There are many moving parts to a buy and hold property purchase, which brings up the question, “where do you start?” Many successful individuals begin with the 1% rule for real estate investing. It’s a simple calculation and baseline metric that gives you a good idea if a rental property is worth investing in, or if you should move on. This rule of thumb is used by well-known real estate geniuses, millionaires, and the like. This, in itself, is a testimony that the 1% rule is certainly worth looking into. So let’s begin!
The 1% Rule for Real Estate Investing Can Guide You in the Property Evaluation Process
Like most real estate investors, you may have a goal of maximizing your cash flow, creating passive income, growing your portfolio, and becoming financially independent. These are fantastic goals to have and a good strategy is needed to achieve them. This is where the 1% rule comes into play.
When considering a buy and hold real estate purchase, it’s always a smart decision to start with the 1% rule. Its calculations can certainly set you on the right path and keep you from heading down the road to regret. Although an investor should never decide to move forward with a deal solely based on the 1% rule for real estate investing, it’s a great property screening tool or jumping-off point. When put into action, it can potentially save you both time and money.
What is the 1% Rule?
The 1% rule is a simple calculation that can give investors an indication if a property can potentially yield a gross monthly rental cash flow of at least 1%, or more, of the total purchase price (some investors include the cost of their upfront renovations and repairs into this calculation). This baseline calculation can help determine if the projected gross cash flow is high enough to cover monthly expenses while also leaving the investor with a positive cash flow.
The 1% rule calculation is as follows for a piece of real estate that has an asking price of $100,000:
Property Purchase Price × 1% = Monthly Rent
($100,000 × 1% = $1,000)
It’s a starting point analysis that allows an investor to determine if the asset makes sense financially, and from there, it can be further analyzed. Let’s breakdown the one percent rule even further with a few examples:
A. Rental Property that Passes the 1% Rule: An investor is considering a piece of real estate for a purchase price of $150,000. The property’s condition and its neighborhood allow for a rent of $1,500 a month. This meets the 1% rule, which means the investment is worthy of evaluating further to ensure it’s, in fact, a good deal.
B. Rental Property that Does Not Pass the 1% Rule: An investor is considering a piece of real estate for $200,000. The property has been newly renovated and looks fantastic, but it’s located in a neighborhood where crime is on the rise, which has brought the rents down considerably in the area. Based on the going rate, the max monthly rent that the investor will receive for this piece of property is $1,200. For this property to meet the 1% rule, it would have to rent out for $2,000 a month. In sum, this property does not pass the 1% rule because its monthly rental cash flow is $800 below the 1% minimum.
Why is the 1% Rule Important When Evaluating a Potential Real Estate Investment?
When evaluating buy and hold properties such as single-family homes, duplexes, triplexes, and the like, starting with the 1% rule can set you on the right path for the following reasons:
1. The 1% Rule is an Essential Starting Point for Evaluating Buy and Hold Properties
The 1% rule for real estate investing serves as a beginning gauge in analyzing a real estate asset’s financial risk or positive cash flow potential. It can make the search for successful real estate deals more streamlined, efficient, and profitable. This is done by quickly eliminating suspected low cash flow generating buy and hold real estate. For instance, let’s say that an individual has ten investment properties lined up to visit. He applies the 1% rule to all ten properties in less than 10 minutes, weeding out the properties that may be a potential waste of time to view. This frees up valuable time to focus on other rental real estate that may yield the proper cash flow.
2. Determines if there is a Baseline Cash Flow that Makes Sense
Although many factors come into play when calculating a buy and hold property’s cash flow potential, the 1% rule for real estate investors is a great way to determine if the cash flow at least makes sense upfront. If your 1% rule calculations show that you require a higher rent than what can actually be collected, you may come up short after your mortgage and operating expenses are paid. This reveals that the property’s cash flow factor may deem the deal not worthy of looking into any further. After all, you most likely became a real estate investor with the goal of getting ahead of the game financially. With this in mind, ensuring that a real estate asset has the potential of securing a positive monthly net income is what can set successful investors apart from the hit-or-miss investors.
3. 1% Rule Helps Set Target Rental Rates
It can be a bit confusing for some investors when figuring out what to charge their tenant for monthly rent. At the same time, it’s imperative that the final number that’s sealed in a rental agreement is enough to produce a positive cash flow. The 1% rule serves as a useful guide in figuring out your target rental rate. A rule of thumb would be to set the rental amount to 1%, or more, of the property purchase price. This 1% buffer can be used to better your chances of having money left over after all your rental property expenses are paid.
Here is an example of the 1% rule to elaborate on the above points:
A real estate investor is considering a single-family home rental property for $100,000. He uses the 1% rule to determine that the rent would need to be at least $1,000 per month for the deal to have a potential positive cash flow. From his market research, he knows this amount per month is feasible, so he moves forward with the deal after it also met certain other criteria.
