The “1% Rule” is a quick rule of thumb that helps an investor predict when the rent will be greater than the mortgage. (See Investopedia) As a rule: The monthly rent collected must be greater than 1% of the purchase price plus total repairs. (Ibid.)
You won’t find properties using this rule on the market. Seller’s cannot estimate your repair costs, because every buyer has different opinions about what needs to be repaired. For this reason, no home seller can ever say for certain that a property meets the 1% rule for you.
Since the seller cannot tell you what repair costs will be, you should use the 1% rule to determine what your available repair budget should be. If you believe that you can make the repairs on your wish-list for less than the estimated repair budget, then the property satisfies the 1% rule and is a good investment for you.
Let’s look at some examples from the current market.
Listing #21912559 – 115 Eye St, Bakersfield, CA 93304
115 Eye St advertises an 11% cap rate at a list price of $129,900. The current gross annual income is $16,800; $16,800 annually breaks down to $1,400/month.
Applying the 1% Rule
If we were to apply the 1% rule test to this property, we would have the following formula: ( $129,900 + Repairs ) = Total_Investment Total_Investment * 1% = Minimum_Rent If Minimum_Rent <= Actual_Rent, then the property is a “good investment.”
Using current rent, we would need to set our repair budget at $10,100. If we can make all repairs for less than $10,100, then this is a good investment property according to the 1% rule. The numbers look like this: ( $129,900 + $10,100) = $140,000 $140,000 * 1% = $1,400 If $1,400 <= $1,400, then the property is a “good investment.”
With a repair budget at $10,100, our total investment is $140,000, and the monthly rent meets or exceeds the 1% value, which is $1,400 per month.
Determining the Repair Budget
A quick way to determine a reasonable repair budget based on the 1% rule is to multiply monthly rent by 100. Then subtract the purchase price. In fact, this is how I determined that $10,100 would be the ideal repair budget for this property.
First, take the monthly rent ($1,400) and multiply it by 100 to get $140,000. If the property is going to be a good investment, our total costs must be $140,000 or less.
Next, to determine the repair budget, we subtract our offer price. $140,000 less the offer price of $129,900 leaves $10,100 for repairs.
Determining an Offer Price
What happens if the repairs will cost more than $10,100?
You have two choices. First choice is to make a lower offer. You can use the same process to make an offer based on the 1% rule. The second choice is to walk away from the deal.
Let’s see what our offer would look like if we decided that we needed $30,000 to repair this property. Our total investment remains the same: $140,000. If we need $30,000 for repairs, then we cannot offer more than $110,000 to purchase the house.
The 1% rule allows us to quickly determine either the minimum monthly rent, the maximum offer price, or the maximum repair budget by using either of the other two values.
Listing #21911721 – 1859 Kentucky St
1859 Kentucky St advertises a 10% cap rate. It reports gross annual rents of $33,000. This means that it collects $2,750 each month on average. It is listed at $324,900.
For this property to satisfy the 1% rule, your total investment must be $330,000 or less. At a list price of $324,900, your repair budget would be $5,100, and if you needed more money for repairs, you’d have to lower your offer price.
Listing #21912266 – 335 Dr. Martin Luther King Jr Blvd
This tri-plex advertises a cap rate of 10%. It is listed at $215,000 and claims annual gross rental income of $24,000. That is an average monthly rental income of $2,000 per month.
Using the 1% rule, we know that our total investment should be $200,000. This property leaves no room for repairs and exceeds our budget. It is not likely that this property will satisfy the 1% rule, even if we have a stellar negotiation.
Other Rules to Live By
The 1% rule is just one of many rules. There is the 70% rule, which indicates that an investor should never pay more than 70% of the after repair value. There is the GRM rule, which indicates that an investor should pick a property based on the number of years it would take for the gross rent to return 100% of the purchase price. And, then there is the Cap Rate rule. See Investopedia’s article on “The One Percent Rule vs. Other Types of Calculations.”
Under the Cap Rate analysis, you look at the properties cash return on a cash investment. This is my favorite rule to invest by, because it takes into consideration management and maintenance expenses. Whereas, the other rules only consider gross rents. See my article on understanding cap rate for more information.