The one percent rule is an analysis tool used by real estate investors to quickly screen potential rental properties. I briefly covered the one percent rule in How to Run the Numbers Using Back-of-the-Envelope Analysis. But in this article I’ll go into more depth about what it is, when to use it (and when not to!), and why it can be helpful. I’ll also address the one percent rule in high-priced markets. There are times when it makes sense to break the rule, but there are also risks to doing that.
More than anything, the one percent rule is about using income discipline when buying investment properties. The mindset of disciplining yourself to only buy real estate investments that meet certain income criteria will help you make more money and avoid common investing pitfalls.
Let’s get started.
What Is the One Percent Rule?
The basic benefit of investment real estate is its ability to produce rental income. So, the one percent rule quickly and easily measures how well a rental property does that.
The one percent rule is simply a rule of thumb that says a rental property should meet the follow criteria:
Monthly Rental Income ≥ One Percent of Purchase Price
So according to the rule, a property with a total investment (price + upfront repairs) of $200,000 should rent for $2,000/month or more in order to be a good investment. If the rent is only $1,500/month, the $200,000 price would not meet the rule. Or if you had to pay $250,000 for a property that rents for $2,000, it would not meet the rule either.
You can also use the reverse of the rule:
100 x Monthly Rent = Maximum Purchase Price
Let’s say you know a property rents for $1,500/month. You could quickly calculate that you can not pay any more than $150,000 (100 x $1,500). So, if you saw a property listed for $160,000, you would know you’re getting closer to a good investment. Or if it was listed for $250,000, you wouldn’t have to waste your time on it.
But the one percent rule is not the final word on a property. It’s just the beginning of the story. And it does not apply to all properties or all situations. So, let’s look at when to use the one percent rule and when not to.
When to Use the One Percent Rule
The one percent rule is best used as a prescreening tool. It’s a way to save time and to remain disciplined as an investor. This means you’ll be using it early in the process while looking for good investment purchases.
For example, you could use it to quickly filter 20 listed properties that your real estate agent sends you. First, you’d scroll down the list of asking prices in order to estimate 1% of each list price. A trick to do this in your head is just move the decimal place over 2 times to the left. For example, $100,000 = $1,000.00.
Then after you have the 1% number, you’d compare that to the market rent for the property. If the rent is close to 1% of the asking price, it’s probably worth researching more. But if the real rent is far below 1%, you can just eliminate that option.
My blogging friend and fellow investor Lucas Hall wrote a good article explaining how to estimate the rent. As a new investor, it may take more time to make a good estimate because you’ll have to scan several sources like zillow.com (rent Zestimates are a good starting point but not always 100% accurate), Craigslist, or RentOMeter.com. But eventually as you study and become an expert on your area, rent prices should become more intuitive without doing a lot of research.
That’s the ideal situation to use the one percent rule. But now let’s look at when not to use it.
When Not to Use the One Percent Rule
After narrowing your list of properties, I recommend moving beyond the one percent rule and using more in-depth analysis tools. For example, if you are going to make an offer and eventually close on a purchase, you’ll need much more information than the one percent rule provides.
The one percent rule just uses the gross income of a property (i.e. what you collect from a tenant). But the bottom line of rental investing is the net income, or what’s left over after all expenses. To really understand a property’s cash flow, you must also deduct expenses like management, vacancy, taxes, insurance, maintenance, capital expenses, and mortgage payments.
I personally like to evaluate and set goals for a property’s cap rate and net income after financing. Sometimes a property that meets the one percent rule will also meet these goals. Other times it won’t. A lot depends on the specifics of the particular property’s expenses or the mortgage financing I can acquire.
I also only use the one percent rule for certain types of properties. In my case, it primarily makes sense for small residential rentals (i.e. houses, duplexes, triplexes, and quadplexes) in A or B neighborhoods. If I’m buying in lower-priced C neighborhoods or if I’m buying mobile home parks, large multi-unit buildings, or commercial property, the income will need to be even better than the one percent rule can provide.