After his purchase, his tenant is placed, and his first month yields the $1,000 he was expecting. He now pays his monthly mortgage of $450, and operating expenses of $365, which leaves him with a total net income of $185 per month. In this case, the 1% rule predicted a positive cash flow, and deemed the property was worth looking into further.
Imagine if the numbers were slightly different, and the calculations were not taken into consideration while vetting the property. What if the investor figured out late in the game that he needed at least $1,000 a month in rent, but the property can only be rented for $800. In this second scenario, with the same expenses, the investor would be in the red each month for -$15. The property would clearly not be worth investing in with a net loss such as this, and he would have known this from the start by using this helpful calculation. Are you starting to see the usefulness of the 1% rule for evaluating rental real estate?
What Should You Consider Next After a Rental Property Passes the 1% Rule?
Since you shouldn’t base a purchase solely on this calculation, once a property passes the 1% rule, it’s time to dig deeper to further confirm that the asset is a deal worth committing to.
There are a few elements you will want to take into consideration to properly run the numbers on the buy and hold property you are considering:
1. Certain Aspects of a Rental Property That May Influence Your Projected Bottom Line:
Investors typically do a quick calculation with the 1% rule, and most likely some quick research into the allowable rent for the single-family home, duplex, or another type of real estate asset they are considering. However, there are several questions an investor might want to ask themselves to confirm the monthly rent estimate is what they thought it to be, and to estimate what it might be in the years to come.
- What are the current tenants paying? If vacant, what have tenants paid in the past?
- How is the quality of the neighborhood the potential buy and hold property is in?
- What does the property’s overall rental market look like?
- Is the property old and in rough shape, or is it in good or at least fair shape?
- Is the home price appreciation on the rise for the city and specific neighborhood?
- How are the demographic and socioeconomic trends in the area looking?
- Is this area prone to high foreclosure rates and vacancies?
- How many days has the real estate asset been on the market for?
2. Real Estate Purchase Costs That May Not Have Been Added to Your 1% Rule Calculations:
There can be quite a few closing costs involved in the purchase of a real estate investment. If you have a general idea what those may be, it’s wise to add those numbers into the mix so they don’t end up having a surprise negative impact on your bottom line. Some investors may include a few of these costs into the loan total, and are therefore already calculated into the 1% rule. Here is a short list of typical closing costs for a rental property:
- Appraisal Fees
- Survey Charges
- Home Inspection
- Title Fees
- Possible Attorney Costs
- Loan Fees
- Incorporation Fees
It’s true that Incorporating can cost you some upfront fees, but it can save you money in the long run through significant tax deductions, as well as protection of your personal assets. If you’d like to look into incorporating your real estate business, Corporate Direct is an excellent resource.
3. Recurring Operating Costs and Other Expenses for a Typical Buy and Hold Real Estate Investment
There will always be operating costs, and this is one of the main reasons the 1% rule for real estate investing is so helpful. Starting out on the right foot by taking into account that you should have a buffer of at least 1% of the purchase price, will give you a better chance of having a positive cash flow. The alternative would be possibly having your operating costs eat away at your monthly rental income that was too low from the start, leaving you in the red. Here are a few examples of operating costs that you may want to take into consideration when running the numbers on a rental property that you are evaluating:
- Property Management Fees
- Lost Income from Vacancies
- Periodic Maintenance and Repairs
- HOA Fees if Applicable
- Property Taxes
- Rental Advertising
- Possible Utilities
- Pest Control
- Business Permit
- Possible Legal or Emergency Costs
Since property taxes can be a huge burden and chip away at your cash flow, we recommend reading Tax-Free Wealth. It’s an outstanding book by Tom Wheelwright, who is the tax advisor to real estate legend Robert Kiyosaki. It provides in-depth details on how to lower your taxes.
1% Rule vs 2% Rule – How They Compare for Real Estate Investors
The 2% rule uses the same calculation method as the 1% rule – a purchase price of $100,000 would need to produce a monthly rental cash flow of $2,000. It’s obvious that having a rental property that cash flows 2% of the purchase price would be more financially rewarding than a 1% cash flow. However, it’s not as simple as it sounds. To better understand the differences between the two, let’s take a look at the PROS and CONS of both:
PROS of 1% Rule Properties
- 1% rule rental properties are easier to find.
- They can often be located in decent neighborhoods with a great overall housing market.
- There’s a good chance of finding properties with little repairs needed.
- It’s common for the appreciation of a 1% rental property to go up in value over time.
- 1% rule buy and hold real estate properties can be a stable investment.
- Perfect for new or seasoned investors.
CONS of 1% Rule Properties
- When done correctly, there are no obvious CONS when utilizing the 1% rule. Although one can say that the fact that a 1% cash flow is not as much as 2%, is a CON.
Let’s take a look at the PROS and CONS that may apply to the 2% rule of real estate investing. This will give you a better understanding of what makes the 2% rule so great when everything comes together for the better, as well as what can make a 2% rule property risky:
PROS of 2% Rule Properties
- Although there are many challenges with 2% rule properties, when a buy and hold asset is found that is workable and can produce a positive cash flow, the investor will come out on top with double the amount of income that a 1% rule property would bring in.
