Real estate investors use what is known as the 1% rule to screen potential rental properties. This simple tool measures the price of the property to the gross income it is expected to generate.
It is called the 1% rule because the monthly rent of the income property needs to be equal to or more than 1% of the property's purchase price, to be considered a "good investment". It is simply a guideline to follow for RE investments.
With any investment tools, it's a good idea to do your due diligence. Alcove doesn't stand by any specific rule, but we like to introduce these concepts to real estate investors for sake of awareness.
The 1% rule is one of the easiest calculations a real estate investor will have to make. You just follow this very simple equation:
Monthly rental income / Purchase price of property = ~1%
For example, you purchase a single-family home for $200,000 and put in $25,000 worth of repairs. You add the two numbers together to get a total of $225,000. Now, take that number and divide by the amount of rent you can you can generate with the property. In this scenario, we'll use a monthly rent of $2,250.
$2,250 / $225,000 = 1%
This becomes an indicator for comparing other properties, and can be used as a guideline if more rent is desired (>1%) or if the purchase price should be dropped (>1%).
The 1% rule is more or less a rule of thumb or a starting point and is good to use when attempting to narrow down your property choices.
When comparing property values in an area to rental prices, you can use the 15 rule to see if that area would be a good place to purchase an investment property. If you find that the rental rates are less than 1% of the list price of properties, there are ways to obtain the 1% like increasing the rent (furnish the rental, update the home, rent by the room, etc.) or by lowering the purchase price (very difficult in a supply-constrained market).
There are limits as to when the 1% rule will work. One such limitation is looking to purchase a property in a very expensive city such as San Francisco or New York City.
You'll be looking at properties that cost well over a million dollars, but rental rates are nowhere near the 1% mark. In those cases, you should consider using some different qualifying formulas.
The 1% rule also is not a good choice when you are hoping to purchase a property that needs extensive repairs.
Although you should add the repairs into the formula, sometimes you do not know the exact cost you will be incurring. You also will not be entirely sure of your operating expenses on your income property, and those will cut down your profitability.
Not passing the 1% rule does not necessarily mean you should walk away, it all depends on your investment strategy.
If your main goal is to have positive cash flow each month through your rental properties, then yes, you should walk away if the property does not pass the 1% rule.
However, suppose you are more interested in long-term appreciation.
In that case, you will need to consider how much the area is expected to appreciate in value, and if that amount would make purchasing the property worthwhile. Raleigh-Durham, NC properties on average do not make the 1% rule. Investors either find ways around this by hoping for appreciation, or by moving their investment focus to smaller cities on the outskirts of town.
Real estate investment is an exciting undertaking with many risks and strategies. The 1% rule is only one of the many rules investors use.
As you become more experienced, you will find rules that work best for you.
If you want to learn how Alcove can help you meet the 1% Rule for a property you're interested in purchasing, try out our Coliving Rent Estimator.
This plug-and-play widget will help you understand how your property fits into the per-bedroom model, and you can earn up to 30% more rental income than you would listing through sites like Zillow.
Try it out today: https://alcoverooms.com/coliving-estimate