Summary: In this article, you’ll learn about the 1% and 2% rules in real estate investing. Learn if and when to use the 1% rule and 2% rule, how these rules are useful when evaluating real estate investments, the drawbacks of each, and other useful real estate investing tips.
Table of Contents
- What is the 1% Rule
- What is the 2% Rule
- When to Use the 1% and 2% Rules
- When Not to Use the 1% and 2% Rules
Introduction
The 1 percent and 2 percent rules in real estate investing can be useful tools for evaluating real estate investments in certain scenarios. With some quick math, investors can screen rental properties to determine if any are worth pursuing further.
These real estate investing rules are all about using income discipline when buying investment properties. That said, they are not hard and fast rules. The 1% rule is simply a quick test to see if a property’s rent to value ratios are healthy or not. Next, I’ll show you how to calculate the 1 percent rule and when it might be helpful to use.
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What is the 1% Rule in Real Estate Investing?
The 1 percent rule in real estate is used to determine if the monthly rental income earned from the property is more than, or at least equal to one percent of the purchase price.
Monthly Rental Income ≥ One Percent of Purchase Price
You can get the same result by reversing the 1 percent rule:
[100 x Monthly Rent = Maximum Purchase Price]
If a property rents for $1,500 per month, after a quick calculation, you know that the purchase price should be around $150,000. Keep in mind that the rental market dictates rental values, not the purchase price of a home.
How the 1% Rule Works
To calculate, multiply the purchase price of the property plus any necessary repairs by 1%. If you’re financing, compare the result to your potential monthly mortgage and you will have a better understanding of a property’s monthly cash flow. Note: The 1 percent rule is best used as a quick, “back of napkin” litmus test that investors use to determine whether rent to value ratios are healthy or not. It doesn’t account for additional costs like, insurance, taxes and maintenance.
Example of the 1% Rule
Let’s assume that you are looking to get a mortgage loan on an investment property with a value of $200,000. Using the 1 percent rule, multiply $200,000 by 1%. The result of your calculation would be $2,000.
What the result of the 1 percent rule tells us is that your mortgage payments each month should be no more than $2,000. If the mortgage owed exceeds $2,000 per month, it will be difficult to earn positive cash flow on the investment property.
An exception would be if you are confident you can rent out the property for more than $2,000 per month. In most cases, it’s wise for investors to dig deeper into numbers beyond the 1% rule to adequately determine if they add up and whether there’s a good opportunity for a positive return on investment.
Takeaways:
- According to the 1% rule, rental income should be equal to or greater than the purchase price.
- Take the purchase price of the property plus expenses for necessary repairs and times by 1% to determine whether rent to value ratios are healthy or not.
- Rental markets dictate rental values.
The One Percent Rule vs Other Useful Real Estate Investing Calculations
As students of real estate investing, we learn that there are dozens of useful and crucial calculations that should be determined throughout the buying process. While the one percent rule is a quick and easy way to evaluate rent to value ratios, we know that it’s only one of many indicators to look at before buying an investment property.
The following are a few useful real estate investing calculations:
- Gross Rent Multiplier: Used to gauge the relative gross income earning potential of an asset. It tells you how long until the asset will start earning gross income that is equal to the purchase price. To calculate, take the fair market value of a home or the purchase price, divided by the gross rental income.
- The 70% rule: This rule suggests what an investor should pay for a fix-and-flip property in order to make money. The rule says that investors should pay 70% of the estimated after repair value (ARV) of a property minus repair costs. Remember, this metric is used mostly on fix-and-flip properties.
- The 50 percent rule: Used for a quick analysis of a single family investment property. The rule says, on average, the total operating expenses will be about 50 percent of the gross rents. The 50 percent rule is long-term average estimate. So, roughly half of the generated revenue gets spent on operating overhead costs over the long term. While you may enjoy years with low bills, eventually you will have to replace the gutters, roof, A/C, electrical, etc.
For a complete glossary of real estate investing terms, definitions and calculations, check out our Top 54 Real Estate Definitions for Investors to Know.
What is the 2% Rule in Real Estate Investing
Like the 1 percent rule, the 2 percent rule in real estate can help investors measure rent to price ratio. This rule of thumb uses the same idea as the 1 percent rule. However, The 2 percent rule suggests that a rental property is a good investment if the money from rent each month is equal to or higher than 2% of the purchase price. How useful is the 2% rule? These days, it’s almost completely obsolete and rarely used. However, investors that buy distressed properties in D & F neighborhoods might use the 2% rule.
How the 2% Rule Works
To calculate the 2% rule, multiplythe purchase price of the property plus any necessary repair costs by 2%.
Depending on what an investor is looking to get out of a rental property, if it doesn’t meet the 2% rule, it could still be an opportunity to invest for appreciation. You must decide if your long-term goal is appreciation or if it’s monthly cash flow. Once you have a better idea of your goals, you can choose whether to use or not use the 2% rule, based on your real estate investment goals.
Please note: Very few investment properties follow the 2% rule.
Example of the 2% Rule
Let’s assume you buy a $150,000 investment property. Using the 2 percent rule, times $150,000 by 2%. The result of the calculation is $3,000. This tells us that your mortgage should be no more than $3,000 per month.
When to Use the 1% Rule and 2% Rule
The 1 percent and 2 percent rules are really only useful at the beginning phase of evaluating real estate investments. Use the 1 percent rule as the prescreening tool. The 2 percent rule is rarely used as a screening tool anymore.
When Not to Use the 1% Rule and 2% Rule
These days, many real estate experts completely disregard the 1 percent and 2 percent rules.
The markets where properties meet the rule criteria usually aren’t located in the best neighborhoods. And to meet the 2 percent rule, rental properties must be on the less expensive end. Which sometimes means an investor will be paying more for repairs and maintenance because the property is “cheaper”.
Buying a home that meets the 2% rule is not something we would recommend to our investors. That’s because it will very likely be located in a D or F neighborhood and in poor shape.
Regardless of these concerns, some investors still find the 1% rule a helpful indicator, under the right circ*mstances.
Drawbacks of the 1% and 2% Rules
We know there are a number of drawbacks of the 1 percent and 2 percent rules when it comes to investing in real estate. While these rules can help investors determine if healthy rent to value ratios exist in the market, they do not stand on their own as key determinants of a successful investment property.
The following are a few of the drawbacks of the 1% and 2% rules:
- Only useful for evaluating the rent to value of a property, it doesn’t necessarily paint the whole picture of investment potential.
- Do not account for other property expenses, like mortgage and acquisition fees, closing costs, repairs and maintenance, insurance, property taxes, and so on.
- Do not tell you anything about the property’s condition, location, net rental income, cash-on-cash (COC) return, cap rate or appreciation.
- It may not even be possible to meet these rules in most markets. Your two options if you want to follow the rule(s) include: buy in other markets or lower your criteria (0.8 percent).
Conclusion
The 1 percent and 2 percent rules in real estate investing can be helpful tools when initially evaluating a property. But it’s merely a quick litmus test in determining whether rent to value ratios are healthy or not. What’s really important is a property’s net income or how much money is left over after all expenses have been paid.
Investors who only use the 1% rule to decide which properties to take a closer look at are likely missing out on great deals. The 0.8% rule could be the new 1% rule given super low interest rates right now. To give you the best shot at a successful real estate investment, set goals for a property’s cap rate and net income after financing.
