The one percent rule is a rule of thumb that helps real estate investors figure out quickly whether a given rental property has the potential to generate positive cash flows each month.
It can be used for analyzing single-family houses and multi-family properties. The basic idea is that properties that reach or surpass the one percent rule are likely to be positive cash flows while properties that do not adhere to the one percent rule may not. As we'll see later, it's not a perfect indicator, but it's certainly a practical starting point for investors looking at many real estate transactions.
How to Calculate the 1% Rule
One of the reasons why the one percent rule is so frequently used by many investors is that it is easy to calculate. The 1 percent rule corresponds to the gross monthly rent as a percentage of the purchase price of the property.
Purchase price of the property / gross monthly rent = 1% rule ratio
Let's review a sample to demonstrate how to use the form in practice. Suppose the asking price for a multi-family home is $1.05 million, but an investor can buy it for $1 million. The investor studies the local housing market and expects the monthly rent to be $8,000. With these two pieces of information, we can calculate the ratio that helps determine if ownership is a good investment.
$8,000 / $1,000,000 = 0.8%
In this example, the gross rental revenue of $8,000 equals 0.8% of the purchase price.
This property falls below the one percent threshold because the gross rental income is less than one print percent of the purchase price of the property. The investor will likely decide to look at other properties because this one does not seem to be a large investment by the one percent rule.
Pros & Cons of Using the 1% Rule
The one percent rule has been successful and has served many investors well over the years. But there are certain disadvantages that investors should be conscious of.
Let us examine the advantages and disadvantages of the one percent rule.
Pros of the 1% Rule
The biggest pro of using the one percent rule is that it enables investors to quickly analyze many potential goods. Often, investors examine several properties at once, and using the one percent rule allows them to reduce the list to only a few that they want to do additional due diligence on. Another good thing about this one percent rule is that it works for various kinds of properties. Many investors use it when they are thinking about purchasing and renting a single-family home. However, it can also be used for quick analysis of multi-family properties. The calculation does not change as a function of the ownership type. The one percent rule also allows investors to avoid being victims of some psychological prejudice. For example, an investor may prefer to purchase assets in the market in which they live. But, if another 30-mile market provides a better ratio of gross rental income to the prices, then the investor will pick up on it for a long time.
Cons of the 1% Rule
Importantly, the 1% rule does not consider several factors that could affect monthly cash flows and return on investment. For example, the one percent rule does not include the following expenditures: property taxes, mortgage payment amount, interest rates and interest costs, property management fees, repair costs, expenses related to high vacancy rates, and closure costs.
It is no secret that these costs can accumulate rapidly and reduce the cash flow the investor receives at home each month. It is also important to understand that some of these expenses may vary greatly depending on the market. For example, property taxes tend to be higher in the northeastern U.S. than in the midwestern region. The one percent rule doesn't factor that in.
Is the 1% Rule Still Useful Today?
Over the last number of years, there has been a debate within the real estate investor community on whether the one percentage remains a good guideline or a good place to start for investors. What any investor needs to understand is that the higher the value of the property goes, becomes more difficult it to find properties in which the gross monthly rent is at least one percent of the total purchase price. In other words, it becomes increasingly difficult for investors to find rental properties that provide reliable passive income as property prices increase. Over the past few years, property prices have increased in most Canadian markets and, not surprisingly, properties have been found. It has become more difficult to meet or exceed the one percent rule, especially in contracts that had higher property values at the outset.
1% Rule vs 2% Rule
The 2 percent rule is essentially a stricter version of the 1 percent rule. The computation is carried out in the same way, but rather than comparing the ratio of the gross monthly rent to the purchase price to one percent, the investor looks for the ratio to reach or exceed two percent. Let's go over our example above to see how the 2 percent rule works. In our first example, the purchase price was $1 million with a gross monthly rent of $8,000. Rather, let's say the property is in a prime location with very high monthly rents of $20,000. In that case, the report would be calculated in the following manner:
$20,000 / $1M = 2%
In this instance, the property was purchased for $1 million and generates a gross monthly rent of $20,000 for the investor. This property reaches the threshold of 2%, which makes it a very sought-after investment. Properties that satisfy both rules are unicorns of the real estate investment world. These are very rare, especially during periods of the price increase. These properties are found by savvy investors during economic downturns when properties can be purchased at a very low cost or even through foreclosure procedures.
Using the 1% Rule for Investing in Private Equity Real Estate
Private equity real estate investors are often introduced to an individually syndicated business, which is our preferred method. Under this arrangement, the investor may choose to invest in the purchase of a pre-determined home. What is good is that the investor can exercise due diligence in determining whether the investment meets its return and risk criteria. One way of doing that quickly is by using the one percent rule. Even if the investor does not purchase the real estate directly, the 1% rule can still be used in the same way when the private equity company is the one that buys the property. The investor merely needs to know or be able to estimate the purchase price and gross monthly rent, as shown in the examples above. Again, even when the property meets the one percent rule, the investor should exercise extra due diligence and consider personal financial matters such as taxes.
Summary of the 1% Rule in Real Estate Investing
At the end of the day, the 1% rule is a rule of thumb used by real estate investors to determine quickly whether a specific asset is worth the due diligence. It is calculated as the ratio of the gross monthly lease to the purchase price of the home. If this ratio reaches or exceeds 1%, then ownership is likely worth further study. In rare cases, the ratio may exceed 2%, indicating that they are likely to be a very good investor. Investors who focus on investment in private equity real estate can use the one percent rule in much the same way as an investor making direct purchase transactions.
In previous post: "How to Invest During a Period of High Inflation?"