When investing in real estate, it’s important to understand the numbers behind where you are putting your money to ensure the investment generates a positive cash flow. There are hundreds of ways to evaluate a real estate investment, but a well-known method to get a quick idea on if a property is worth pursuing is the 1% rule.
What is the 1% Rule?
The 1% rule compares the total price of an investment property compared to the income it will generate to determine if it’s a good investment. To pass the 1% rule, the gross income of the property must be greater than or equal to 1% of the total price.
Example
A two family rental property costs $400,000. Each unit rents for $2,100 for a total of $4,200.
$400,000 * 0.01 = $4,000
Since the $4,200 total rent is greater than the $4,000 1% calculation, this property passes the 1% rule so far.
Now, let’s say the property requires around $40,000 worth of repairs to make the property suitable for living. In this case, we would add the repair costs to the total purchase price for a total of $440,000.
$440,000 * 0.01 = $4,400
When taking the repairs into consideration, the $4,200 total rent is less than the $4,400 1% calculation, this property does not pass the 1% rule, indicating it may not be the most profitable investment.
the Limitations of the 1% Rule
While the 1% rule is a good pre-screening method you can use to narrow down your options, it does not take into consideration very important factors like property taxes, insurance, and other operating expenses. To really evaluate an investment, you’ll need to look at other factors such as Net Operating Income (NOI), Gross Rent Multiplier (GRM), Cap Rate, etc. — I’ll be publishing a blog post going over these calculations more in-depth soon.
Final Words
Overall, the 1% rule is a great tool to use when trying to decide if an investment may be worth your time and effort. Although it shouldn’t be used as your primary evaluation method, it is a quick and easy way to give you an idea if a property will cash flow.
