Breaking Down the 1% Rule in Real Estate

Real estate investment is all about making money, and for many investors, rental income plays a significant role in achieving financial success. However, identifying properties that can generate positive cash flow can be challenging. Luckily, there’s a method that can help you quickly evaluate a home’s potential and make informed investment decisions. It’s called the 1% rule in real estate. In this article, we’ll explore the 1% rule, how to calculate it, and how it compares to other popular investment rules in real estate.

Understanding the 1% Rule in Real Estate

The 1% rule is a fundamental principle in real estate investing that assesses the relationship between the purchase price of an investment property and the gross income it can generate. According to this rule, the monthly rent must equal or exceed 1% of the purchase price for a property to pass as a viable investment opportunity.

While the 1% rule can serve as a helpful tool for identifying potential investment properties, it’s important to remember that it’s just a rule of thumb. It provides a starting point, but you should consider other factors when determining the appropriate rental amount to charge tenants.

Calculating the 1% Rule

Calculating the 1% rule is straightforward. All you need to do is multiply the property’s purchase price by 1%. Alternatively, you can move the comma in the purchase price two places to the left. The result will give you the minimum monthly rent you should charge.

If the property requires any repairs, include them in the calculation. Add the repair costs to the purchase price and multiply the total by 1% to obtain the minimum monthly payment.

Examples of the 1% Rule in Action

Let’s look at a couple of examples to illustrate how the 1% rule works:

Example 1: Purchase price: $150,000 $150,000 x 0.01 = $1,500

Using the 1% rule, you should aim to find a mortgage with a monthly payment of $1,500 or less and charge your tenants a minimum monthly rent of $1,500.

Example 2: Purchase price: $200,000 Historical monthly rent: $2,500

In this case, the property meets the 1% rule since the monthly rent of $2,500 equals or exceeds 1% of the purchase price.

Example 3: Purchase price: $200,000 Historical monthly rent: $1,800

This property does not pass the 1% rule because the monthly rent is less than 1% of the purchase price. In this situation, you may want to continue your search for a more profitable rental property or consider making an offer no higher than $180,000.

The 1% Rule and Other Investment Rules in Real Estate

While the 1% rule is valuable, it’s not the only method for evaluating real estate investment opportunities. Here are a few other popular rules worth considering:

Gross Rent Multiplier (GRM):

The GRM assesses the time it takes to recoup your investment through rental income alone. To calculate the GRM, divide the purchase price by the gross annual rent. The resulting number represents the years required to recover your investment based solely on rental income. A lower GRM indicates a potentially more lucrative property.

70% Rule:

The 70% rule is commonly used in house flipping. It suggests that an investor should pay no more than 70% of the property’s after-repair value (ARV) minus repair costs. To apply the 70% rule, multiply the estimated ARV of the property by 0.7 (or 70%). Subtract the estimated repair costs from this total; the resulting amount is the maximum you should pay for the property.

For instance, let’s consider a property with an estimated ARV of $150,000. The estimated repair costs are around $30,000. Applying the 70% rule, you would calculate $150,000 x 0.7 = $105,000. Subtracting the repair costs of $30,000 from this figure, you should not pay more than $75,000 for the property, based on the 70% rule.

2% Rule:

Similar to the 1% rule, the 2% rule focuses on the monthly rent in relation to the purchase price. According to the 2% rule, the monthly rent for an investment property should be equal to or greater than 2% of the purchase price. This rule is more aggressive, requiring a higher rental income than the purchase price.

For example, if you have a property with a purchase price of $150,000, you would calculate $150,000 x 0.02 = $3,000. Using the 2% rule, you should find a mortgage with a monthly payment of $3,000 or less and charge your tenants a minimum monthly rent of $3,000.

It’s important to note that the 2% rule may not be feasible in all markets, and it may lead to higher vacancy rates or difficulties finding tenants. Consider the specific characteristics of the market and property before applying this rule.

Factors to Consider Beyond the 1% Rule

While the 1% rule provides a valuable guideline, it’s essential to consider additional factors when evaluating the profitability of an investment property. Some factors to keep in mind include:

1. Net Operating Income (NOI): The net operating income accounts for the property’s operating expenses, such as maintenance costs, property taxes, insurance, and vacancy rates. It represents the profit you generate from the property after deducting these expenses from the rental income. Calculating the NOI gives you a more accurate picture of the property’s potential profitability.

2. Internal Rate of Return (IRR): The internal rate of return compares the property’s future value to its present value. It considers factors like cash flow, appreciation, and potential resale value. The IRR helps you assess the overall return on investment and make informed decisions about the property’s long-term financial prospects.

Conclusion: Know the Rules of Investment Properties

When venturing into real estate investment, understanding the various rules and calculations can significantly assist you in making informed decisions. While the 1% rule is a valuable starting point, it’s crucial to consider other factors like the GRM, 70% rule, and 2% rule to understand a property’s potential comprehensively. Additionally, factors such as net operating income and internal rate of return provide deeper insights into profitability and long-term investment viability. By incorporating these rules and elements into your investment analysis, you’ll be better equipped to identify lucrative opportunities and make sound investment choices.

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