If you’re looking to invest in real estate, you’ve likely faced the anxiety of trying to discern whether a prospective property is going to be a winner or a loser.
While there’s no 100% perfect way to predict profit — like any investment, there is always risk involved — there are calculations that experts make when they’re evaluating a potential investment.
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One such calculation is the 1% rule, a quick way to tell whether you should take a closer look at a property, or walk away ASAP.
What is the 1% rule?
The 1% rule is a simple calculation to see whether a property will provide an adequate monthly cashflow.
You simply calculate the monthly rent you’d be able to charge, and see whether it is at least 1% of the purchase price. For example, a $200,000 rental property should bring in at least $2,000 a month in rent.
You may want to also include the projected cost of any renovations or repairs you’d need to make upon purchasing, and include that in the total cost (1). So, a $400,000 property that needs $30,000 in renovations would need to make $4,300 a month.
If the calculation tells you that the rent you’ll collect every month won’t cover the mortgage payment, you might want to pass on that property.
You can use this rule for residential or commercial property. If you have multiple tenants in one property, their collective rents would need to equal 1% of purchase price.
But what makes the rule useful — it’s basic — is also one of its pitfalls. That’s because there are many factors that it leaves out, such as HOA fees, property taxes, insurance, maintenance, potential vacancy, and the interest on your mortgage.
What critics say
In addition to the simplicity of the 1% rule, detractors have some other concerns with using this metric to make an investment decision.
In a blog post for real-estate investing platform BiggerPockets, one real estate investor notes the rule itself was popular after the global financial crisis, when home prices were lower (2). Today, house prices have climbed substantially.
Many real estate investors use the cash-on-cash return calculation to decide whether a property is a good investment. While it’s not as simple as the 1% rule, cash-on-cash return shows you what percentage of your investment you’ll make back in a year in cash flow (3).
Calculate cash-on-cash return by dividing the annual pre-tax cash flow (rent) by the total amount you’ve invested in the property. Some experts say your cash-on-cash return should be equal to or outpace what you’d make if you had other types of investments (3).
Dave Ramsey has said that he aims for a cash-on-cash return between 8 to 10% for residential rental properties, and 10 to 14% for commercial properties.
Another reason some critics say the 1% rule isn’t always the best metric is that in higher-cost housing markets, it isn’t always easy to hit that 1% (1).
1% in practice
For one budding real estate investor, the 1% rule helped him take his first steps into the market.
Atif Afzal started investing in real estate in 2019, as a way to generate a steady income stream in addition to his work as a freelance film composer and musician, according to a Business Insider report (4).
Afzal now owns four properties in Monroe, N.Y., and claimed all of his investments had immediate cash flow. Even though the rule doesn’t account for all the expenses involved in real estate investment, he told Business Insider that it’s remained one of the main metrics he uses when making a decision.
For Afzal, cash flow is a top priority, because it means he’s able to show lenders that his investments aren’t losing money, and he can get more loans.
“As long as I’m able to be close to the 1%, I’m willing to buy that property,” Afzal told Business Insider.
While the 1% rule won’t tell you everything about a property, it can give you quick insight into what your cash flow is likely to be. It won’t work for everyone, or every property, but it can be a useful yardstick when you’re starting your search.
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Article Sources
We rely only on vetted sources and credible third-party reporting. For details, see ourethics and guidelines.
Rocket Mortgage (1); BiggerPockets (2), (3); Business Insider (4)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.