What’s all the Buzz about the “1% Rule”?
What is the 1% Rule?
As you’re evaluating real estate deals, you’ll often hear people reference the “1% Rule.” This “rule” is simply a term used to identify if the monthly rental income on an investment property equals one percent of that same property’s purchase price. For example, let’s look at our sample property.
Purchase Price: $119,950 Monthly Rental Rate: $1,195
1,195 (Monthly Rent) / 119,950 (Purchase Price) x 100 = 1% (0.996 to be exact)
The 1% Rule is an evaluation tool more than it is a rule, and it’s one that is used widely as a screening tool to quickly help investors identify how a property will cash flow.
While we do see the value in using the 1% Rule as a starting point for evaluating an investment property, we have concerns over using it as a make-or-break benchmark for an investment. Remember, the 1% rule does not factor in any of the other property expenses that could arise, so it truly is a limited evaluation. Purchasing a property for investment requires a thorough analysis of numerous factors and we believe they all should be considered equally.
Here are a few other things you should be giving weight to in evaluating an investment property.
1. Maintenance and CapX
Since the 1% Rule does not factor in any of the other potential expenses associated with owning an investment property, understanding the condition of the property you are evaluating is paramount. If you’re investing in something that will have lots of maintenance issues or large ticket items that need to be updated in the near future, those should be factored into your returns. Having a property bring in rent at 1% of the purchase price means very little if you’re going to have to replace a roof, HVAC, and ongoing plumbing issues all in the first few years.
At Bridge, our turnkey properties are fully-renovated so that investors don’t have to worry about these big ticket items, and our third-party inspection at the END of the renovation helps us identify any remaining, foreseeable maintenance issues we might have missed in our renovation and get them fixed. This level of quality in the renovation means a property coming below the 1% rule could easily bring more returns than an investment with less updates.
In a similar fashion, active investors looking at properties that need massive updates, but are bringing more than the 1% Rule might find this risk worth while since their immediate returns could offset the cost of repairs in the end. Consider a $37,000 home in need of massive updates, but currently occupied and bringing in $625/month rent. While Bridge doesn’t sell properties like these (our homes are all fully-renovated), there are investment opportunities like this for investors who have the wherewithal to take on a fixer-upper of that magnitude, knowing they’ll be cash flowing for a while with their current tenant in place. In this case, the numbers show far ABOVE a 1% Rule, but that doesn’t necessarily make it the right investment for you.
2. Property Manager and Vacancy
Understanding the costs associated with the property management company and their ability to keep tenants happy and in the home long-term should be factored into your evaluation of an investment property. The longer a tenant stays, and the kinder they are to your house, the less vacancies you’ll experience and the less maintenance issues you’ll (hopefully) have to deal with. There’s no perfect science here, but you need to understand the vetting process the property manager has for placing a tenant in your home, and you need to be sure the home itself is a beautiful space a tenant would be proud to live in and want to treat well.
A property that appeases the 1% rule but has a tenant who doesn’t respect the property and won’t pay rent on time will inhibit the returns on that investment far more than a property that’s below the 1% rule, but has excellent management and the look and feel of a home tenants love and want to take care of for a long time.
3. The Market
When thinking about property investment, you should absolutely consider the market where the home is located. Take a historic look at property values, appreciation, employment trends, and property taxes in order to paint a picture of the long-term outlook for that market. This will give you a better picture of your opportunity than the 1% rule ever could.
Here in Kansas City, we enjoy the benefits of an incredible real estate market with steady appreciation and relatively low property taxes, making our city a great place to invest.
In the end, every investor needs to decide what is important to them and what criteria they use to evaluate whether a deal is one they want to move forward with. The 1% rule is absolutely helpful in quickly assessing a deal, but it should not be the end-all-be-all on whether or not you move forward. Looking more deeply at the factors outlined in this post will give a more holistic picture of an investment and help you make a truly informed decision.