What is the 1% Rule and How do You Use it?
The 1% rule is a quick and simple tool used by real estate investors to analyze a rental property. The 1% rule broken down, is quite simply, 1% of the purchase price is where the market rents (not current rents) should be at. So quite simply a $100,000 house should rent for at least $1,000/month. The easiest way to do this math is to just move the decimal 2 places to the left, $100,000.00 becomes $1,000.00. You can also reverse engineer this and take the market rents and multiply that by 100. Let's say you are buying a duplex and the market rent for each unit (2 in a duplex) is $1,000. This means that before any expenses you would be collecting $2,000/month in rent. If you take that $2,000 and multiply by 100 you would get your potential property value of $200,000.
When to use the 1% rule
This type of analysis tool is used when first looking at properties as a quick "back of the napkin" approach. Being able to rule out properties, quickly, becomes a very important skill once you start analyzing multiple properties and don't have time to deep dive into every property. Because it is a quick and simple approach it is not always perfect and should not be the only metric you are using to screen potential deals.
When not to use the 1% rule
After you have a list of properties that meet or are close to the 1% rule you will want to start using more in depth analysis tools to evaluate the properties more precisely. If you are going to make an offer on a property you will want to make sure and have a lot more information than just potential rents.
The 1% rule uses the gross income of a property (the total income you collect from the tenant). But at the end of the day investing is about the net operating income (NOI), or what's left over after all expenses. To really understand a property's cash flow, you must also deduct expenses like property management, vacancy, property taxes, insurance, maintenance, capital expenses (CAPEX), and the mortgage payments.
The 1% rule should be used for certain types of properties: single family homes, duplex, triplexes and quadplexes. When you start looking over 4 units you are now in commercial real estate and there are different analysis tools for those properties. Also, if you are buying in an area that may have little to no appreciation or buying in an C class area the income will need to be even better than the 1% rule.
Another challenge when using the 1% rule is that it can't be used (or found) in high priced markets. Let's look at this in more detail.
Is the One Percent Rule Even Possible in Some Markets?
As you may very well know, understanding where to invest is where having local knowledge is key to succeeding. Prices, rents, and other investing metrics vary widely based on different regions, and even within cities themselves. And in many large cities the 1% rule is impossible to find.
For example, I put some information together to evaluate a couple high priced markets. Below is some data regarding average rents and median home prices as of December 2020.
San Francisco — Median Home Price (2020 Q3) $1,125,000 / 1% = $11,250 / Average rent = $3,188
Denver — Median Home Price (2020 Q3) $506,000 / 1% = $5,060 / Average rent = $1,635
Minneapolis — Median Home Price (2020 Q3) $324,500 / 1% = $3,245 / Average rent = $1,667
As you can see some of these hot markets don't work with the 1% rule. That's not to say you can't make or find properties in some of these areas that could meet the 1% rule, it can just be more challenging and will require more networking and more deal sourcing. There are many people investing in these hot markets, so that must mean it's still profitable, right? This goes to show that the 1% rule should not be the only tool you use when evaluating properties.
How to use the 1% rule
Now you may have seen earlier where I mentioned "market rents" — you will want to take this into consideration over what the current owner may be getting for rents. The reason this is important is because many times rental properties are renting under market rate and if you analyze properties based off of low rents then your potential purchase price would be off.
The best way to determine market rent for rental properties is to search sites like Zillow.com, Rencast, BiggerPockets, Hotpads, Facebook marketplace, craigslist, and most importantly network with local property managers. Make sure and do your research on multiple platforms until you become knowledgeable in your asset class in your desired market. I have another article explaining what an asset class is and why it is important to select your asset class. It is important to research multiple platforms because nothing is 100%, even the Facebook marketplace ads. A landlord can advertise any rent they want and that does not mean they will get that rent or even that the rent is at market level.
Is there a time when you should break the 1% rule?
