Today I am going to explain the 1% rule and how it functions in Real Estate investing. The 1% rule is not necessarily a standard or law you have to follow. It is just a general rule of thumb. It is a quick way to make an assumption of whether or not a rental property will be worth your time and effort to analyze further. It does NOT guarantee that it will cash flow for you as there are many other factors to consider, but can be used to quickly see if a property will work to get you the returns you are looking for.
How it works
The numbers for it are pretty simple actually. Even if you are not good at math, anyone can calculate 1%. We will just use round numbers here for simplicity. If your purchase price is $100,000, the 1% rule suggests that the monthly rents should be at least at $1,000. That is 1% of the purchase price. $200,000 purchase = $2,000 in rent. $300k=$3k, and so on. If we make it a little trickier, a purchase of $84,500 should at a minimum rent for… $845.00/mo. If it is a little difficult, you simply move the decimal place to the left two spaces. Or you can use your calculator/phone to multiply the purchase price by 0.01.
Why does it matter?
In today’s market (late 2018, early 2019) or any higher priced market, the property valuations tend to rise higher than the market rental rates. When this happens your margins for profitable cash flow diminish. In many cases you will have negative cash flow. In my opinion, this is bad. You want to make money, right? Well, some people don’t care about cash flow. They’re even willing to or maybe even want to be losing money on a property. The reason is for either tax write-offs to offset their other gains and/or hoping for appreciation.
There were many in the pre-2008 market crash that bought on speculation, hoping or planning for continued appreciation. Property values kept climbing and to many people it seemed a “no-brainer” to buy something even with negative cash flow just so they could sell it in a year or two and make a bunch of money.
This was probably fueled more by some people having success doing that and would then go tell others how they just made an easy $50-100k so other people that heard that would start jumping in, buying over-priced rental properties, not understanding how to analyze a property and of course the banks were handing out loans to everybody. But then, when prices tumbled, they realized they would have to sell at a loss, they were already losing on the monthly payments since the rents didn’t cover the mortgage, and since it wasn’t their primary residence, people just walked away or filed for bankruptcy.
I don’t want this to happen to me or to you. So the lesson to learn is to buy right. NEVER buy purely for speculation. If it cash flows well now, it will probably still cash flow during a recession. In fact for many investors that could withstand the market crash in 2008-2009, they saw a higher demand for rents. Since banks tightened up their loans, less people could buy a house and therefore needed to rent.
So, when searching for a rental property to purchase, make sure it cash flows well to start with. Not break even and definitely not negative cash flow. The 1% rule is a guideline to start with. If it isn’t even close to the 1% rule, I wouldn’t even bother looking further.
My first property was at the 1% rule AND I knew rents could be raised, which then makes it a better than 1% rule. The higher the number you can get, the better your cash flows should be. Notice I said “should” be. As mentioned earlier, there are many other factors to consider such as property taxes, HOA fees (which I hate), whether or not the owner pays utilities, the location of the property, the condition, and many others. There are places still where you can find a 2% or even a 3% property, but in most cases these are ones you will not want. They will likely be in “war zone” areas where it will end up costing you a lot more in vacancies, repairs, and other headaches you don’t want. So keep that in mind. This is not the case for ALL of those 2 & 3% properties, but probably most. Just know your area.
The 50% rule
Besides the 1% rule of thumb, if that works out for you, you then need to consider expenses. It is best to do a thorough analysis which we will cover how to do that in a later post. But for the meantime you can also follow the 50% rule. This states that your monthly expenses tend to be about 50% of the rents. This of course will also change depending on the property type. But again, just a rough guideline.
Using our first example, the $100k property which collects $1k in rent, this rule means that you can expect to pay about $500/mo in your expenses for maintenance, CAPEX or capital expenditures, property management, pretty much any cost outside of the mortgage & interest. Take away 50% from the $1000, leaving you with $500, but then take away your mortgage & interest payment, for now we’ll estimate this at $450 assuming 20% down and a 5.5% interest rate. This leaves you with a monthly estimated cash flow of about $50.
To me, that does not sound very pleasing. Not the returns I look for. But again, this is just a very general rule of thumb, many factors to consider so for me personally if it is at least close to meeting the 1% rule, and you like the location, I would definitely investigate further to run a deep analysis. Why I say “close to” the 1% rule is because even if it is just slightly under, chances are rents can be raised and probably will be raised over time. So for me as long as it meets my minimum cash flow standards to start with, it will likely be a good investment.
What do do next
There are areas where you can pretty easily find 1 – 1.5% properties. In today’s market these tend to be in the Midwestern states. Not necessarily in every city in those states. But even in other states, if you look within in hour drive of a major city, you may be able to find a winner. It will take patience and running a lot of analysis until you find one that jumps out at you.
But you better be ready to make an offer. When you find those gems, you need to move quickly because others are seeing them as well and they sell fast. Often I come across one of these and the same day it is listed I call to get more info, and they tell me they already have an accepted offer. Very frustrating but that is how today’s market works. If you can build up a relationship with some Realtors in the areas you like, they may be able to send you a property before it goes on the public MLS for all to see. This would then give you the upper edge.
This happened for me on my 2nd & 3rd properties. I bought them together as a package from the seller, but they were a pocket listing with my agent in Arkansas. They met the minimum returns I look for, the rents were already above the 1% rule, the tenants paid their own utilities, they were in great shape in a good area, will need updates to the interior, but they are fully rented, AND the rents were below market values. So after I get the rents fully raised, I prefer to do it over a couple of years when they are way below to not force people to move out if they are paying on time, then this will be very good and provide about a 35% cash on cash return. I admit, I was lucky on that one. I had contacted the agent about a different property but when that one didn’t work out she mentioned these other ones and we went from there.
Again, just to emphasize, these are general rules of thumb. It does not mean you cannot or should not buy a rental property that doesn’t meet the 1% rule. There may be some out there in areas with very low property taxes and the tenants pay all utilities, so please don’t comment saying that I am crazy. There are exceptions to everything and for everyone’s personal preferences for returns. But again, generally speaking, if you find a property that costs $200k but the monthly rents are only $600 and there is no room for an increase, don’t waste your time. Look into other, better opportunities.
Use the 1% and 50% rules to help guide you to finding a great First or Next rental property and work your way to great passive income. Depending on where you are you may have to look to other states. I know it can be scarier doing that. But if you can get over that fear as discussed in the last post, you can move toward your financial freedom and start building a rental property, cash-flowing empire. Do what works for you and be smart with your investments.