When it comes to real estate investing, one of the most common challenges is figuring out whether a particular property is likely to generate positive cash flow. With so many variables to consider, such as purchase price, rental income, and ongoing expenses, investors often turn to rules of thumb to simplify their decision-making process. One such rule is the 1% Rule, a quick and easy method to gauge whether a rental property might produce enough income to justify the investment. In this blog, we’ll explain how the 1% Rule works, its pros and cons, and how it can be applied to different types of real estate investments.

What is the 1% Rule in Real Estate?

The 1% Rule is a basic guideline used by real estate investors to help evaluate potential rental properties quickly. The rule suggests that for a property to be considered a good investment, its gross monthly rent should be at least 1% of its purchase price. The idea is that properties that meet or exceed this threshold are more likely to generate positive cash flow, whereas properties that fall short might not be as lucrative.

While the 1% Rule is a great starting point, it’s not a foolproof method. It serves as a rough estimate to help investors narrow down their options and identify properties worth further investigation.

How to Calculate the 1% Rule

The 1% Rule is easy to calculate, which is one of the reasons why it’s so widely used. To determine if a property meets the 1% threshold, divide the gross monthly rent by the property’s purchase price. Here’s the formula:

Gross Monthly Rent / Purchase Price = 1% Rule Ratio

Let’s look at an example to see how it works in practice.

Example of the 1% Rule

Suppose an investor is considering purchasing a multifamily property with a listed price of $1 million. After researching the local market, the investor estimates the property will generate $8,000 in gross monthly rent. To calculate the ratio:

$8,000 (monthly rent) / $1,000,000 (purchase price) = 0.8%

In this case, the property’s rent is only 0.8% of the purchase price, meaning it falls short of the 1% threshold. While this doesn’t necessarily mean the property is a bad investment, it does suggest that further research and due diligence are needed.

Pros and Cons of Using the 1% Rule

While the 1% Rule is a helpful tool, it’s important to understand its strengths and limitations.

Pros

• Quick Analysis: The main advantage of the 1% Rule is that it provides a fast and simple way to assess whether a property is worth further consideration. Investors can use it to quickly filter through multiple options without getting bogged down in complex calculations.
• Applicability to Different Property Types: Whether you’re looking at single-family homes or multifamily buildings, the 1% Rule works the same way. It’s versatile and can be applied across various types of real estate investments.
• Helps Avoid Bias: The 1% Rule helps investors focus on properties that make financial sense, even if they’re located in less familiar markets. For example, an investor might prefer properties in their hometown, but the 1% Rule could prompt them to explore markets that offer better rental-to-price ratios.

Cons

• Overlooks Important Expenses: While the 1% Rule is helpful for initial screening, it doesn’t account for various costs that can impact cash flow, such as property taxes, mortgage payments, insurance, property management fees, repairs, and vacancies. These costs can quickly erode potential profits, so it’s important to consider them separately.
• Doesn’t Reflect Market Variations: The rule doesn’t take into account regional differences in property expenses. For example, taxes and maintenance costs can vary significantly from one area to another, which might make a property in a high-tax area less profitable even if it meets the 1% Rule.

Is the 1% Rule Still Relevant Today?

The 1% Rule remains a valuable tool for real estate investors, but it’s important to understand its limitations. As property values rise, it’s becoming increasingly difficult to find rental properties that generate 1% or more of the purchase price in gross monthly rent. This challenge is especially prevalent in high-demand markets where prices have soared.

For this reason, some investors have turned to alternative guidelines, such as the 2% Rule, which is a more stringent version of the 1% Rule. The 2% Rule requires the monthly rent to be at least 2% of the property’s purchase price. While properties meeting the 2% Rule are rare, they can be found in markets experiencing economic downturns or in foreclosure sales.

Using the 1% Rule for Private Equity Real Estate Investments

While private equity investors don’t typically purchase properties directly, they can still use the 1% Rule to evaluate potential investments. When investing in a private equity firm’s portfolio, the investor can assess the projected rental income and the price of the property to see if the deal meets the 1% threshold. This can help determine whether the property is likely to generate positive cash flow and whether the investment aligns with their return expectations.

Conclusion

The 1% Rule is a helpful guideline that can quickly highlight promising rental properties and weed out potential investment failures. It’s a simple tool that allows investors to estimate the cash flow potential of a property based on its purchase price and gross rental income. While it’s not a substitute for more detailed analysis, it’s an excellent starting point for real estate investors looking to streamline their property search.

As property prices continue to rise, it may become more challenging to find properties that meet the 1% threshold. However, the 1% Rule remains a valuable tool when used in conjunction with more in-depth analysis, helping investors make smarter decisions in the competitive world of real estate investing.