The answer to this question is quite simply, yes. Since there are so many different investing strategies it makes sense that one rule can't hold true for all strategies. The easiest and most common example is when an investor is looking to HouseHack. If you plan to live in one unit or 1 bedroom, it might not make you money every month. Does that mean it is a bad deal? Absolutely not! If you are paying $1,000 a month in rent but you can buy a duplex and spend only $500 a month that could be a huge win for you financially. That's $6,000 a year you could save. The important thing to verify is that if you do plan to move out of your duplex, the property does then cash flow. Remember, Cash flow is king. I would not recommend buying a duplex that breaks even or loses you money monthly, unless you plan to live there, and it is cheaper than living elsewhere.
A real Twin Cities example
Now, let me show you what this actually looks like on the ground. A few weeks ago I looked at a duplex in northeast Minneapolis listed at $375,000. Side-by-side, two beds each, separately metered, two-car garage. The seller's broker said the units were renting for $1,200 each, $2,400 a month gross.
Run the 1% rule on $375,000 and you need $3,750 a month in rent. The property is bringing in $2,400. That is 0.64%. It fails the test.
But here is where it gets interesting. I pulled comps on Rentometer and Zillow for similar units in that pocket of northeast and the market rent is closer to $1,500 a unit. That bumps gross rents to $3,000, or 0.8%. Still below 1%, but the gap is way smaller, and a big piece of that lift is just bringing rents to market over the first year or two. That is the kind of deal where the 1% rule rules it out at first glance, but a closer look tells a different story. This is exactly why the rule is a filter, not a final answer.
Other quick rules I stack with the 1% rule
The 1% rule is the first filter, but it is not the only one I use. Here are two more I run alongside it.
The 50% rule. Take your gross rents and assume 50% of that gets eaten by operating expenses — vacancy, repairs, capital expenses, property management, insurance, and reserves. This is before your mortgage payment. If gross rent is $3,000, plan for $1,500 to disappear before you pay the mortgage. The 50% rule is conservative and not perfect, but it forces you to plan for the things first-time investors forget to plan for, like a roof and a furnace.
The GRM, otherwise known as the gross rent multiplier. You take the purchase price and divide it by annual gross rent. So a $300,000 duplex bringing in $30,000 a year has a GRM of 10. Lower is better. In the Twin Cities, anything under 10 is worth a closer look. Anything over 14 and the numbers usually do not work without a strong value-add play.
Why the 1% rule is harder to hit today than it used to be
Now, I have to be straightforward with you. The 1% rule is harder to hit today than it was even five years ago. Prices in the Twin Cities have appreciated significantly since that 2020 data above, and rents have not kept pace at the same rate. Add higher interest rates on top of that and the math gets tighter every year.
That does not mean you give up on the rule. It means you adjust your strategy. You hunt for properties with below-market rents, properties that need cosmetic work, or properties in transitioning neighborhoods where rents are rising faster than the city average. I have not seen the 1% rule die in this market. I have just seen it move further off the MLS and deeper into off-market deals, networking, and value-add plays. That is where I spend most of my time scouting for clients.
What to do when a property is close but not quite there
At the end of the day, plenty of good investments do not hit the 1% rule on day one. The question is whether you can get there. Here is what I look at when a property is close but not quite there.
First, are the rents under market? If a duplex is renting at $1,000 a unit but comparable units rent for $1,300, you can be at the 1% rule within a year by raising rents at lease renewal or after a turnover. Just be aware of any local rules and always give proper notice.
Second, is there a finished basement or unfinished space that could become a third bedroom, an additional unit, or a short-term rental? Forced appreciation, which is my personal favorite, is exactly this. You spend $20,000 finishing a basement to add a bedroom, and suddenly your rent goes up $300 a month and your property value goes up $30,000 to $40,000. That is how you turn a 0.85% deal into a 1.1% deal in 12 months.
Third, is the cosmetic condition rough? Paint, flooring, appliances, and a deep clean can lift rents 10 to 15% on a tired unit. The best part is none of that work requires permits or a contractor's license. If you want to know what kind of cosmetic budget actually moves the needle, I can connect you with the contractor I use.
Real estate investing is not a one size fits all. And so, one analysis tool will not be perfect for every niche. There are times when the 1% rule makes perfect sense, then there are times it doesn't. Know your niche and your market well and use what is best suited for you.
Best of luck investing!
Do you use the 1% rule? If not, what do you use to screen deals early on? Would love to hear from you!