CONS of 2% Rule Properties
- Although it’s possible, it’s difficult to find properties that fit the 2% rule.
- In many cases, the investor is limited to searching specific states and areas to locate good 2% rule real estate.
- Most times, investors need to make costly upfront repairs to get the property into shape for renting to a tenant.
- Tends to have a higher amount of issues, maintenance, and upkeep while rented, resulting in less cash flow.
- 2% rule properties are often found in low-income, high-crime areas, and this is why the property price is typically lower.
- Higher chance of evictions and vacancies.
- Appreciation of the buy and hold property is uncertain.
- Investment is not as stable as a 1% rule property.
- Not recommended for investors who are just starting out.
The bottom line is that a 1% rule property is less complicated and has a better chance of being a stable real estate investment, while a 2% rule property is hard to come by and not as stable. However, if as a professional property investor, you have the time and the know-how, 2% rule properties can certainly be found, and may be worth the extra effort.
Alternative Calculations – Using an ROI Formula to Pre-Screen a Rental Property
As mentioned, the 1% rule for real estate investors is a quick calculation that doesn’t take into account the operating expenses. Because some investors like to include these numbers in their upfront calculations, they may use an ROI formula to calculate the property’s potential cash flow loss or gain. ROI, or return on investment, represents, in this case, the amount of return on a property, relative to the investment’s cost.
Utilizing an ROI formula can give the investor a look at the bigger picture while evaluating a potential buy and hold property. This is because it considers operating expenses from the beginning.
Let’s look at the following detailed ROI formula example broken down into steps:
Step 1 – Gathering basic info such as purchase price and projected monthly rent: An investor is evaluating an off-market property where the owner is looking to sell quickly and is asking for a cash transaction. The asking price is $100,000. The potential buyer conducts research by asking a local property management company what the going rents are for the neighborhood, and comes up with $800 per month.
Step 2 – Calculating the gross yearly income: The monthly rent of $800 is multiplied by 12 to come up with a yearly gross income number. This comes to a total of $9,600. Sounds like a good amount of money per year, but the investor now has to take into account his operating expenses such as taxes, insurance, repairs, a property manager, and the like. If your a new investor and are just starting your insurance vendor search. We use and recommend Arcana Insurance.
Step 3 – Deducting estimated expenses to see what the net yearly income might be: He doesn’t know what his exact operating expenses would be, so to be on the safe side, he takes out a conservative amount of 40% in potential expenses from the gross yearly income, which would leave 60% for himself. To see what is left after 40% of expenses are deducted, the yearly income of $9,600 is multiplied by 0.60 (60%), and he is then left with a net income of $5,760 per year.
Step 4 – Calculating the Return on Investment: To calculate what his final ROI is, he then takes the net income of $5,760 and divides it by the total purchase price, $5,760 ÷ 100,000, which comes to an ROI of .0576%. To make it a simple, rounded number, multiply .0576% by 100, and you have your final ROI calculation of 5.76%.
Quick Summary of the Above ROI Formula
- $800 (monthly rent) × 12 (months in the year) = $9,600 (gross yearly income)
- $9,600 × 0.60 (60%) = $5,760 (net yearly income)
- $5,570 ÷ $100,000 (total purchase price) = .0576% (ROI)
- .0576 × 100 = 5.76% (final return on investment)
This particular example came up with an ROI of 5.76%. This percentage is decent and performs better than some investments such as a 401K. In reality, most investors would like to see a final ROI in the range of 7 to 12%.
The 1% rule is a good quick screening tool for seasoned, as well as new investors. As mentioned, it doesn’t account for the operating expenses because some investors prefer not to add the expenses into the mix during this upfront property evaluation process. For investors who would like to consider their expenses from the start, using the ROI formula is a good choice. If you’d like to see some visual examples of the ROI formula, take a look at this video by Morris Invest, that goes over evaluating a rental property with ROI calculations. Additionally, if you feel you would like more tools to confirm a buy and hold property is a good deal, you may want to utilize DealCheck. It’s advanced software can analyze any rental property to estimate its cash flow.
Use the 1% Rule Strategy as a Starting Point to Quickly Evaluate Potential Buy and Hold Properties!
As you can see, the 1% rule for real estate investing is an excellent way to pre-screen potential properties. It allows the investor to weed out rental properties that may not generate the proper cash flow, allowing them to allot more time to the properties that may be worth looking into. As discussed, the 1% rule is only a jumping-off point that will give you a good indication if a buy and hold property should be evaluated further, or crossed off your list. The 1% rule, if used correctly, is the basis for a stable investment. Try it out on your next rental property search; you may just wonder why you haven’t used this calculation earlier!
If you’d like to invest in properties that pass the 1% rule, or would just like to discuss this topic further with a seasoned investor, simply book a quick call with a Morris Invest team member.