The one percent real estate rule is a shortcut for measuring the viability of a rental property investment. The one percent rule states that the monthly rent should equal one percent or more of the property’s purchase price to be considered a “good investment."
How to Calculate the One Percent Real Estate Rule
There are three variables in the one percent rule:
- The purchase price (if you incur any upfront costs to renovate the property and prepare it for market, include those costs in the purchase price for the purposes of the one percent rule),
- The monthly rent amount,
- And the percentage (which will be at least one percent to meet the one percent rule).
And there are formulas to solve for any missing variable. Let’s look at three examples where we can solve for each variable.
Example 1: Calculating the Ideal Rent Amount Using the One Percent Rule
Here is the formula for finding the amount of rent a property should generate using the one percent real estate rule:
Purchase price x 1% = the one percent test’s ideal monthly rent amount
Let’s calculate the one percent rule on a $400,000 investment property. Simply take 400,000 times .01 (the decimal conversion of one percent), and you get 4,000. So, to pass the one percent test for this real estate investment, you would need to charge $4,000 per month in rent.
The great thing about this formula is that you don’t really need to do any math; simply move the decimal place in the purchase price two digits to the left to find the monthly rental rate.
Example 2: Calculating the Ideal Purchase Price of An Occupied Property Using the One Percent Rule
If you know how much monthly rental income is collected from a property, you can determine how much you should spend to acquire the property using the one percent rule. Here’s the formula:
Monthly rent / 1% = the recommended max purchase price
For example, let’s say a property is generating $3,500 per month in rental income. If you take 3,500 divided by .01, you get 350,000. According to the one percent rule of rental property, you shouldn’t spend more than $350,000 to purchase the property.
Example 3: Calculating How Close an Occupied Property Comes to Meeting the One Percent Rule
If you know the rental income amount and the purchase price, you can see how close an investment property comes to meeting the one percent rule by using this formula:
(Monthly rent / purchase price) x 100 = the percentage you can compare to one percent.
Say you’re considering investing in a rental property with a purchase price of $600,000 and a monthly rental income of $5,500.
If you divide 5,500 by 600,000, you get .009. Multiply that by 100 to convert it to a percentage, and you get .9%. This property would not pass the one percent test because the monthly rent amount is less than one percent of the purchase price.
Why the One Percent Rule Matters
The one percent real estate rule is simply a basic rule of thumb that allows investors to analyze the financial merits of a rental property in a matter of seconds. The idea is that investors would like to recoup the upfront cost of their investment property within 100 months of ownership (which would be 8.3 years).
Does the One Percent Rule Always Apply?
The fact is, there are many real estate markets in which the one percent rule simply does not apply.
The one percent rule is most relevant in slow-growth markets where real estate investors are more reliant on stable monthly cash flow than on the value of the property increasing over time.
In high-value markets, like major metro areas and most of California, for example, investors aren’t just investing in rental properties for positive cash flows, they’re also expecting to benefit from sizable appreciation over the long-term. So, investors in these markets can afford to have the monthly rents be less than one percent of the purchase price. In many Californian cities, one percent is unattainable, and investors should be looking to hit something like 0.75% instead.
Plus, as rental rates increase (like we’re seeing in hot markets like Los Angeles), properties that might not pass the one percent test in their first year get closer and closer to passing the test as time goes on.
Pros and Cons of the One Percent Rule
Benefits of the one percent rule:
- Investors can compare rental properties quickly.
- Investors might try using the one percent rule to negotiate a lower purchase price on an investment property.
Downsides of the one percent rule:
- The one percent rule ignores important factors like projected appreciation and property expenses (including maintenance, property taxes, and property insurance)
- It’s not applicable in many local real estate markets. Any market where the median rents are less than one percent of the median purchase price is not a good fit for the one percent rule.
Alternative Benchmarks to the One Percent Rule
A lack of effective planning and research is one of the biggest mistakes to avoid when investing in real estate. And this includes completing your due diligence on the financial returns of your prospective investments.
The one percent rule was never intended to be a hard-and-fast gauge for evaluating rental properties; it’s just a quick calculation you can often do in your head to get a vague idea of the investment’s feasibility. Consider these additional financial metrics in addition to the one percent rule.
The two percent rule works the same way as the one percent rule. It just increases the amount of monthly income required to pass the test as a “good investment.” Instead of the month rents equaling at least one percent of the purchase price, investors who follow the two percent rule expect rents to equal at least two percent of the purchase price.
It is nearly impossible to meet the 2% rule in an average real estate market. You’re most likely to hit this target on low-end properties with substantial maintenance and repair expenses. For example, a property for $80,000 that cashflows $1,600 per month would meet this real estate rule.
The 50 percent rule says that a property’s operating expenses (not including the mortgage payment) should cost 50 percent of the rental income or less.
With so many real estate investors underestimating the operating expenses of a property and overestimating profits, this rule is meant to give investors a realistic target for expenses and profitability.
The 70 percent rule typically only applies for fix-and-flip projects. This rule states that the purchase price should not exceed 70 percent of the home’s after-repair value minus the costs of renovations.
This rule is meant to give flippers a wide enough profit margin to make the project worthwhile.
Gross Rent Multiplier
A gross rent multiplier (GRM) is the ratio of the purchase price to the annual rental income. GRM does not take operating expenses like property taxes, insurance, or utilities into account.
GRM shows how many years it would take the property to pay for itself in gross rents received.
Unlike the other benchmarks we’ve looked at so far, there isn’t a result of thumb for GRM. You’re not necessarily looking to hit a specific number. But this metric is useful when comparing one asset against another to see which will pay for itself first.
A cap rate in real estate is another metric used to estimate the potential ROI (return on investment). It works by dividing the net operating income by the current property value or projected purchase price.
Cap rates are most often used when evaluating commercial properties. But, since residential properties of more than four units are categorized as commercial real estate, it makes sense for sophisticated real estate investors to understand how cap rates are calculated.
Invest in Rental Property with Gatsby Investment
Traditional real estate investors need to carefully calculate many ratios to determine whether or not a rental property is a good investment. But when you invest with Gatsby Investment, all the complex financial evaluations are done for you by a seasoned team of professional real estate analysts.
Here at Gatsby, we specialize in an investment strategy called real estate syndication; we pool funds from multiple investors to finance a single real estate project (very similar to what you might think of as crowdfunding). We offer full-service project management to our investors, taking care of scouting locations, acquiring properties, securing favorable financing, renovations/construction, interior design, and ongoing property management for long-term rentals (or the resale of a short-term flip project).
Our analysts scrutinize hundreds of potential real estate investment deals for every one property we accept into our portfolio. We only offer our investors the projects with the best possible return potential.
With Gatsby, you benefit from low minimum investments, a wide range of investment types, true ownership in the underlying real estate (as opposed to the debt-equity offered by most crowdfunding platforms), and a proven track record of successful projects.
Why go it alone when you can partner with experienced industry insiders to achieve better results? Sign up with Gatsby today!