Another challenge to the one percent rule (and one of the most common objections I hear) is that it can’t or shouldn’t be used in high-priced markets. Let’s take a look at that situation in more detail.
Is the One Percent Rule Even Possible in Some Markets?
As you probably know, real estate investing is very local. The trends and numbers vary greatly from one region to another. And in some regions and big cities, it’s nearly impossible to find properties that meet the one percent rule.
For example, I used Zillow Local Market Reports to evaluate several high-priced or hot real estate markets as of February 2018. Here are the results:
- San Francisco, California (city): Median sales price = $1,289,300, 1% = $12,893, Median rent = $4,285/month
- Denver, Colorado: Median sales price = $391,300, 1% = $3,913, Median rent = $2,047/month
- Washington, DC: Median sales price = $388,300, 1% = $3,883, Median rent = $2,146/month
In the case of Denver and Washington D.C., you’d have to buy an average home at almost half of its value to meet the one percent rule. And in San Francisco, you’d have to buy a home at almost one-third of its value to meet the one percent rule!
Needless to say, buying at that big of a discount will almost never happen in any of these areas. So, your options are to:
- Buy in other areas (either outside of those markets or lower priced locations within the market)
- Lower your criteria (i.e. have a “.5% rule” or some other criteria)
Many investors choose option #1 and simply buy properties long distance in other markets. A friend of mine Rich Carey at richonmoney.com has done this for years. He initially lived in Washington D.C. and later abroad in Korea, and he now owns a portfolio of free-and-clear rental properties in Alabama.
Others may choose option #2 and lower their criteria for how much income a rental property needs to produce. This could still work if you make money in other ways, like price appreciation. But before you go that route, let me explain why the one percent rule and income discipline matter.
Why the One Percent Rule and Income Discipline Matter
Real estate is just a tool to accomplish your financial goals. You invest your savings, time, and energy, and hopefully the property pays you back much more money over time. You can then use this money to achieve financial independence and do what matters.
So, how exactly does this tool of real estate help you? Primarily in two ways:
- Rental Income – Net, spendable income that can be saved for rental debt snowballs, buying more properties, or paying for your lifestyle.
- Price Appreciation – The growth of your equity (i.e. wealth) from either a discount in price upfront or an increase in price after the purchase. This equity can then be harvested when a property is sold or refinanced.
As a smart investor, you should take advantage of both of these profit centers to achieve a better overall result. But of the two, rental income is the most straightforward.
I love buying properties at a discount or adding value, but these processes are inherently more speculative and risky. At best, they both take more time and energy to capitalize on than collecting rent. And at worst, the “profits” on paper can disappear before you can take advantage of them.
This is why I set goals for a minimum cap rate and net income when purchasing a property. Like gauges on the dashboard of a car, these formulas tell me how well a property produces income. And the one percent rule is just a proxy or quick approximation for these more detailed calculations.
If you choose to lower your expectations for rental income (i.e. not meet the one percent rule), you must make up for this shortfall somewhere else. And that could sometimes be a difficult task.
Let’s look at two example properties – one that meets the one percent rule and one that doesn’t – in order to see how this works.
Example – A Property That Meets the One Percent Rule
Let’s say you buy a duplex for $100,000. This price includes your purchase price plus all up front costs (closing costs and repairs). You invest 20% of your own cash or $20,000, and you borrow $80,000 at 5% for 30 years at a payment of $430/month.
The gross rent for the property is $1,000 per month (i.e. it meets the one percent rule). Its operating expenses (management, maintenance, vacancy, taxes, insurance, etc) are $400/month. So, here is what the rental income looks like for this property:
|Sample Property – Meets the One Percent Rule|
|Rental Income||Operating Expenses||Net Operating Income||Mortgage Payment||Net Income After Financing|
Not every property that meets the one percent rule will end up with the same results. But in this case, your net operating income (i.e. before making your mortgage payment) is $7,200/year. That produces a cap rate of 7.2% ($7,200 / $100,000).
And the bottom line income you put in your pocket (before income taxes) will be over $2,000/year. This is a cash-on-cash return of about 10% on your $20,000 down payment.
