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What Is the 1 Percent Rule for Investing in Real Estate?

Buying real estate is complicated – yes, even turnkey real estate.

That’s because there are literally hundreds of variables to consider in your decision, including your personal financial standing, your existing portfolio, the nature of the deal on the table, and even broader economic conditions.

Wouldn’t it be nice if there was a simple test that could tell you whether a rental property was worth buying?

Well, there is. Kind of.

Welcome to the helpful, yet admittedly somewhat limited world of the 1 percent rule.

The 1 Percent Rule in Real Estate

In real estate, the 1 percent rule is an informal “rule of thumb” to help investors figure out which properties are worth buying.

Essentially, you’re trying to determine whether the gross monthly rent generated by a property will meet or exceed 1 percent of the total purchase price. Generally, you’ll also need to factor in the costs of initial repairs, but you won’t need to do this for turnkey real estate properties, as you can start renting them out immediately.

1% rule

For example, let’s say you’re considering purchasing a property for $250,000. For this property to pass the 1 percent rule test, it must generate at least $2,500 in gross monthly rent. If it can only sustain $2,000 in gross monthly rent, it’s not worth considering. If it can sustain $3,000 in gross monthly rent, it’s definitely worth considering.

Let’s see how this plays out.

Assume that this property is in an average Ohio city at the time of this article’s writing. If you make a $50,000 down payment on this property, taking out a $200,000 mortgage at a fixed interest rate of 7.5 percent over 30 years, your mortgage payment (including property taxes and home insurance) should come out to $1,700-$1,800. A gross monthly rent of $2,500 is more than enough to cover that, plus occasional maintenance expenses, while still leaving some room for monthly positive cash flow. Rent of $2,000 would make things a bit tight, while rent of $3,000 would be quite profitable.

Obviously, this is meant to be a high-level and noncommittal test, as there are many variables you’ll need to consider as you evaluate a piece of real estate. This rule doesn’t take into consideration things like property taxes, home insurance, maintenance costs, or even future appreciation; it’s meant to simplify things so you can easily weed out properties that aren’t worth considering at all.

That said, this is an excellent place to start when shopping for turnkey real estate properties to add to your portfolio.

The Case for Breaking Even on Your Real Estate

Rental property investors often seek properties capable of generating positive monthly cash flow, or recurring monthly profits, for obvious reasons. But in many cases, there’s nothing wrong with simply breaking even on your real estate investments.

Consider:

  •       Debt and inflation. We live in an economy driven by a constant level of inflation; inflation rates may rise and fall, but they always exist. Holders of good debt tend to benefit in inflationary environments, as inflation represents the devaluation of money. In other words, the value of your debt will decrease as time goes on. This is one marked advantage of real estate investing, since it simultaneously allows you to buy properties for lower nominal prices while capitalizing on the diminishing relative value of your debt.
  •       Financial leverage and property appreciation. Breaking even is also suitable for rental properties because you can take advantage of both financial leverage and property appreciation. The property appreciation dynamic is easier to understand; real estate has historically performed very well in the United States, and most expert economists and investors agree that trend will continue into the future. Over time, your turnkey real estate will become more valuable, ultimately leading you to profitability. On top of that, because you’ll likely borrow money to purchase these properties, you’ll get to take advantage of financial leverage, using borrowed money to increase your total buying power. You can buy a $250,000 property with only $50,000 to start, then after 30 years of breaking even, sell a property that could be worth $1m or more. In other words, even a small initial investment can generate huge eventual returns.
  •       Future changes to your income and expenses. Also, keep in mind that rental property dynamics are always in flux. Just because you’re breaking even now doesn’t mean you’ll always break even on the property. If the neighborhood becomes more popular, and you commit a couple of big renovations, you could easily justify charging more in rent, while simultaneously lowering your maintenance expenses.

Special Considerations for Turnkey Properties

Turnkey properties are a bit unique in the context of the 1 percent rule, and for a few reasons.

The first and most notable is that you won’t have any initial repairs to factor into your equation. Instead, you can run this calculation using only the purchase price.

Second, turnkey real estate properties tend to be recently renovated and highly desirable, possibly allowing you to charge slightly above market rent – and fill those properties faster.

Third, and less beneficially, turnkey real estate properties are sometimes more expensive than their counterparts. This partially erodes some of the other advantages, but it should balance out in your favor.

When to Adjust the 1 Percent Rule

Applying the 1 percent rule is a great place to start in your real estate analysis, but you’ll need to make some adjustments if you want to act in your own financial best interest.

Consider the following:

  •       Exceptional conditions. Are there any aberrant conditions about this property or the finances associated with it that would compromise this equation? For example, are the property taxes excessively high or excessively low? Is this an uncommonly rented area, leading to uncertainty about the appropriate rent to charge? Would you be able to secure a lower purchase price if you pay in cash?
  •       A highly desirable property or area. You might be willing to violate the 1 percent rule if it means securing a highly desirable property, or one in a highly desirable area. For example, you may feel confident that this specific neighborhood is going to explode in growth over the next several years. If so, it might be worth paying a premium to get a property in the early stages of this growth.
  •       Reasonable expectations of near future changes. You should also factor in any reasonable expectations you have of near future changes. Do you believe that rents in the area will increase or decrease in the coming years? Are there signs of increasing or decreasing property taxes? (Good luck with decreasing property taxes). What changes could make the purchase more or less favorable to you?

Using the 1 Percent Rule in Real Estate Appropriately

If you want to use the 1 percent rule appropriately and effectively when buying turnkey properties, follow these strategies:

  •       Use the 1 percent rule as a starting point. The 1 percent rule is not an iron law, and it’s incredibly simplistic by design. Accordingly, you should only use it as a starting point; it’s not meant to tell you a perfect answer. Depending on what you find, you may be willing to entirely disqualify a property. However, the 1 percent rule alone should not compel you to move forward with a given purchase.
  •       Use the 1 percent rule as a basis for comparison. This rule is perhaps best used as a basis for comparison. Oftentimes, we have to make adjustments to the 1 percent rule when we consider the dynamics of a local market. But if you’re comparing multiple properties within the same market, the 1 percent rule can help you narrow down your list of considerations to only the most reasonable potential acquisitions. Among properties that “pass” the 1 percent rule test, which seem to be the most profitable?
  •       Be ready and willing to adapt as necessary. Finally, be ready and willing to adapt as necessary. That means making alterations to the 1 percent rule as part of your initial analysis, as well as reevaluating your standing years after your acquisition. As you gain more experience as a real estate investor, you’ll find it easier to leverage this rule in your strategic analysis.

Do you need help finding strong properties to add to your portfolio? Or are you on the fence about whether or not to keep adding to your real estate holdings?

You’re one free call away from answers. Contact us today for a free consultation!

 

Derek Bryan
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