In real estate investing, two commonly referenced guidelines are the 1% rule and the stricter 2% rule.
Simply put, these guidelines dictate that a property's gross monthly rent should amount to 1% or 2% of its purchase price respectively. This basic yet powerful metric has guided countless real estate investors through their investment decisions.
However, with shifting terrains in the market and varying local conditions, the pressing question arises: Are these rules still pivotal in determining the potential of rental properties? And if so, how does one navigate the balance between the two?
Join us as we explore the benefits, challenges, and intricacies of the 1% and 2% rules. We'll dive into how they relate to key factors like operating expenses, interest rates, and local real estate trends, helping you navigate your investment journey more clearly.
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. This rule is a quick and easy way to determine if a rental property will likely generate enough income to cover the costs of owning and operating the property and create a profit for the investor.
What is the 2% rule?
The 2% rule states that the expected monthly rental income should equal or exceed 2% of the purchase price. Using the same example, a $200,000 rental property should generate a monthly rental income of at least $4,000.
Pros and cons of the 1% and 2% rules
The 1% and 2% rules in real estate should simply be viewed as a rule of thumb — not an ironclad investing strategy. Landlords use them 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% and 2% rules 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.
Setting the right rent price: Other factors to consider
While the 1% rule and 2% rule can be helpful starting points for setting your rental rate, they do not guarantee how the property will perform. The following are essential factors to consider when determining rent prices:
- Operating costs: A significant downside of the 1% and 2% rules is that they do not consider all the costs associated with owning and operating a rental property, such as property management fees, repairs and maintenance, property taxes, and insurance. Rental property owners should consider these costs when determining the expected profits for a rental property.
- Local rental market: Local market conditions — such as the availability of similar rental properties in the area, the demand for rental properties in the area, and the cost of living in the area — have a significant impact on rent prices. In San Francisco, where the average home value is over $1.2 million, the 1% rule dictates that rent should be $12,000. But since the actual median San Francisco rent price is $3,525, landlords applying the 1% rule would have a hard time finding potential tenants.
- Property conditions: If a property is in a high-demand area but is outdated and in need of an upgrade, you may not be able to follow the 1% or 2% rule. The property’s age, appliances and fixtures, and any recent renovations or repairs impact a landlord’s ability to charge certain rental rates.
How to research local rental rates
Rental property owners have various tools to determine the range of rent prices for properties in their area. First, review the local regulations to understand whether your area has laws around rent control and rent increases. These regulations will help you create a maximum cap for your rental rate.
Next, research the rent prices of similar homes in your area. There are several resources to help you do this. You can look up apartments or houses for rent on listing sites such as Zillow, Redfin, Apartment List, Apartments.com, or many other websites. You can also use Azibos rent estimate calculator to quickly check if your proposed rent price is in range with other properties in your area.
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.
"The right real estate agent can be an invaluable asset when it comes to researching rental rates and giving renters access to the most up-to-date and accurate information," explained Matt Ward, a knowledgeable figure in Nashville's real estate industry. "From understanding the current market trends to helping negotiate the best deal, a reliable real estate agent can offer expertise and guidance throughout the process."
Rent prices can change throughout the year, so it's best to do this analysis when you're looking to fill your unit so your rental rate is based on the most up-to-date information.
Applying the 1% and 2% rules with other rent price factors
Let's use an example to demonstrate how to use the 1% or 2% rule to set a rent price and then adjust it based on the factors listed earlier in this article.
Say you purchased a three-bedroom, two-bath apartment in Evanston, IL, a suburb just outside Chicago, for $500,000. The 1% rule would dictate a monthly rent price of $5,000, and the 2% rule would be $10,000. But both are unrealistically higher than the median rent price in this zip code, which, according to Zillow, is about $2,600.
Next, you'll think about the property's features and amenities. For this example, let's say the building was built in the 1970s, and the kitchen and bathrooms are a little outdated, so you might consider setting a lower rent price. But, the location is quite desirable — it's within walking distance to the beach, has nearby restaurants and grocery stores, and, importantly, is close to the metro station that goes into downtown Chicago. You know that Chicago's economy is flourishing (thanks to its growing tech sector), attracting many young individuals and families to the area and making it a competitive rental market. You then calculate a budget for your monthly operating costs, knowing that maintenance expenses will be higher for an older apartment and Chicago’s property insurance rates are also increasing.
Factoring in the unit's desirable location, job market, and high operating costs, you can confidently set a rent price slightly higher than the average for the area and ultimately list the unit at $2,900.
Alternatives to the 1% and 2% rule
The 1% and 2% rules are undeniably simple and popular tools that many investors use to determine a rental property's potential profitability quickly. However, they are not the only yardsticks available. Here are some alternatives that offer nuanced and diversified perspectives:
- Gross rent multiplier (GRM): This metric measures the ratio between a property's purchase price and gross annual rent. For instance, if a property is priced at $300,000 and has a yearly gross rent of $30,000, its GRM is 10. Typically, a lower GRM suggests a more lucrative opportunity, but it's crucial to factor in operating expenses, which this doesn't account for.
- Net operating income (NOI) calculates the property's annual profit after subtracting operating expenses before deducting taxes and mortgage payments. It offers a clearer picture of the property's profitability. A positive NOI suggests the property generates enough rental income to cover operating expenses.
- Cash flow analysis: Going beyond rental income, this focuses on the monthly cash flow, the difference between the monthly rent, and all monthly expenses, including mortgage payment, property taxes, insurance, and operating costs. A positive cash flow is crucial for maintaining liquidity and ensuring sustainable profitability.
- 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.
- Future Value Analysis: Consider the property's future value instead of focusing only on current returns. Factors like planned infrastructure projects, future rent increases, or zoning changes can significantly impact the property's long-term appreciation.
By incorporating these alternatives, investors can formulate a holistic investment strategy. While the 1% and 2% rules serve as quick evaluation tools, combining them with these alternatives can ensure a more comprehensive and informed real estate investment decision.
The 1% rule and 2% rule in real estate investing
In the ever-changing world of real estate investing, the 1% and 2% rules stand out as foundational benchmarks. Originating from the basic idea that a property's gross monthly rent should align with a certain percentage of its purchase price, these rules have guided many investors. However, the real estate market, with its fluctuations in interest rates, operating expenses, and local market conditions like median home price and median rent, demands a broader view.
Rental properties carry unique challenges and rewards, from a bustling San Francisco neighborhood to a serene spot in the Midwest. Property taxes, mortgage payment considerations, net operating income, and even anticipated rent increases can dramatically affect the viability of an investment property. Furthermore, the rules don't factor in immediate repairs or advantages like tax benefits, which can impact cash flow.
Thus, while the 1% and 2% rules offer a glance into potential investments, savvy real estate investors delve deeper. They assess property taxes, explore gross rental income possibilities, and gauge the property's sale price against the local real estate trends. They consider the gross rent multiplier, balance it with operating costs, and remain vigilant about the property's future value.
While the 1% and 2% rules provide a framework, the combination of property-specific insights, local market dynamics, and the investor's adaptability shapes successful real estate ventures.
Important Note: This post is for informational and educational purposes only. It should not be taken as legal, accounting, or tax advice, nor should it be used as a substitute for such services. Always consult your own legal, accounting, or tax counsel before taking any action based on this information.
