What Is The 1% Rule In Real Estate And Does It Work?

The 1% rule in real estate is an easy way to check if a rental property will generate enough income to cover the costs of owning and operating the property.

What is the 1% rule?

The 1% rule states that a rental property's income should be at least 1% of the purchase price. For example, if a rental property is purchased for \$200,000, the monthly rental income should be at least \$2,000.

The 1% rule is a quick and easy way to determine if a rental property will generate enough income to cover the costs of owning and operating the property and create a profit for the investor.

Pros and cons of the 1% rule in real estate

The 1% rule in real estate should simply be viewed as a rule of thumb — not an ironclad investing strategy. For example, some landlords instead go by the 2% rule which dictates that the rent price of the rental should match or exceed 2% of the rental purchase price. Eg. if you purchased a property for \$200,000 you would charge \$4,000 per month. And there are several more alternative methods to setting the rent price which we explore later in this article.

Landlords use these rules because they’re easy to calculate, provide a rudimentary benchmark for expected rental income, and can help identify undervalued properties.

That said, investors should be cautious and consider other important factors when determining whether to purchase a property. The 1% rule may not provide a reliable benchmark for rental property investments in areas with high cost of living or high rental demand. They also do not account for fluctuations in the local real estate market, such as changes in supply and demand, which can impact the potential rental income of a rental property.

How To Calculate The 1% Rule

Calculating the 1% rule is simple. Divide the property purchase price by 100 to calculate 1% of the value of the property. According to the 1% rule, this will give you the minimum you should charge in monthly rent.

If the property requires any repairs, you should also factor the cost of these renovations into the equation by adding them to the purchase price.

Examples Of The 1% Rule For Investing

Here’s an example for a home with the purchase price of \$150,000:

\$150,000 /100 = \$1,500

Using the 1% rule, you should find a mortgage that has a monthly payment of \$1,500 or less and charge your tenants a minimum monthly rent of \$1,500.

Let’s say the home required about \$10,000 worth of repairs. In this situation, you would add the cost of repairs to the purchase price of the home, for a total of \$160,000. Then, you’d multiply that total by 1% to get a minimum monthly payment of \$1,600.

Does The 1% Rule Work in Today's Market?

The 1% rule has stood as a simple rule of thumb for decades. However, with the rapid increase in property prices, it begins to look less tenable to apply the 1% rule to rental real estate.

For example, the average house price in the US reached \$430,300 in 2023 (31% higher than in 2020), and average prices in developed areas far surpass that. However, average rents are currently around \$1,702, with even more expenses in states like California only going up to an average of \$2,541.

These of course are just averages. However, the housing market is only going to get more expensive making it increasingly hard to find properties in good areas that will work with the 1% rule.

This is not to say that the 1% rule can’t work in real estate only that location will play an increasingly vital role in finding affordable properties with high rental demands and good growth opportunities. As such, investors should consider other factors when evaluating rental properties and setting rental prices.

How to Set the Rent Price: Other Factors to Consider

The 1% rule (and the 2% rule) can be a helpful starting point when it comes to understanding the potential profitability of rentals and setting expectations for the rental rate you charge. But, these rules are not guarantees that you will be able to charge this much in rent for the property.

On top of this, there are a few additional factors that you should consider when determining rent prices:

1. Operating expenses: One significant negative when it comes to using the 1% rule is that is doesn’t take into account any of the costs associated with owning and managing the property. Costs such as HOA fees, property management fees, repairs and maintenance, property taxes, and insurance all quickly stack up. When looking at rent prices you need to make sure that the amount you charge comfortably covers these expenses to make it a viable business opportunity.‍
2. Location, location, location: Local market conditions will have a direct impact on the property price, appreciation, rental competition, and rental prices. For example, in San Francisco, where the average home value is over \$1.25 million, the 1% rule dictates that the rent then should be \$12,500 - however, if you attempted to charge this much you would have a very hard time finding tenants as the actual median rent price is \$3,367
3. Property condition and amenities: As well as location, the property’s age, appliances and fixtures, and any recent renovations or repairs also have an impact on the property value and the landlord’s ability to charge a premium in rent.

The importance of market research

So what do you do if the 1% rule doesn’t work? How do you determine the fair rental rate? The answer is to do comprehensive research into like-properties in the area.

You can use sites like Zillow, Zumper, Apartments.com, or others to explore the current rental market stock that’s available and use these prices as guidelines.

You should do this at several different times during the year, as with most industries rentals have up and down periods which can affect rent prices seasonally.

It's also a great idea to talk to real estate agents and property managers in your area who have heaps of current knowledge on the local housing market and expertise in determining a home's value.

When doing your market research it’s important that the comparison properties you look at are of a similar size and age. They have the same number of bedrooms and the fixtures and fittings aren’t too dissimilar (no point comparing a rundown two-bed to a newly renovated four-bed).

Finally, you should research local rent control regulations as these could impact how high you can set the rent and your ability to increase the rent in the future.

Alternatives to the 1% Rule in Real Estate

The 1% rule (and 2% rule) are simple and popular tools that many investors have used over the years to determine a rental property's potential profitability. However, they are not the only real estate metrics that investors can use to evaluate a property's potential and performance. A few others include:

1. Gross rent multiplier (GRM): This metric measures the ratio between a property's purchase price and gross annual rent. It doesn’t, however, account for operating costs.
2. Net operating income (NOI): is calculated by determining the total revenue of the property minus all the necessary operating expenses. This calculation is used to determine the profitability of income-generating real estate investments.
3. Cash-on-cash return: The cash-on-cash return rate, also known as cash yield, measures the amount of cash flow relative to the amount of cash invested in a property investment and is calculated on a pre-tax basis. To calculate cash on cash you need to divide the Net Annual Cash Flow (before tax)  by the Total Equity Invested
4. Cap rate: This measures a property's annual return on investment. It's calculated by dividing the NOI by the property's purchase price. A higher cap rate indicates a better investment opportunity but often signals a higher risk.
5. Cash flow: Positive cash flow is an indication that you are making more money than you are spending each month. On the other hand, negative cash flow is a sign that your rental is not currently profitable and you may need to take action. To calculate real estate cash flow you will need to subtract your expenses from your income.
6. Capital gains analysis: This is harder to estimate, but involves analyzing things like planned infrastructure projects, future rent increases, or zoning changes which might significantly impact the property's long-term appreciation. The goal is to get an estimate of the property's potential long-term value instead of focusing only on current returns.

Understanding and employing a variety of analytical methodologies in addition to the 1% rule will allow you to gain a more complete understanding of a property, its risks, and potential and ensure the property aligns with your long-term investment goals.

Final Words: The 1% Rule in Real Estate Investing

The 1% rule is a simple benchmark figure that investors can use to establish what would be a good income for a property and even predict a property's annual income. However, it doesn’t account for operating expenses, location, or other market factors. As such, it should always be accompanied by further research.

One thing to keep in mind, whether you’re using the 1% rule or other key metrics like cash on cash, cap rate, or cash flow, is that it’s crucial for investors to have a good grasp of a property’s finances. This means accurate income and expense tracking throughout the year and regular reports.

The easiest way to stay on top of your rental property finances is with purpose-built software like Landlord Studio

Easily track all of your income expenses with auto-matching bank feeds, smart scan receipts, create recurring expenses, and automate income tracking with our online rent collection feature.

Plus, instantly generate any of over 15 accountant-approved reports, including your P&L, trailing 12 months, and a Schedule E report (perfect for tax time).