If you are thinking about investing in real estate then the first thing on your to-do list is selecting the right property. However, choosing the right property can require a lot of work and months of calculations. All this work can now be done in a snap with the help of the 1% rule real estate.
What is the 1% rule estate?
Generally, in the case of most real estate investments, you make money from rental income. The 1 percent rule in real estate serves as a guidance tool for real estate investors to evaluate rental properties. It is used to determine if the property’s monthly rent is more or at least equal to one percent of the property’s purchase price. The monthly rental value must be greater than the mortgage payment along with all other expenses.
How to calculate the 1% rule real estate?
The 1 percent rule real estate can be calculated by simply multiplying the purchase price by 1 percent. Or in simple terms, divide the purchase price by 100. The result will give you an idea of what your property’s minimum monthly rent should be to generate monthly cash flow.
Purchase value of the property X 1% ≤ monthly rent
Or
Purchase value of the property X 0.01 ≤ monthly rent.
If the rent is known then we can also calculate an estimated value of a rental property by:
Monthly rent X 100 ≥ Purchase value of the property
If the property requires any sort of renovations or maintenance, then according to the 1% rule real estate calculator:
(Purchase value of the property + cost of expenses) X 1% ≤ monthly rent.
The 1% rule real estate example
Let’s assume as a real estate investor you want to invest in a rental property and therefore are looking to acquire a mortgage loan. If the purchase price of the property is $100,000, by using the one percent rule the minimum monthly rent comes out to be $1000. Therefore, you should look for a mortgage loan whose monthly payments are less than $1000.
Now consider the same property which requires some maintenance whose expense is $20,000. Therefore the total value of the property becomes $120,000. Thus, the minimum monthly rent according to the 1% rule in this case comes out to $1200.
Let us take a look at some more examples to understand better how to use the 1% rule in evaluating rental properties.
Suppose a property is listed for $200,000 for sale. And the previous owner charged a rent of $2300 per month. Then according to the 1% rule, the minimum monthly rent permissible is $2000. Therefore it would make a good investment.
Now considering the same house is listed for sale at the same price. However this time the owner charged its previous tenants a rent of $1900. The monthly rent is less than 1% of the purchase price. Thus, this would not be a good deal for the investors, and should look for other investment properties. However, in this kind of scenario investors always have the room to negotiate and lower the purchase price accordingly.
Limitations of the 1% rule real estate
The 1% rule real estate is a rule of thumb and serves as the fastest method of evaluating a rental property. However, there are certain things you must also consider while evaluating an investment property in order to reap profits.
The one percent rule is quite simple and doesn’t count all the complex factors that affect the rent of a property. Some of the factors are:
- Location
Not every rental property agrees with the one percent rule. Properties in different locations work differently. Factors like good neighborhood play an important role in determining the rent of a property. Sometimes a neighborhood’s popularity increases overnight. Thus, originally the property that wasn’t supported by the 1% rule can still be a good investment.
- Maintenance cost, vacancies, and other expenses
Before investing in a property you cannot predict what your future expenses will be. The property may undergo some kind of accident that requires repairs. Moreover, the tenants might leave in between leaving your property vacant. All these unpredictable costs are not considered during the evaluation process. Therefore the one percent rule doesn’t give a proper insight for long-term investment in rental properties.
- Taxes
Property taxes vary from city to city. Property taxes in New Jersey are much higher than that of states like Colorado and Alabama. This factor is not included in the calculation.
- Interest rates
Interest rates have never been this low. Investors can earn profits on investment properties that do not comply with the one percent rule.
- Applicable for low-class properties
Generally, properties whose monthly rent is equal to 1% are mostly less expensive properties. Expensive properties, bungalows do not meet the 1% rule.
Alternative investment rules
The one percent rule is used to identify potential rental properties which might be a good investment. To truly determine the profitability of investment property you must consider other methods of evaluating a property.
- Gross rent multiplier (GRM)
In this method, the property market price is divided by the gross income. From the result, we can calculate in how many years will the investment pay off. Although it is not guaranteed but in general lower GRM means better return. GRM also doesn’t take additional expenses and taxes into account.
- Cap Rate
A popular substitute for Gross Rent Multiplier is Capitalization Rate or Cap Rate. It is calculated by dividing the net operating income(NOI) by the purchase price. The net operating income is the difference between total rental income and total expenses including taxes.
- 70% rule
The 70% rule is popular among fix-and-flip properties. According to this rule, an investor should not spend more than 70% of the after repair value(ARV). Although using this rule you need to have certain experience in the real estate market to get an estimate of your repairing cost.
- Return on investment
Return on investment or ROI is used to calculate whether the investment is profitable or not. The ROI measures the return of an investment compared to its investment cost. It is calculated by dividing an investment’s net return by the initial cost.
Bottomline
The one percent rule is a good starting method to identify potential properties that have a higher chance of yielding profits. It allows investors to discard properties that might have trouble generating proper cash flow in the future. As we have already established the 1% rule real estate is a guideline that helps investors in screening the properties before investing. However, it is advised that you must also consider other factors that give more detailed and in-depth results about the property.