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If you’re thinking about purchasing an investment property as a source of rental income, it’s sometimes hard to determine what properties will provide a positive cash flow. The 1% rule is a quick and easy tool that can help you determine the risk and potential reward of owning an investment property. In this article, we’ll look at how the 1% rule works, when to use it, and when it’s not a good fit.

What Is the 1% Rule?

The 1% rule, also called the 1 rule in real estate, is a preliminary strategy used to determine the profitability of investment properties. With this rule, the monthly rent must be at least 1% of the purchase price plus any repairs. The basic idea is that if a property meets the 1% rule, you should be able to cover your monthly expenses and make money from the property.

To calculate the 1% rule, simply multiply the purchase price of the property plus any repairs by 1%. The result should be the minimum you charge in monthly rent.

How to Use the 1% Rule

While it’s a quick and easy tool, the 1% rule is only one factor in determining the potential value of a property.

• When to Use It
  The 1% rule can help you save time when you’re looking at properties and is best used as a prescreening tool early in the process.
  
  Let’s say you’re looking at a list of properties. You can quickly estimate 1% of the asking price by moving the decimal point two spaces to the left. For example, $200,000 = $2,000.00.
  
  You can then compare that 1% number to the market rent for the property. If the market rent is close to 1% of the asking price, you might want to research the property further. If the market rent is below 1%, you can probably move on to other options.
  
  
• When Not to Use It
  While the 1% rule is often a good first step and a quick way to narrow down your list of potential properties, experts recommend doing a more in-depth analysis before moving forward with a purchase.
  
  The 1% rule calculates the gross rental income of a property, but to really understand if a property can be profitable, you’ll need to look at the net income – what’s left over after expenses. You’ll need to deduct management expenses, taxes, insurance, maintenance costs, capital expense, and your mortgage payments. You’ll need to consider the neighborhood and how many repairs the property will need.
  
  Keep in mind that prices vary widely from region to region. In higher-priced markets, the 1% rule will not generally be helpful.

A Tale of Two Properties

Let’s look at a couple of typical scenarios:

• Where the 1% Rule Indicates a Good Purchasing Decision
  You consider purchasing a property for $100,000, which includes closing costs and repairs. You plan to put down 20% ($20,000) and borrow $80,000 at 5% for 30 years.
  
  The market rent is $1,000. Your monthly mortgage payment of $430 plus operating expenses (management, maintenance, taxes, insurance, etc.) of $400 equals $830 total. Your net income each month would be $170 per month or $2,040 per year. Using the 1% rule indicates this property could be a good investment.
  
  
• Where the 1% Rule Indicates a Bad Purchasing Option
  You consider purchasing a property for $200,000, which includes closing costs and repairs. You put down 20% ($40,000) and borrow $160,000 at 5% for 30 years.
  
  The market rent is $1,000. Your monthly mortgage payment of $860 plus operating expenses (management, maintenance, taxes, insurance, etc.) of $400 equals $1,260 total. Your net loss each month would be -$260 per month or -$3,120 per year. Using the 1% rule indicates this property would not be a good investment.

Other Rules to Consider

When determining the best investment opportunities, consider also using other popular methods like the gross rent multiplier, the 50% rule, and the square footage rule. Let’s look at each:

• Pay Yourself First
  Before thinking about investing in rental properties, make sure you have an emergency fund, are contributing to a retirement fund, and have paid off high-interest debt.

• Gross Rent Multiplier
  Also known as a GRM, this tool helps you figure out the amount of time it will take to pay off the investment. Using a GRM, you take the purchase price and divide it by the gross annual rent. That total will be the number of years it will take to pay off the investment using only the rental income. With this formula, the lower the GRM, the more profitable the property may be.
  
  
• 50% Rule
  Set aside half of your rental income each month to cover repairs, maintenance, taxes, insurance, and other property-related costs, but don’t include your mortgage payment.
  
  
• Square Footage Rule
  Set aside $1 per square foot to cover annual maintenance costs. This means that a 1,500-square-foot rental will require approximately $1,500 in maintenance costs per year.

The Right Decision for You

When you’re looking at investment properties, it’s important to know what you’re getting into before you buy. Whichever strategies you use, you’ll want the numbers to work for your individual needs so you can meet your financial goals. If you’re interested in property investment or need assistance with a mortgage, reach out to NOLA Lending Group, our mortgage division. They can help you get started.

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