You’d think that after 15 years of being a landlord and reading about personal finance, I’d know all the rules of thumb. However, I recently came across the 1% rule of real estate investing and had to look up the definition. Perhaps I knew in the past and just forgot about it. We’re accidental landlords, our rentals are homes that we already lived in. The exception was an investment property that was insanely cheap. It was in great condition – no repairs necessary. We didn’t have to do a single calculation on it, because we already had a condo in the same complex. We knew everything about the neighborhood already.
I love rules of thumb because they help me verify that I’m on track. So…
What is the 1% Rule in Real Estate Investing?
It’s a quick estimation of whether you are getting value when you buy a rental property. The monthly rent should be 1% of the purchase price plus any necessary repairs. For example, a $200,000 home (with no repairs) should rent at $2000 (or more) to cover the mortgage payments.
Similarly, you could do the reverse and multiple an expected rent by 100 to figure out how much you should pay for a property.
When to Use the One Percent Rule
The best time to use the rule is early in the search as a prescreening tool. That’s what the experts say at least.
I was looking at the properties we have and I thought, “What if we sold them to another investor?” Or if I were an investor today, would I buy the rentals all over again?
Our oldest property currently has a Zillow estimate of $200,000. That makes figuring out the 1% rule very easy because we just finished that example. Zillow’s Rent Zestimate is a little less than $1800. The rent we’re making is $1350. We’ve kept it low for a long time because our tenant is an elderly widow living there on a fixed income and we don’t have to do anything. Keeping the vacancies minimal is also important to us.
We’re losing money on the property as condo fees keep going up. It’s starting to be an older property and the expenses will go up to maintain it.
It wasn’t bought to be a rental in the first place. However, if someone bought it now and got a tenant in it, perhaps it would be close to 1%.
My old condo is worth $358,000 now according to Zillow. However, the rent Zestimate is a little less than $2300. For it to follow the 1% rule, we should be collecting $3,580 a month in rent. Zillow says we couldn’t get close to that. It’s true, we have it rented for only $1900. We’ll look to raise this rent too because the condo association has had a couple of fires and the insurance has gone up.
Fortunately, we bought the condo a long time ago, so the mortgage is lower. Unfortunately, that’s not enough to generate positive cash flow.
So far no investor should buy either of our properties.
Our newest property was bought in 2013 and it was a great deal at $95,000. We sold it for nearly double at the end of 2019. We did a 1031 Exchange, which allows us to roll the money into a new property without paying taxes on the sale. We did all this because it is easier to manage property closer to where we live.
We paid about $200,000 for the new property and it jumped to $265,000 as prices have skyrocketed in the last year. We’ve only been able to get $1600 in rent though. Zillow says that we may have been able to get $1800, but the $1600 was fair for the market. In the last couple of months, Zillow has jumped the rent estimate to $2500.
If an investor about the property from us for $265,000 and tried to rent it out to someone new, I doubt it would get $2,500, much less $2,650.
This is actually our primary residence instead of a rental property. However, it used to be rental property. We lived in California, but in 2011 we bought a house in Rhode Island. The real estate market was still down and we figured we could get a price and rent it out to a military family until we retire in it. We only rented it for one year.
We bought it for $400,000 and we were able to rent it for $2,600. That’s not near 1% either. Zillow says it is worth nearly $700,000 now, but the rent would be a little more than $3,400. That’s only about 0.05% – very far from 1%.
Throw out the 1% Rule?
I think our area of New England makes the 1% rule very difficult to do. There might be some properties that are 1%, but it’s very hard. Perhaps if we bought a 3-family house, we could get enough rent.
Another “problem” is that the housing market has exploded in the last year. Rents have gone up too, but it seems like that they haven’t gone up fast enough to make hitting the 1% rule easier.
One way to get to the 1% rule is to wait. Rents go up over time, but your mortgage should stay the same. Let’s review the first property again. The purchase price of the property was around $140,000, so the current rent of $1350 is very close. If we charged a market rate, we’d finally have over the 1% rule.
What’s better than the 1% Rule?
Many real estate investors prefer to use the rent multiplier over the 1% rule. It’s very similar, but rather than just giving you a decision to move forward or not, it can be used to quantify how good or how bad a deal is. You simply divide the price of the property by the rent. So, we can use the very first example above with the $200,000 price and $2000 rent to come out with a rent multiplier of 100. That means it will take 100 months of rent to break even. Of course, you wouldn’t really break even because there are other expenses such as property taxes and repair costs. It’s just a good guideline to compare properties.
If you have another property that costs $100,000 and the rent is $1,500 that’s a much better deal as it would pay off in 66 months or five and a half years. Again, it’s important to note that about half the rent will go to other things over the long term.
Even though both properties pass the 1% rule, you can see how much better the second property is. Or, in the case of my property examples above how much worse they are.
Some people use the Gross Rent Multiplier (GRM), which just means that it uses the gross rents or the rent for a whole year. The math isn’t different, it’s only a matter of whether you want the answer in terms of months or years.
The 1% rule works to show you if a property is a good investment. It isn’t perfect though. Some locations are expensive and the 1% rate may not be possible. When that happens you may have to look at investing in another location, which can create its own set of management headaches. Or, you may decide to get as close as you can by minimizing the GRM and counting on appreciation to add value.
For us, the toothpaste is already out of the tube. We’re far enough along where we may be able to pay off the mortgages soon and have a real monthly cash flow. If we can raise the rental rates to be a little competitive it will certainly help. However, this is a tough time due to COVID, so staying with lower rents for a while longer may make the most sense.