What can you do with that $2,040/year? You can put it in the bank and save it for the next purchase. You can apply it to the debt on this or other properties to more quickly pay off your mortgages. Or you could use it fund part of your living expenses.
In addition to the income, you’ll also be paying down your mortgage about $1,100 in the first year and more in subsequent years. And you’ll benefit if the rent or property value appreciate over time.
Now, let’s look at a property that does not meet the one percent rule. In this case, the monthly income is equal to .5% of the total purchase price.
Example – A Property That Does NOT Meet the One Percent Rule
In this example, let’s say you buy a duplex for $200,000. Again the price includes your purchase price plus all up front costs (closing costs and repairs). You invest 20% of your own cash or $40,000, and you borrow $160,000 at 5% for 30 years at a payment of $859/month.
The gross rent for the property is the same as the other at $1,000 per month (i.e. it does not meet the one percent rule). Its operating expenses (management, maintenance, vacancy, taxes, insurance, etc) are also $400/month. So, here is what the rental income looks like for this property:
|Sample Property – Does NOT Meet the One Percent Rule|
|Rental Income||Operating Expenses||Net Operating Income||Mortgage Payment||Net Income After Financing|
In this case, your net operating income (i.e. before making your mortgage payment) is $7,200/year. But because the purchase price was twice as much, the cap rate is only half as good at 3.6% ($7,200 / $200,000).
And the bottom line income from your rental (before income taxes) will be negative $3,108/year. This means you’ll have to feed the property cash from another source – likely your job salary or the positive cash flow from another rental.
Does this automatically mean the non-one percent-rule property is a bad deal? Not always. Let’s look at how a property that doesn’t meet the one percent rule can still make money (eventually).
How to Break the One Percent Rule and Still Make Money
With the property that did not meet the one percent rule, the principal on the mortgage gets reduced by almost $2,400 in the first year. So on paper at least, the negative result is not as bad. It’s only a loss of -$708 (-$3,108 + $2,400).
And if the property appreciates by 3% that same year, it could look even better. A 3% price increase on $200,000 is $6,000. So again on paper, you would be ahead by $5,292 (-708 + $6,000). On an investment of $40,000, that’s a respectable 13% return.
So, this gets to the essence of how most investors can still make money on an investment property when it doesn’t meet the one percent rule. They must depend more heavily on price appreciation.
But as I said earlier in the article, price appreciation is a more speculative source of profit in real estate. The “return” above is simply on paper until the property is sold or refinanced. And with illiquid investments like real estate, that’s not always easy to do.
But “speculative” doesn’t always have to be a bad word.
One of the most profitable strategies in real estate is to force appreciation of a property (i.e. adding value). If you can improve the cosmetics, add an extra bedroom, convert a basement to a rental unit, increase rents, or do any other creative method to increase value, you can make an enormous amount of money – even without initially strong rental income.
And if you are an investor who holds rental properties for a long time in an appreciating location, you’ll also make a lot of money in the long-run. You likely will have to feed the property cash in the short-run, but eventually the rent appreciation can catch up and bail you out. Obviously, you have to have some extra cash and staying power to make this happen!
The primary issue then is how much you will depend on speculation and how much you will depend on rental income.
If you buy properties that don’t meet the one percent rule (or some other base measure of income discipline), you’ve made your decision. You’re depending more on speculation for your profits. And if you’re comfortable with that AND you have a plan to make it happen, then go for it!
But if you would like a more balanced combination of profit from rental income and speculation, then find properties in good locations that also meet the one percent rule or some other income measure.
Income Discipline Leads to Successful Investing
That’s a quick look at a simple real estate investing tool called the one percent rule. I hope you can now apply the tool or adjust it for your own unique investing criteria.
The main point is to figure out some way to maintain income discipline with your investment purchases. In the end, each individual piece of real estate is just a little business that should pay you a money. The more rental income your little business pays you, the sooner you will reach your real estate and financial independence goals.
Best of luck with your investing!
Do you use the one percent rule for your rental property investing? If you don’t, how do you screen potential deals early in the process? I’d love to hear from you in the comments below.
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