of all is this should save you time from having to analyze deals that should have never even made it onto your desk in the first place. Let’s save our precious time for those deals really worth analyzing.
Do you have questions about anything above? Have you heard of a better way to quickly analyze potential properties?
Let’s talk in the comment section below.