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April 25th, 2018 by Chad Carson
The one percent rule is an analysis tool used by real estate investors to quickly screen potential rental properties. 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 pre-screening 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:
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:
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:
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.
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