The 1% Rule in Real Estate: What It Is and How Investors Use It

The 1% rule can help investors determine whether a property’s rental income can cover its costs.

The 1% rule can help investors determine whether a property's rental income can cover its costs.

The goal of real estate investing is to make money. At the very least, you want to break even on your monthly mortgage payments. But as you begin researching different rental properties, it's hard to determine which ones will produce sufficient cash flow.

That's where the 1% rule comes into play — it can help you determine the viability of an investment opportunity. Let's look at how the 1% rule works in real estate and when it makes sense to use it.

What's the 1% Rule in Real Estate?

The 1% rule states that the monthly rent for an investment property should be equal to or greater than 1% of the purchase price. For example, if a property costs $300,000, you will need to be able to charge at least $3,000 in monthly rent. If the rent price doesn't seem realistic for that property, you may want to keep looking. This rule can help you determine whether the mortgage is worth the income it may generate.

However, it's important to remember that the 1% rule is only a guideline, and there are many factors to consider before buying real estate. It also doesn't take into account any taxes and insurance you'll have to pay.

Thinking about buying an investment property? A Freedom Mortgage loan specialist can help you explore your options and find loan terms that meet your financial goals.

How To Calculate the 1% Rule

The 1% rule is fairly simple — here's the formula for calculating it:

Monthly rent ≥ .01 x purchase price

You'll start by taking the purchase price and multiplying it by .01. The result should be greater than or equal to 1% of the property's monthly rent. If it isn't, you may not be able to break even on mortgage payments.

Example of Using the 1% Rule

Let's say you're interested in buying a $250,000 condo as an investment property. The condo also needs $25,000 worth of repairs, bringing the total cost to $275,000. Here are the steps you'll take to use the 1% rule:

• $250,000 + $25,000 = $275,000 total cost
• $275,000 x .01 = $2,750

Using the 1% rule, you should be able to charge at least $2,750 per month in rent.

When Should Investors Use the 1% Rule?

Applying the 1% rule can help you determine whether a property will generate enough income to both cover its expensesprofit. However, this guideline works best under certain market conditions and investment strategies.

Best Times to Use the 1% Rule

Here are some scenarios when it makes sense to use the 1% rule:

• As a quick screening tool: This rule is most effective as an initial screening tool, especially when steady rental income is the main driver of returns.
• In cash flow markets: It works well in affordable areas where rent prices consistently exceed the cost of the mortgage and expenses.
• For entry-level investments: New investors can use the 1% rule as a framework for evaluating deals. It's a simple way to avoid overpaying and focus on properties with strong cash flow potential.

When Using the 1% Rule Might Not Make Sense

While the 1% rule is helpful in many situations, there's no one-size-fits-all solution when it comes to real estate investing. Here are a few times the 1% rule may not make sense:

• In high-cost markets: The 1% rule probably won't apply in expensive cities where the home values far exceed the rent potential.
• When you're playing the long game: If your focus is on long-term appreciation, the 1% rule won't accurately reflect the property's overall return potential.
• When hidden costs are high: The 1% rule doesn't account for property taxes, insurance, maintenance, or HOA fees, all of which can significantly reduce your returns.

Other Real Estate Investment Rules

The 1% rule is just one of several benchmarks real estate investors can use to evaluate potential deals. Here are a few other guidelines to help you assess a property's profitability:

• Gross rent multiplier: The gross rent multiplier (GRM) compares a property's purchase price to its annual rental income. You'll calculate it by dividing the property's price by its yearly rent. A lower GRM generally indicates a better return potential, but you should still factor in expenses and market trends.
• 2% rule: The 2% rule states that a property's monthly rent should equal or exceed 2% of its purchase price. While this is rare in most markets, it can help you identify exceptional cash flow opportunities in low-cost areas.
• 28% rule: The 28% rule is often used by homeowners and investors alike to gauge affordability. It recommends that housing expenses, including mortgage payments, property taxes, and insurance, shouldn't exceed 28% of your gross monthly income.
• 70% rule: Popular among house flippers, the 70% rule suggests that you shouldn't pay more than 70% of a property's after-repair value (ARV) minus the renovation costs. It's designed to help investors leave room for profit while accounting for repair expenses and market fluctuations.

Together, these rules provide a helpful framework for evaluating investment properties from multiple angles.

Final Thoughts: The 1% Rule in Real Estate

The 1% rule is a quick and easy way to evaluate whether a rental property is likely to produce positive cash flow. However, it's just one of many metrics you can use in real estate investing. You also want to consider the property's location, financing options, and expenses. Before making a purchase, run the numbers carefully and compare multiple metrics to ensure the property truly meets your financial goals.

If you're ready to finance your next investment property, Freedom Mortgage offers flexible loan options and expert guidance. Reach out today to get prequalified.