The 1% Rule: What It Means for Real Estate Investors

The 1% rule is a real estate investment guideline that indicates the minimum monthly rent you should 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.

While the 1% rule can be a useful metric for investment properties, it is meant to be a filter more than anything. You should take this with a grain of salt, especially when current domestic prices are accounted for.

This post will detail the 1% rule, what doesn’t account for it, and other metrics you should consider.

How the 1% Rule Works

The 1% rule helps you calculate how much rent you should charge a tenant. The rule accounts for the purchase price of the asset and the cost of necessary repairs. For example, if you buy a house for $230,000, spend $20,000 on repairs, you should charge your tenants $2,500 monthly if you follow the 1% rule. If your property is a duplex, you will charge $1,250 per tenant.

The guidelines can give you a basic idea whether a property is worth investing in or not. If your mortgage payment is going to exceed the rent you’re paying, then, in theory, it probably isn’t an ideal investment.

What the 1% Rule Doesn’t Eat

If the 1% guideline was your only calculation needed, you’d make your money back in 100 months, or 8.33 years. However, real estate investing is more complex than that. here is a list of some Among the things that are not included in the 1% rule:

• mortgage interest rates
• Homeowners Association (HOA) Fees
• insurance premium
• property taxes
• property management fee
• Maintenance and repair of ongoing assets
• unusual markets, such as San Francisco, New York, and other large cities
• utilities
• legal fees
• Additional income from rent, laundry, storage etc.
• Marketing
• vacancy period
• cash reserves
• Appreciation
• depreciation
• real estate market (in general)
• rent increase per year
• expenditure increase per year

Dave Mayer pointed out that the 1% rule is an old suggestion made in a different market. While this was a great metric to use in the immediate aftermath of the financial crisis, it is not as helpful today. If you’re basing your investment strategy solely on the 1% rule, you’ll miss out on many potentially great investments with rent-to-value ratios below 1%.

Alternatives to the 1% Rule

Many investors analyze dozens—if not hundreds—of deals before investing in one. In their early research stage, investors try to quickly disqualify assets that do not meet certain thresholds.

While you’ll never know exactly how much you’ll make on an investment, there are a few other calculations you can do to help narrow your search to determine what you’re investing in.

cash flow

Focusing on immediate return can make your monthly cash flow a better metric.

Cash Flow calculates your gross monthly cash flow by subtracting your total operating expenses. Typically, “good” cash flow is when you net $100-$200 per unit monthly. However, it all depends on how much your initial investment is. If you’re earning $200 a month on a $100,000 investment, that’s not an attractive return. However, if you’re earning $200 monthly on an investment of $10,000, that’s a 2% monthly return.

How to Calculate Cash Flow:

Based on these calculations, you would earn $250 each month or $3,000 per year, with no tax benefits included. Cash Flow can tell you how much you make monthly, but that knowledge only gets you so far.

cash-on-cash return

Most investors prefer to calculate cash-on-cash return.

Your cash-on-cash return is how much money you earned in annual pre-tax cash flow based on how much you initially invested. Cash-on-cash return calculates the percentage of your investment that is returned in cash flow this year. This will help you determine whether the $250 a month you are making in profit is worth it. Most investors prefer this method of calculating their operating income.

Let’s say you buy a property for $200,000. You have a 20% deductible ($40,000), pay 2% in closing costs ($4,000), and make another $6,000 in repairs. In total, you spent $50,000. If your new annual cash flow is $3,000, then $3,000 / $50,000 = your cash-on-cash return is 6%.

If this property were a duplex and you made $500 monthly instead, your cash-on-cash return would be 12% ($6,000 / $50,000). You’ll want to target a cash-on-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 doesn’t account for your tax burden or depreciation. Your cash-on-cash return never accounts for the following:

• equity
• opportunity cost
• Appreciation
• Risks associated with your investment
• full holding period

internal rate of return (IRR)

IRR determines the potential profitability of your property investment by estimating the full holding period, compared to the cash-on-cash return, which focuses only on the profitability of your initial investment.

If you plan to hold onto your investments for a few years, calculating your IRR is probably your best bet (even though many investors prefer the simplicity of the cash-on-cash return solution). Here are the full details on how to calculate your IRR.

Should You Use the 1% Rule?

The 1% rule was never a real “rule”. This was a useful guideline at one time, but when you narrow down the scope of investing in property you can make many more accurate calculations. If you live and die by the 1% rule, you will miss out on many great investment opportunities. Calculate your cash-on-cash return, or IRR, instead.

Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.