Are you new to the world of real estate investing and wondering how to evaluate a property before making a purchase? The 1% rule is a popular method used by real estate investors to filter out potential properties that are not worth their time and money.
In this guide, we will discuss everything you need to know about the 1% rule – how it works, its history, benefits, and drawbacks.
By the end of this reading, you will have a better understanding of the 1% rule and why it is an essential tool for successful real estate investing.
What is the 1% Rule?
The 1% rule or real estate 1 rule is a guideline in real estate investing that suggests a rental property should generate a monthly rent equal to or greater than 1% of the total upfront cost of the property, including purchase price and necessary initial repairs.
For instance, if you purchase a property for $100,000, the 1% rule indicates that you should aim for at least $1,000 in monthly rent.
This rule serves as a preliminary assessment tool for investors, identifying properties that could yield a favorable cash flow and return on investment.
However, this is just a general rule of thumb, and you can always adjust the ratio based on factors like the property's location, condition, and rental market.
History of the Rule
The 1% rule is not a new rule in real estate, and its origins can be traced back to the early days of real estate investing. The rule helped investors evaluate a potential investment property quickly and efficiently, ensuring they did not waste time on bad deals.
Today, the 1% rule remains an essential tool for investors, especially newbies, and helps them identify high-yield rental properties with potential for positive cash flow.
The one percent rule works by taking the assumed purchase price or the property's sale price and dividing it by the monthly gross rent.
The 1% Rule during the 2007 Recession
During the 2007 recession, the real estate market was characterized by an oversupply of properties. Local real estate markets were faced with a multitude of options, which made the process of selecting profitable properties for investors and real estate agents much more complicated.
In this environment, the 1% rule served as a reliable guide for investors. By ensuring that the monthly rental income was at least 1% of the property's purchase price, investors could filter out unprofitable properties and focus on those with potential for good returns.
The 1% Rule in Today's Market
However, in today's real estate market, the 1% rule may not always be the best metric to use.
The rule doesn't account for variables such as property taxes, insurance, operating costs, maintenance costs, repair costs, and mortgage rates, all of which can significantly impact a property's profitability.
Additionally, in markets where property prices have skyrocketed, it may be challenging to find properties that meet the 1% rule.
Therefore, while the 1% rule can still be a useful starting point, investors should consider other factors and perform a comprehensive analysis to ensure a property is a good investment.
Advantages of the 1% Rule in Real Estate Investment
- Simplifies Property Screening: The 1% rule provides a straightforward screening process for potential investment properties. It quickly identifies properties that are likely to provide a positive monthly cash flow.
- Facilitates Comparative Analysis: The rule offers a standard metric that can be used to compare various properties, enabling investors to easily identify the most promising investments.
- Minimizes Risk: By focusing on properties that meet the 1% rule, investors can minimize the risk of negative cash flow, thereby safeguarding their investments.
- Promotes Financial Discipline: Adhering to the 1% rule can instill financial discipline in investors, helping them avoid overpriced properties or unrealistic rental income expectations.
- Useful in Diverse Markets: While it may be challenging to find properties that meet the 1% rule in some high-value markets, it can be a highly effective tool in markets with lower property values and higher rental demand.
Drawbacks of the 1% Rule
- Limited Scope: The 1% rule doesn’t take into consideration other pivotal factors such as property taxes, insurance, and maintenance costs. Ignoring these expenses can lead to an inaccurate representation of potential profitability.
- Over Simplification: Real estate investments are complex and require a thorough analysis. By relying solely on the 1% rule, investors could potentially overlook other significant aspects of the property, including its condition, location, and long-term appreciation potential.
- Not Universal: The rule is not universally applicable. In high-value markets or areas with low rental rates, meeting the 1% rule can be challenging and may limit the investor's options.
- Potential for Neglecting Quality: With the focus on meeting the 1% rule threshold, investors might compromise on the quality of the property, which could lead to higher maintenance costs or difficulty in finding tenants.
