Evaluating potential rental properties quickly with a 1% or 2% rule
TL;DR - If the monthly rent is 1% of the total purchase price, the rental property should produce a return.
We believe the 1%, or 2%, "rules" should really be called guidelines. When you know your market and property type intimately, they could be used to quickly rule out bad investment properties or identify properties that need more thorough analysis but seldom can be used on their own. These so-called rules can be very dangerous if a more profound analysis is not conducted on each property. These "rules" do not account for things like property tax, insurance, HOA dues, and other expenses.
Evaluating potential rental properties quickly with a 1% or 2% rule
You decide to invest in the real estate market. Congratulations! You made a wise decision.
Now, your goal is to find profitable properties. As an intelligent real estate investor, you know that much of the return on investment from the properties come from rental income.
So the best starting point for you to find where to invest could be the 1% rule or the rule of thumb.
What is the 1% rule or the rule of thumb, and How do you calculate if the property meets it?
The 1% rule or the rule of thumb is a tool for prescreening rental properties. If you need to choose between many properties, with this tool, you can narrow down your list and focus on those who meet this criterion.
The calculation of the 1% rule is straightforward.
To get your desired monthly rental income using the 1% rule, multiply your total purchase costs by 0.01 or remove the last two zeros from the total purchase price.
You don't consider operation costs and mortgage costs in the 1% rule.
Now let us calculate if the desired property meets the 1% rule.
Let's say you plan to buy property for $100,000.
You have $15,000 in cash and plan to take the loan for $85,000 to purchase the property and do all necessary repairs to it. The loan will cost you $382 a month for 30 years at a 3.5% rate.
So the gross income from the rent using the 1% rule will be 100000*0.01 = $1000 a month.
Operating costs (maintenance, management, taxes, vacancy, insurance, etc) = $500 a month
Loan = $382 a month
Net income = $1000 - $500 - $382 = $118 a month
With the 1% rule, your goal is to find the property which when rented, will bring you sufficient positive cash flow after covering all expenses.
Your costs, in this case, will be $882. Any property that meets the 1% rule will be equal or can cover these costs, enabling you to generate a return on your investment (in this example).
Can you only consider the 1% rule for the return on your investment?
Of course not! It is an excellent place to start. However, to determine the rent for your tenants, you need to do additional analyses and consider other factors too.
You'll be using the 1% rule early in the process while looking for good investment purchases.
You can easily filter 10 of the listed properties your real estate agent sends you. Then you can compare them with the market rent for the property to see if the rent is close to 1%. If it is not, you can eliminate that property.
But this rule is less effective with properties with higher-than-average maintenance costs, vacancy rates, or unusually high ownership costs. So you can use the 1% rule for the preliminary elimination, not as the sole method of evaluating real estate investments.
That is why before buying a rental property, you should always consider other factors like the location, current market trends, mortgage payments, etc.
Which factors do you need to consider when using the 1% rule to return your investment?
The location factor
The location of the property plays an essential role in the overall return. The properties near the public spaces and parks, shopping centers, restaurants, business centers, quality local schools are more expensive.
In this case, it will be more challenging to make a 1% rule in rent. For example, you want to buy a property for $600,000. It will be impossible to rent it for $6,000 a month.
Market Price of the rent
In some states, the market price of the rent is higher than the sum you will get with the 1% rule. Do you have to invest in properties where the market price of the rent does not satisfy the 1% rule? Yes. Do additional analysis to decide what to do.
Sometimes these investments are more profitable. In this case, lower your criteria considering the cash flow a rental property needs to produce.
For example, you can invest in a property if the rental costs cover operation and mortgage costs with the 0.5% rule. However, it would be best to make additional analyses to find profitable investments according to your investment criteria.
Mortgage payments
As we mention in our example, you need to consider mortgage payments when investing in real estate. Your monthly income from the rent must be more significant and cover them too.
Using a mortgage calculator and the 1% rule, you can better understand whether the investment is a good deal.
What is and when can you use the 2% rule?
The 2% rule uses the same criteria as the 1 % rule in real estate. Its goal is to help investors to determine rent and positive cash flow.
When should you use the 2% rule to see if the investment in real estate will bring you enough cash flow?
You can use it when the total price of the investment is too low. For example, you can buy the property for $40,000 and rent it for $800 monthly.
You can use it when maintenance costs are high. For example, buying older properties for a lower price needs additional repairs and maintenance. To cover these costs, you can try to raise the cost of the rent to meet the 2% rule.
You can use it when you rent properties with several months of vacancy. Higher vacancy rate properties are more likely to meet your investment criteria if they meet the 2% rule.
You can use it if you buy a property in harsher climates or rougher neighborhoods. However, these properties required higher maintenance and associated costs.
How can you be sure your investment is a good one?
When dealing with real estate investing, you need to rely on general principles and analysis. You can use the 1% or 2% rules as prescreening tools only. For your final decision, you need additional investigation.
Every investment comes with a risk. To lower the risk, we can help you. We know our markets, and we will help you find a profitable rental investment with a high ROI. As a result, you will increase your monthly cash flow and can choose to reinvest or improve your lifestyle.
As experienced real estate investors, we will cover everything for you. Don't wait. Contact us and join the community.
