The 1% rule is a real estate investment guideline that indicates the minimum monthly rent you must charge to break even on a rental property. The rule states that your rent must be at least 1% of the sale price of your property.
Although the 1% rule can be a useful metric for investment properties, it is meant to be more of a filter than anything else. You should take it with a grain of salt, especially when calculating current home prices.
This post will break down the 1% rule in detail, what it doesn’t represent, and other metrics you should keep in mind.
How does the 1% rule work?
The 1% rule helps you calculate how much rent the tenant should charge. The rule calculates the purchase price of the property plus the cost of the necessary repairs. For example, if you bought a home for $230,000 and then spent $20,000 on repairs, you would have to pay renters $2,500 per month if you followed the 1% rule. If your property is a duplex, you will instead charge $1,250 per tenant.
A guidebook can give you a basic idea of whether or not a property is worth investing in. If your mortgage payments are going to be greater than what you’re charging in rent, then in theory, it’s probably not an ideal investment.
What the 1% rule is not
If the 1% guideline was the only necessary calculation, you’d get your money back in 100 months or 8.33 years. However, real estate investing is much more complex than that. This is a list of just some of them Things that are not considered in the 1% rule:
- Mortgage interest rates
- Homeowners Association (HOA) Fee
- Insurance premiums
- Property Taxes
- Property management fees
- Ongoing property maintenance and repair
- Atypical markets, such as San Francisco, New York and other large cities
- legal fees
- Additional income from rent, laundry, storage, etc.
- vacancy periods
- cash reserves
- Real estate market (in general)
- Rent increase per year
- Expense growth per year
Dave Meyer pointed out that the 1% rule is an old proposition that was created in a different market. While it was a nice metric to use shortly after the financial crisis, it is not as useful today. If you base your investment strategy on just the 1% rule, you will miss out on many potentially great investments with rental-to-price ratios of less than 1%.
Alternatives to the 1% rule
Many investors analyze dozens if not hundreds of trades before investing in any one. In the initial research phase, investors quickly try to weed out properties that don’t meet certain thresholds before getting into the nitty-gritty.
Although you’ll never know exactly how much you’ll make on an investment, a few other calculations you can do will help you narrow your search when deciding what to invest in.
Focusing on immediate yield may make monthly cash flow a better metric.
Cash Flow calculates your total monthly cash flow minus your total operating expenses. Typically, “good” cash flow when net is $100-$200 per unit per month. However, it all depends on the amount of your initial investment. If you’re making $200 a month on a $100,000 investment, that’s not an attractive return. However, if you’re making $200 per month on a $10,000 investment, that’s a 2% monthly return.
Here is how the cash flow is calculated:
|total monthly cash flow
(including rent and ancillary income, such as parking, pet fees, etc.)
|Monthly mortgage payments (principal and interest)||$950|
|Property management fee (10% of rental income)||$ 200|
|Reform of the budget reserve (10% of rental income||$ 200|
|vacant reserves budget (5% of rental income)||$100 dollars|
|Additional expenses (eg, other insurance, gas/mileage, supplies, etc.)||$100 dollars|
|monthly net cash flow (or Net Operating Income – NOI for short)||$250|
Depending on these calculations, you’ll earn $250 per month or $3,000 per year, not including any tax benefits. Cash flow can tell you how much you make per month, but that knowledge only gets you so far.
Most investors prefer calculating returns on cash over cash.
The cash return on cash is the amount of money you earned in your annual pre-tax cash flow divided by the amount you initially invested. Cash Return on Cash calculates the percentage of the investment you made this year in your cash flow. This will help you determine if the $250 per month you make in profit is worth it. Most investors prefer this method of calculating their operating income.
Let’s say you buy real estate for $200,000. You cut 20% ($40,000), paid 2% in closing costs ($4,000), and fixed another $6,000. In all, I spent $50,000. If your new annual cash flow is $3,000, then $3,000 / $50,000 = 6% cash return.
If this property is a duplex and you get $500 a month instead, the cash back yield will be 12% ($6,000 / $50,000). You’ll want a cash return of between 10-12%, preferably closer to 12%, to outperform the S&P 500 and other popular stock market funds.
Keep in mind that this is your annual pre-tax cash flow. It does not take into account the tax burden or depreciation. Your cash back return never counts as:
- Opportunity costs
- risks associated with your investment
- the entire booking period
Internal rate of return (IRR)
IRR determines the potential profitability of your real estate investment by estimating the entire holding period, compared to the cash-for-cash return, which focuses solely on the profitability of your initial investment.
If you plan to hold your investment for a few years, calculating your internal rate of return is probably your best bet (although many investors prefer the simplicity of a cash-in-cash return problem). Below is a full breakdown of how your internal rate of return is calculated.
Should you use the 1% rule?
The 1% rule was not an actual “norm”. They were once useful guidelines, but you can make several more accurate calculations when narrowing down which properties are worth investing in. You are likely to miss out on many great investment opportunities if you live and die by the 1% rule. Calculate your monetary return, or IRR, instead.
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Note by BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.