- Possibility of Misleading Outcomes: The 1% rule is based on gross income, not net income. Relying on this rule could therefore lead to misleading outcomes and a less profitable investment than initially expected.
Resources to Find Properties That Meet the 1% Rule
As a real estate investor, turning to Coffee Clozers can prove to be a great decision.
This platform allows you to download property listings for an entire city, offering comprehensive metrics including cash flow and cash-on-cash return. This wealth of information can be instrumental in identifying properties that meet the 1% rule, accelerating the process of finding potentially lucrative investments.
Coffee Clozers excels in tracking emerging areas. It empowers investors to discover properties in a local real estate market, which are often primed for appreciation.
Such areas can provide a double advantage: not only do they meet the one percent rule, but they also offer the potential for significant appreciation, boosting your investment returns.
Additionally, Coffee Clozers can help identify properties that need some value addition. These properties, often requiring minor enhancements or fixes, might not meet the 1% rule initially.
This includes properties that are ADU eligible, have ability extra space to add a bedroom, and mislabeled property types in the MLS.
However, with an appropriate value-add strategy, these properties can be transformed into profitable investments that fulfill the 1% rule.
So, how do you find properties that meet the 1% rule? There are several online tools and resources to help you identify and evaluate potential rental properties.
Calculating the 1% Rule Using Redfin and Zillow
To calculate the 1% rule using Redfin and Zillow, follow the steps outlined below:
- Choose a City: Start by choosing the city in which you're interested in investing. For instance, if you're considering investing in properties in Los Angeles, enter "Los Angeles" into the search bar on the Redfin homepage.
- Filter on Parameters: After you've chosen a city, filter the properties based on your investment parameters. For example, you may want to filter properties by price, number of bedrooms, square footage, etc.
- Download the Properties to a CSV File: Once you have your list of potential properties, Redfin offers an option to download this information into a CSV file. This file will include all the property details you'll need to evaluate each one.
- Get Median Rent by Zip Code from Zillow: Go over to Zillow and use their Rent Index tool to find the median rent for each zip code that corresponds to your potential properties. This tool provides a comprehensive overview of rent prices within a specific zip code.
- Calculate the Property Price Divided by Rent for the 1% Rule: The final step is to take your property's price (from your CSV file) and divide it by the median rent (from Zillow's Rent Index). If this number is less than or equal to 1%, then the property meets the 1% rule. If it's greater than 1%, then the property does not meet the 1% rule and may not be a sound investment based on this rule alone.
Additionally, real estate investment communities like BiggerPockets.com offer an opportunity to learn from and network with experienced professionals in the industry.
Steps to Find Median Rent for a Property
Finding the minimum monthly rent for a property is an essential step in understanding your property's potential profitability. Here are the steps to guide you:
- Research the Market: Begin by doing a comprehensive market research of the area where your property is located. Websites like Zillow, Redfin, and Realtor.com can provide a wealth of information about median rental rates in different neighborhoods. These values can be used to calculate gross annual rent.
- Check Competing Properties: Look for similar properties within your area, focusing on properties with the same number of bedrooms, bathrooms, and similar features. Check their current rental prices to gather a range of prices.
- Use Online Rent Calculators: There are several online rent calculators that can provide an estimated rental price based on your property's location, size, amenities, and condition. Check out - 5 Best Rental Property Calculators for Real Estate Investors
- Consult a Real Estate Agent: If you're still unsure, or if the property is in a complex or highly variable market, consider consulting with a local real estate professional. They will have a deep understanding of the market and can provide insight into a realistic monthly rent for your property.
Remember that setting the right rental price for your property is a balance between maximizing your income and ensuring the property is occupied.
Median rent gives you a benchmark, but the final decision should consider factors such as the condition of your property and the current market demand.
The 1% rule is a useful tool for evaluating rental properties and identifying high-yield investment opportunities. While it is not a perfect metric, it can help investors filter out potential properties that are not worth their while.
Remember to consider other factors, such as the property's age, location, and rental conditions, when evaluating rental properties.
With the right approach and tools, you can find profitable rental properties and maximize your return on investment.