A Guide to One Percent Rule in Real Estate Investing

Real estate investors can use a variety of litmus tests to determine whether a property could be worth investing in. No single rule is a failsafe in real estate, but several can be informative when screening or evaluating properties. The one percent rule is among the most common tests used by investors who prioritize rental income.

What is the One Percent Rule in Real Estate?

The one percent rule assesses the financial viability of a real estate investment according to rental income and mortgage payment. The rule bases these measures on 1% of a property’s cost plus repairs, and the mortgage payment.

The rule essentially checks two things. First, monthly rents should exceed 1% of the total cost (purchase plus repairs). Second, monthly mortgage payments should be below the 1% mark.

It’s important to note that this measurement doesn’t consider payments like property taxes, insurance, or general maintenance.

As with all rules and guidelines in real estate, the 1% rule shouldn’t be blindly followed in every situation. It’s highly applicable in many situations, though.

Why Does the 1% Rule Matter?

The one percent rule is a straightforward way to estimate whether a property will at least break even. If the property meets the 1% rule, then it will likely at least cover its expenses. Covering expenses ensures that the property doesn’t need ongoing funding to remain solvent, and it gives investors the opportunity to earn a positive return.

The rule can also be used conversely to determine required rent income by dividing the calculated 1% by leased square footage. Investors can then see whether that rate per square foot is competitive with the local real estate market.

1% Rule on Rental Property

The 1% rule is most useful as a preliminary screening tool when applying for rental properties. It’s an easy way to estimate viability quickly, and to check whether rents are within what the local market currently supports.

This is one metric that’s used both in the residential real estate market and commercial real estate market. It has broad use across properties ranging from single-family homes to large multi-family and commercial buildings.

How to Calculate One Percent Rule (with Examples)

Calculating the one percent rule is straightforward. The total acquisition cost should be multiplied by 1% (0.01). The cost of acquisition includes the purchase price, financing and closing costs, and any repairs made. It doesn’t include ongoing expenses, like taxes, insurance, accounting fees, or maintenance.

Example 1: Residential House Passing 1% Rule

For an example of a residential property that passes the 1% rule, consider a house purchased for $200,000. All-in, the total cost of acquiring the property was $220,000. One percent in this example would be $2,200.

The monthly mortgage payment on this house is $2,000, and the local area supports rents around $2,400 for a house of this size. The house in this example would pass the 1% rule.

Example 2: Residential House With Mortgage Payment Too High

Another house was purchased in the same market for $200,000, but at a time when interest rates were much higher. The total cost was again $220,000. The mortgage payment was $2,250, however, because interest rates had jumped. Rents were still supported at around $2,400.

The house wouldn’t pass the 1% rule, because its mortgage payment of $2,250 is higher than the 1% amount of $2,200. The particular house might merit some consideration because the mortgage is just over 1% each month, but there also may be much more attractive opportunities in the area.

Example 3: Residential House With Rent Too Low

In a more depressed area, an older house needing some repair might be purchased for $60,000. Another $30,000 in repairs and $6,000 in closing costs would bring the total cost up to $96,000. One percent, thus, would be $960.

A mortgage payment on a $50,000 loan might be well below $960 each month. Because the area is so depressed, however, the rent that can be charged is only about $800 per month. The house wouldn’t pass the 1% rule in this case, as the rents aren’t sufficient.

Example 4: Commercial Property Passing 1% Rule

A commercial property with multiple spaces was purchased for $500,000, and the total cost was $600,000 after closing and repairs. This places the 1% mark at $6,000.

An interest-only loan payment might be just $3,300, which is well below the $6,000 market. If the property’s spaces could be leased for $7,000 per month, then it’d pass the 1% rule.

Pros and Cons of One Percent Rule

As with any single metric used in real estate investing, the 1% rule has both advantages and disadvantages.

Pros of the One Percent Rule

• Simplicity: The rule offers a quick and easy way to screen potential properties’ financial viability.
• Risk Mitigation: Following the rule can mitigate risk by reducing the likelihood that funds need to be provided simply to cover the mortgage payment.
• Cash Flow: The rule is especially good at helping investors assess whether a property would be likely to have positive cash flow.

Cons of One Percent Rule

• Oversimplification: The rule is oversimplified in that it disregards taxes, insurance, maintenance, appreciation, and many other factors.
• Miss Appreciation: Because the rule focuses on cash flow, it can miss properties that wouldn’t have positive net operating incomes — but might be highly profitable due to appreciation.
• Market Limitations: In high-cost areas, finding properties that meet this criterion can be challenging, limiting investment opportunities.
• Neglect of Expenses: The rule doesn’t account for property-specific expenses, which can significantly impact profitability.

Other Rules to Calculate the Worth of a Real Estate Investment

When the one percent rule isn’t beneficial, there are several other rules that investors might use similarly:

• 2% Rule: Functions the same as the 1% rule but doubles the amount to 2%. This is a stricter and more conservative adaptation.
• 28% Rule: Spends no more than 28% of monthly income on mortgage, taxes, and insurance. This is a well-established rule for homebuyers, although the allowed amount is being increased by many lenders. It might be useful if investing in single-family homes.
• 70% Rule: Used by flippers, who aim to spend at most 70% of after-repair value (ARV) on purchase and repairs.

Wrapping Up

Understanding the one percent rule can help you screen properties for potential investment. It’s an easy way to identify potential properties and could help you avoid one that would only drain your funds. Use it as a screener, and investigate any properties that pass more fully to decide whether they merit an investment.