When evaluating a potential investment property, the 1% rule in real estate investing and the 2% rule are valuable tools for evaluating real estate investments in specific scenarios. With some quick math, investors can screen potential rental properties to determine if any are worth pursuing further. These rules are simple, quick tests that help determine if a property’s rent-to-value ratio is healthy. That being said, they are not hard and fast rules.
To help you understand the benefits of using these rules, let’s go over when and how to use them when evaluating a real estate investment property, potential drawbacks of the rules and additional real estate investing tips.
What is the 1% Rule in Real Estate Investing?
The 1% rule in real estate determines whether the monthly rental income earned from the property is more than or equal to one percent of the purchase price.
Monthly Rental Income ≥ One Percent of Purchase Price
You can get the same result by reversing the 1 percent rule:
[100 x Monthly Rent = Maximum Purchase Price]
For example, if a property rents for $1,500 per month, after a quick calculation, you know that the purchase price should be around $150,000. Remember, the rental market dictates rental values, not the purchase price of a home.
How the 1% Rule Works
To calculate, multiply the purchase price of the property plus any necessary repairs by 1%. If you’re financing, compare the result to your potential monthly mortgage to get a better understanding of a property’s monthly cash flow. Note: The 1% rule is best used as a quick, “back of napkin” litmus test to determine whether rent-to-value ratios are balanced or not. It doesn’t account for additional costs like property insurance, taxes and maintenance.
Example of the 1% Rule
Let’s assume you are looking to get a mortgage loan on an investment property with a value of $200,000. Using the 1 percent rule, we multiply $200,000 by 1%. The result is $2,000.
The result of the 1% rule tells us is that the mortgage payment each month should be no more than $2,000. If the mortgage owed exceeds $2,000 per month, it will be difficult to earn positive cash flow on the investment property.
An exception would be if you are confident you can rent the property for more than $2,000 per month. In most cases, it’s wise for investors to dig deeper into numbers beyond the 1% rule to adequately determine if they add up and whether there’s a good opportunity for a positive return on investment.
Takeaways:
- According to the 1% rule in real estate investing, rental income should be equal or exceed the purchase price.
- Take the purchase price of the property plus expenses for necessary repairs and times that by 1% to determine whether rent-to-value ratios are healthy.
- Rental markets dictate what a property can rent for, not the price of the home.
The One Percent Rule vs Other Useful Real Estate Investing Calculations
As students of real estate investing, we learn that there are dozens of useful and crucial calculations that should be determined throughout the buying process. While the 1% rule is a quick and easy way to evaluate rent-to-value ratios, we know it’s only one of many indicators to look at before buying an investment property.
Here are a few additional useful real estate investing calculations:
- Gross Rent Multiplier: Used to gauge an asset’s relative gross income earning potential. It tells you how long until the asset will starts earning gross income to the purchase price. To calculate, take the fair market value of a home or the purchase price divided by the gross rental income.
- The 70% rule: This rule suggests what an investor should pay for a fix-and-flip property in order to make money. The rule says that investors should pay 70% of the estimated after repair value (ARV) of a property minus repair costs. Remember, this metric is mostly used on fix-and-flip properties.
- The 50% rule: Used for a quick analysis of a single family investment property. The rule says, on average, the total operating expenses will be about 50 percent of the gross rents. The 50% rule is long-term average estimate. So, roughly half of the generated revenue gets spent on operating overhead costs over the long term. While you may enjoy years with low bills, eventually, you will have to replace the gutters, roof, A/C, electrical, etc.
For a complete glossary of real estate investing terms, definitions and calculations, check out our Top 54 Real Estate Definitions for Investors to Know.
What is the 2% Rule in Real Estate Investing
Like the 1% rule, the 2% rule in real estate can help investors measure rent-to-price ratio. This rule of thumb uses the same idea as the 1% rule. However, The 2% rule suggests that a rental property is a good investment if the money from rent each month is equal to or higher than 2% of the purchase price. How useful is the 2 percent rule? These days, it’s almost completely obsolete and rarely used. However, investors that buy distressed properties in D & F neighborhoods might use the 2% rule.
How the 2% Rule Works
To calculate the 2% rule, multiply the purchase price of the property plus any necessary repair costs by 2%.
Depending on what an investor is looking to get out of a rental property, if it doesn’t meet the 2% rule, it could still be an opportunity to invest for appreciation. You must decide if your long-term goal is appreciation or if it’s monthly cash flow. Once you have a better idea of your goals, you can choose whether to use or not use the 2% rule based on your real estate investment goals.
Please note: Very few investment properties follow the 2% rule.
Example of the 2% Rule
Let’s assume you buy a $150,000 investment property. Using the 2 percent rule, times $150,000 by 2%. The result of the calculation is $3,000. This tells us that the mortgage should be no more than $3,000 per month.
When to Use the 1% Rule and 2% Rule
The 1 percent and 2 percent rules are only useful at the initial phase of evaluating real estate investments. Use the 1 percent rule as a prescreening tool. The 2 percent rule is rarely used as a screening tool anymore.
When Not to Use the 1% Rule and 2% Rule
These days, many real estate experts completely disregard the 1 percent and 2 percent rules.
The markets where properties meet the rule criteria usually aren’t in the best neighborhoods. And to meet the 2 percent rule, rental properties must be on the less expensive end. Which sometimes means an investor will be paying more for repairs and maintenance because the property is “cheaper.”
We would not recommend buying a home that meets the 2% rule to our investors as it will very likely be located in a D or F neighborhood and in poor shape.
Regardless of these concerns, some investors still find the 1% rule a helpful indicator under the right circumstances.
Drawbacks of the 1% and 2% Rules
We know the 1% rule in real estate investing and the 2% rules have a number of drawbacks. While these rules can help investors determine if healthy rent-to-value ratios exist in the market, they do not stand on their own as key determinants of a successful investment.
The following are a few of the drawbacks of the 1% and 2% rules:
- Only useful for evaluating the rent-to-value of a property and it doesn’t necessarily paint the whole picture of investment potential.
- Does not account for other property expenses, like mortgage and acquisition fees, closing costs, repairs and maintenance, insurance, property taxes, and so on.
- Does not tell you about the property’s condition, location, net rental income, cash-on-cash (COC) return, cap rate or appreciation.
- It may not even be possible to meet these rules in most markets. If you want to follow the rule(s), you can buy in other markets or lower your criteria (0.8 percent).
The 1% and 2% rules in real estate investing can be helpful tools when evaluating a property. But it is merely a quick litmus test in determining whether rent-to-value ratios are healthy. What’s really important is a property’s net income, or how much money is left over after all expenses have been paid.
Using the 1% Rule in Real Estate Investing Today
Investors who only use the 1% rule to decide which properties to take a closer look at are likely missing out on great deals. The 0.8% rule could be the new 1% rule. To give you the best shot at a successful real estate investment, set goals for a property’s cap rate and net income after financing.
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