Breaking down the 1% rule in real estate: What you should know before investing

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’s a method you can use to help quickly determine a home’s potential.

If you’re looking for an investment property to make money in real estate, learn how to apply the 1% rule in real estate to find the right home and determine the right monthly rent to charge.

What Ii the 1% rule in real estate?

The 1% rule of real estate investing measures the price of an investment property against the gross income it can generate. For a potential investment to pass the 1% rule, its monthly rent must equal at least 1% of the purchase price.

If you want to buy an investment property, the 1% rule can be a helpful tool for finding the right property to achieve your investment goals. For example, if you buy a $300,000 investment property, you should earn at least $3,000 a month in rent to satisfy the 1% rule in real estate. If that rent price doesn’t seem realistic due to the property’s location or size, you may need to keep searching.

It’s important to remember that the 1% rule is a good place to start, but you should consider other factors when determining how much rent to charge your tenants.

How to use the 1% rule

To apply the 1% rule, you can either multiply the property’s purchase price by 1% or move the decimal point in the purchase price two places to the left. The result should be the minimum you consider charging in monthly rent.

Purchase price ? 0.01 = Monthly rent

If the property requires any repairs, 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 with a property selling for $150,000:

$150,000 ? 0.01 = $1,500

Based on the 1% rule, you should charge your tenants $1,500 a month in rent.

Let’s say you need to make about $10,000 in repairs before renting the home. Add the cost of repairs to the home's purchase price for a total of $160,000. Then multiply the total by 1%. You’ll get a $1,600 minimum monthly rental rate.

Purchase price + Repair costs ? 0.01 = Monthly rent

The 1% rule and other investment rules in real estate

When it comes to real estate investing, the 1% rule isn’t the only method to determine the best opportunities to buy a rental house. Other popular methods include the gross rent multiplier, the 70% rule and the 2% rule.

Gross Rent Multiplier

The gross rent multiplier (GRM) gauges the amount of time it takes to pay off an investment. It’s a property’s purchase price divided by its gross annual rent. The result is the total number of years it’ll take to pay off the investment only with rental income. The lower the GRM, the more lucrative the property may be.

Purchase price ? Gross annual rent = Years to pay off investment

Let’s say you purchase a $200,000 investment property. You charge $2,500 in monthly rent, and your annual gross rental income is $30,000 (2,500 ? 12).

$200,000 ? $30,000 = 6.67 years

The property’s GRM is 6.67. So, it should take about 6 years and 7 months to pay off the property with rental income. Of course, you’ll need to consider other expenses when determining a property’s profit potential, including repair, operating and maintenance costs and vacancy rate.

You can use GRM to compare investment properties, too. If one property has a GRM of 6.67 while another has a GRM of 8.33, the property with the lower GRM (6.67) may be the better option because you should be able to pay off the investment faster. When comparing properties, make sure they’re in similar markets with similar operating, maintenance and other costs.

70% Rule

The 70% rule is for house flippers. It recommends that an investor pay no more than 70% of a home’s after-repair value (ARV) minus repair costs.

To calculate the 70% rule, multiply the home’s estimated ARV by 0.7 (70%). Take the result and subtract any estimated repair costs. The final result will be the amount you should pay for the property. Let’s look at an example.

Let’s say you’re interested in a property you estimate will have an ARV of $150,000. You also estimate you’ll need to spend about $30,000 on repairs to flip the home.

$150,000 ? 0.7 = $105,000 – $30,000 = $75,000

Based on the 70% rule, you shouldn’t pay more than $75,000 for the property.

2% Rule

The 2% rule works the same as the 1% rule. The 2% rule says an investment property’s monthly rent should equal at least 2% of the purchase price.

Purchase price + Repair costs ? 0.02 = Monthly rent

Here’s how to apply the 2% rule on a property selling for $150,000:

$150,000 ? 0.02 = $3,000

According to the 2% rule, your monthly mortgage payment shouldn’t exceed $3,000, and you should charge $3,000 in monthly rent.

The 2% rule is more extreme than the 1% rule – basically doubling the monthly rent amount. But it can work in certain markets and provide a financial safety net if an investor struggles to fill vacancies or needs a major, costly repair on the property.

No matter which rule you choose, you can run the numbers on a potential property to help ensure you’re making an affordable investment.

When the 1% rule works

The 1% rule is a good prescreening tool that can help you decide between a good investment and a bad one and narrow your choices of properties. As you review listings, apply the 1% rule to the listing price, then compare it to the area’s median rent. If the median rent falls below 1% of the listing price, you may want to remove that property from your list of investment options.

When the 1% rule doesn’t work

The 1% rule has its limitations. It’s best to use the rule to ballpark figures because it doesn’t factor in costs like maintenance, property taxes, insurance and operating expenses.

You should also be aware of potential problems when purchasing an investment property in the most expensive cities where it’s more expensive to buy a home, but the average rent is lower than 1% of the purchase price. For example, the median list price in San Francisco is about $1,100,624. Using the 1% rule, you should charge $12,906 as your minimum monthly rent.

But the median rent in San Francisco is close to $3,000 per month. To match the 1% rule to the median rent in San Francisco, you’d need to find a $300,000 property – and that’s only a quarter of the median list price in the city.

Factors to consider beyond the 1% real estate rule

When trying to assess the profitability of an investment property, especially for a property in one of the best places to invest in real estate, other factors are also worth considering. One is net operating income. It’s the profit you make on a property after subtracting operating expenses. This formula accounts for various factors that the 1% rule doesn’t.

You’ll also want to think about the internal rate of return (IRR), which compares a property’s future value to what it’s worth today.

The bottom line: Know the rules of investment properties

When considering an investment property, you must assess the return on investment a home can provide. In other words, know what you’re getting into before throwing money at it. Now that you have a few strategies to help you make this critical decision, it may be time to start your real estate investment journey.

Start the approval process with Rocket Mortgage® today to find the best financing solution for your real estate investment goals.