No matter the asset class, investors are constantly looking for ways to narrow down the universe of investment options and focus on those that have the most potential. Normally, it would require a lot of work to analyze potential properties and estimate the cash on cash return for each one. Estimating the cash on cash return requires the accurate estimation of other income and expenses, including gross rental income, operating expenses, cash flow, and ultimately the cash on cash return.
Because it would take too much time and resources for all but the largest institutional investors to do this for every prospective property, investors have developed prescreening techniques, or rule of thumb shortcuts, to help them quickly filter down to the investment properties that have the most potential. The one percent rule is one of the more common shortcuts that investors use to do this. In this article we will go into detail on how to calculate the one percent rule, the pros and cons of using it, and how to apply it in different circumstances.
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What Is the 1% Rule in Real Estate?
The one percent rule is a rule of thumb that helps real estate investors quickly determine whether a particular rental property is likely to generate positive cash flow on a monthly basis. It can be used to analyze single-family homes as well as multifamily properties. The basic idea is that properties that meet or exceed the one percent rule are likely to be cash flow positive, while properties that fall short of the one percent rule might not. As we will see later, it is not a perfect gauge, but it is definitely a handy starting point for investors analyzing numerous real estate deals.
How to Calculate for the 1% Rule
One of the reasons that the one percent rule is used so often by so many investors is that it’s easy to calculate. The one percent rule is calculated as the gross monthly rent as a percentage of the purchase price of the property. The formula is as follows:
Purchase price of the property / gross monthly rent = 1% rule ratio
Let’s go through an example to show how to use the formula in practice.
Example of the 1% Rule
Let’s suppose that the asking price on a multifamily residential property is $1.05M, but an investor is actually able to purchase it for $1M. The investor studies the local real estate market and believes that the monthly rent will be $8,000. Using these two pieces of information, we can calculate the ratio that helps to determine whether the property is a good investment.
$8,000 / $1,000,000 = 0.8%
In this example the gross rental income of $8,000 is 0.8% of the purchase price. This property does not meet the one percent threshold because the gross rental income is less than one percent of the purchase price of the property. The investor will probably decide to look at other properties because this one does not appear to be a great investment by the one percent rule.
Pros & Cons of Using the 1% Rule
The one percent rule works pretty well and has served many investors well over the years. But, there are some drawbacks that investors should be aware of. Let’s take a look at the pros and cons of the one percent rule.
The biggest pro of using the one percent rule is that it allows investors to analyze many potential properties quickly. Often investors will look at multiple properties at a time, and using the one percent rule allows them to narrow the list to just a few that they want to do further due diligence on.
Another nice thing about that one percent rule is that it works for different types of properties. Many investors use it when looking at single-family homes to buy and rent. But, it can also be used to quickly analyze multifamily properties. The calculation does not change depending on the property type.
The one percent rule also helps investors to avoid falling prey to certain psychological biases. For example, an investor might prefer to buy property in the market where they live. But, if another market 30 miles away offers a better ratio of gross rental income to price, then the investor will pick up on this before long.
Importantly, the one percent rule does not take into account several factors that might ultimately impact the monthly cash flow and return on investment. For example, the one percent rule does not consider the following expenses: property taxes, the mortgage payment amount, interest rates and interest expenses, property management expenses, the cost of repairs, expenses associated with high vacancy rates, and closing costs. It’s no secret that these costs can add up quickly and reduce the amount of cash flow that the investor gets to take home each month.
It’s also important to realize that some of these expenses can vary considerably by market. For instance, property taxes tend to be higher in the northeastern part of the United States compared to the Midwest. The one percent rule does not take this into consideration.
Is the 1% Rule Still Useful Today?
In recent years there has been debate in the real estate investing community about whether the one percent rule is still a good guideline or starting point for investors. The thing that every investor needs to understand is that as property values increase, it gets harder to find properties where the gross monthly rent is at least one percent of the total purchase price. In other words it gets harder for investors to find rental properties that offer reliable, passive income as property prices increase. The last several years have seen property prices increase in most markets across the country, and unsurprisingly, finding properties that meet or exceed the one percent rule has become harder to do, especially in markets that had higher property value to begin with.
1% Rule vs. 2% Rule
The two percent rule is basically a more stringent version of the one percent rule. The calculation is performed exactly the same way, but instead of comparing the ratio of the gross monthly rent to purchase price against one percent, the investor looks for the ratio to meet or exceed two percent.
Let’s revisit our example above to see how the two percent rule works. In our initial example, the purchase price was $1M and the gross monthly rent was $8,000. Let’s suppose instead that the property is located in a premier location that commands very high monthly rents of $20,000. In this case the ratio would be calculated as follows:
$20,000 / $1M = 2%
In this example the property was purchased for $1M and generates $20,000 in gross monthly rent for the investor. This property meets the two percent threshold, which makes the property a highly coveted investment. Properties that meet the two percent rules are unicorns of the real estate investing world. They are very rare, especially in periods of rising prices. Generally speaking, these properties are found by astute investors during periods of economic collapse, when properties can be bought very cheaply or even through foreclosure proceedings.
Using the 1% Rule for Investing in Private Equity Real Estate
Private equity real estate investors are often presented with an individually syndicated deal, which is our preferred method. Under this arrangement, the investor can choose to invest in the purchase of a predetermined property. The nice thing about this is that the investor can do their own due diligence to determine if the investment meets their return and risk criteria. One way to do this quickly is to use the one percent rule.
Although the investor is not purchasing the property directly, the one percent rule can still be used in a similar manner when the private equity firm is the one purchasing the property. The investor simply needs to know or be able to estimate the purchase price and the gross monthly rent, just as we showed in the examples above. Again, even when the property satisfies the one percent rule, the investor should perform additional due diligence and consider related personal finance topics like taxes.
Summary of the 1% Rule in Real Estate Investing
The bottom line is that the one percent rule is a rule of thumb used by real estate investors to quickly determine whether a particular property is worth doing more due diligence on. It is calculated as the ratio of the gross monthly rent to the purchase price of the property. If that ratio meets or exceeds one percent, then the property is probably worth further research. In rare instances, the ratio can exceed two percent, which indicates that it is probably a very strong investment candidate. Investors who focus on investing in private equity real estate can use the one percent rule in much the same way as an investor doing direct purchase deals.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.