Summary: In this article, you’ll learn about the 1% and 2% rules in real estate investing. Learn when to use the 1% rule, when to use the 2% rule, how these rules are useful when evaluating real estate investments, drawbacks of each, and other useful real estate investing tips.
- What is the 1% Rule in Real Estate Investing?
- What is the 2% Rule in Real Estate Investing
- When to Use the 1% Rule and 2% Rule
- When Not to Use the 1% Rule and 2% Rule
- Drawbacks of the 1% and 2% Rules
The 1 percent and 2 percent rules in real estate investing can be useful tools for evaluating real estate investments. These rules are particularly helpful for determining the cash flow potential of a property. With some quick math, investors can easily screen rental properties to determine if there is positive cash flow potential.
These real estate investing rules are all about using income discipline when buying investment properties. If a property doesn’t meet the criteria of the 1 percent (or 2 percent) rule, real estate investors can quickly know that it likely won’t be a cash flowing investment and to move on to the next property. Next, I’ll show you how to calculate the 1 percent rule and when to use it.
What is the 1% Rule in Real Estate Investing?
The 1 percent rule is used to determine if the monthly rent earned from an investment property will exceed the property’s monthly mortgage payment. The purpose of the rule is to make sure that the rental income earned from the property is more than, or at least equal to the mortgage payment.
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 you can’t pay more than $150,000 on an investment property.
How the 1% Rule Works
To calculate, multiply the purchase price of the property plus any necessary repairs by 1%. This is the baseline rent you should charge every month. 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 estimation. It doesn’t account for additional costs like, insurance, taxes and maintenance.
How to Determine Rental Price Using the 1% Rule
For rental property owners, the 1 percent rule can be a good baseline indicator for how much to charge for rent. This real estate rule of thumb is one measurement tool to help investors weigh the risk versus potential return on any given property.
- a property that costs $100,000 should rent for at least $1,000 per month.
- A property that costs $200,000 should rent for at least $2,000 per month and so on…
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 and it may be best to walk away.
The only exception would be if you are confident you can rent out the property for more than $2,000. In that case, it may be wise for investors to dig deeper into the numbers to determine if they add up and there’s a good opportunity for a positive return on investment.
- The rent should be equal to or greater than the mortgage payment to ensure an investor at least breaks even on the property.
- Take the purchase price of the property plus expenses for necessary repairs by 1% to determine the absolute lowest amount to charge for rent.
- The goal is to find a mortgage loan with monthly payments that are less than 1% of the property’s purchase price.
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 a property’s cash flow, 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: Uses the monthly rent level to determine how long it will take to pay off the investment in full. Divide the total borrowed value (loan amount) by the monthly rent. [Loan amount/rent]
- 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 also helps 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? It’s a good initial measure for “cash flow investors” to quickly determine if an investment has the potential to be profitable.
How the 2% Rule Works
To calculate the 2% rule, multiply the purchase price of the property plus any necessary repair costs by 2%. According to this rule, investors should charge no less than 2% of the total purchase price for monthly rent.
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: Not every investment property follows the 2% rule.
How to Determine Rental Price Using the 2% Rule
Just like the 1% rule, multiply the property’s value by 2% to determine how much to charge for rent each month.
- a property that costs $100,000 should rent for at least $2,000 per month.
- A property that costs $200,000 should rent for at least $4,000 per month and so on…
Example of the 2% Rule
Let’s assume you secure a mortgage loan of $150,000 on an 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 and you should charge no less than $3,000 per month for rent.
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. If those numbers meet the rule, use the 2 percent rule as a second screening tool.
When Not to Use the 1% Rule and 2% Rule
As I said before, the 1 percent and 2 percent rules aren’t so much rules as they are guidelines. There are some experts that completely disregard these rules because they believe them to be too broad and restrictive.
Their argument is that the markets where properties meet the rule criteria aren’t located in the best places to invest in real estate. 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”.
The above are some of the reasons investors may choose to disregard the 1 percent and 2 percent rules in real estate investing altogether. Regardless of these concerns, it can still be a helpful indicator of rental income to property price ratio under the right circumstances.
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 understand how to find properties with positive cash flow, 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 cash flow 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 some markets. Your two options if you want to follow the rule(s) include: buy in other markets or lower your criteria (0.5 percent).
The 1 percent and 2 percent rules in real estate investing can be helpful tools when evaluating a property’s cash flow potential. But it’s only the first step in determining whether a property is a good investment or not. What really matters is a property’s net income or how much money is left over after all expenses have been paid. 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.
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