Breaking Down The 1% Rule In Real Estate: What You Should Know Before Investing
Lauren Nowacki6-minute read
February 27, 2022
When you invest, you expect to make some money. For real estate investors, much of their return on investment typically comes from rental income. When looking for a lucrative deal, it can be hard to determine what property will generate a positive cash flow. Luckily, there is a method you can use to help quickly determine a home’s potential. If you’re looking for your own investment property to make money in real estate, learn how to apply the 1% rule in real estate to help you find the right home and determine the right monthly rent to charge for it.
What Is The 1% Rule In Real Estate?
The 1% rule of real estate investing measures the price of the investment property against the gross income it will generate. For a potential investment to pass the 1% rule, its monthly rent must be equal to or no less than 1% of the purchase price.
If you want to buy an investment property, the 1% rule can be a helpful tool for and finding the right property to achieve your investment goals. You can use it to quickly determine how the property will cash flow or, if the property is currently unoccupied, you can use the rule to help set monthly rent to charge.
It’s important to remember that this is just a rule of thumb. It’s a good place to start, but other factors must be considered when determining how much rent to charge your tenants.
How To Calculate The 1% Rule
Calculating the 1% rule is simple. Just multiple the purchase price of the property by 1% – or, even easier, move the comma in the purchase price to the left two spaces. The result should be the minimum you charge in monthly rent.
If any repairs are required of the property, you’ll also want to factor them into the equation by adding them to the purchase price, then multiplying the total by 1%.
Examples Of The 1% Rule
Here’s an example for a home with the purchase price of $150,000:
$150,000 x 0.01 = $1,500
Using the 1% rule, you should find a mortgage that has a monthly payment of $1,500 or less and charge your tenants a minimum monthly rent of $1,500.
Let’s say the home required about $10,000 worth of repairs. In this situation, you would add the cost of repairs to the purchase price of the home, for a total of $160,000. Then, you’d multiply that total by 1% to get a minimum monthly payment of $1,600.
An Investment Property That Passes The 1% Rule
Let’s say you’re looking to purchase an investment property that’s listed for $200,000 and has historically charged $2,500 for monthly rent. Per the 1% rule, the monthly rent should be equal to or greater than $2,000 per month. Since this property charges, $2,500 per month, it passes the 1% rule.
An Investment Property That Does Not Pass The 1% Rule
Let’s say the same property, listed for $200,000, has historically charged $1,800 for monthly rent. This property would not pass the 1% rule because the monthly rent is less than $2,000 (or 1% of the purchase price).
In this case, you would continue your search for a more profitable rental property or make an offer of no more than $180,000 to purchase the home.
The 1% Rule And Other Investment Rules
When The 1% Rule Works
The 1% rule is a good prescreening tool. It works well as a guide for determining a good investment from a bad one and narrowing down your choices of properties. As you review listings, apply the 1% rule to the listing price and then see if what you get is close to the median rent for the area. If the median rent for the area is way below 1% of the listing, you may want to remove that property from your list of options.
When The 1% Rule Doesn’t Work
As we’ve stated throughout this article, there are limitations of the 1% rule and it’s best to only use the calculation as a rule of thumb because it doesn’t consider other costs, like maintenance, taxes, insurance and operating costs.
You’ll also want to be aware of the problems that may arise in purchasing an investment property in the most expensive cities, where it may be more expensive to buy a home, but the average rent for the area is lower than 1% of the purchase price. For example, the median list price in San Francisco is about $1,148,500. Using the 1% rule, you should charge a minimum monthly rent of $11,485. However, the median rent in San Francisco is close to $3,000 per month. In order to match the 1% rule to the median rent in San Francisco, you’d have to find a property listed for about $300,000 – almost a quarter of the median list price for the city.
Factors To Consider Beyond The 1% Rule
When trying to calculate the profitability of an investment property, especially if it’s located in one of the best places to invest in real estate, there are other things to consider. For one, the net operating income, which is the profit you make on the property after subtracting the operating expenses. This formula takes into account those factors listed above that the 1% rule does not. You’ll also want to think about the internal rate of return (IRR), which compares the future value of the property to what it’s worth today.
Get Started On Your First Investment Property
When it comes to choosing an investment property, there are several things to consider in terms of how the home can provide a return on investment. Now that you have a few methods for making that decision, it may be time to start your real estate investment journey. Speak with a Home Loan Expert today to find the best financing solution to get you on your way.
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