Using the 1% Rule When Expanding Your Portfolio
May 12, 2017
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How To Use The 1% Rule When Expanding Your Real Estate Portfolio
Portfolio expansion is always an exciting time for a landlord or property manager. New projects, new dollars, and new challenges can be a compelling and tempting proposition. But it’s crucial to keep perspective in mind: is this a smart investment of my time, money, and energy? Will this property be an asset capable of leasing and generating steady revenue into the future? Or a sinkhole I’ll soon regret?
Before signing on the dotted line, you should of course thoroughly research the legal and financial implications of the purchase. Find out the rules and regulations of the community in which the property is located, track future rental trends in the area, and make sure you know what you’re getting yourself into. But there are a few tips and rules of thumb that can help you quickly assess the strength of a potential investment before going through too much time-consuming research. Enter: The 1% Rule.
The 1% Rule
The 1% Rule is used to compare the monthly rent earned from a property investment to the property’s monthly mortgage cost and other expected costs of management. In other words, it helps determine whether or not you’ll be able to (at the very least) break even on an investment.
The 1% Rule is often used by real estate investors as a preliminary gauge before more time consuming due diligence needs to occur. It would benefit any small-to-mid-sized landlord to become familiar with the practice and to employ it whenever an opportunity arises.
So, let’s take a look at an example. If you were considering purchasing a $250,000 property with 4 identical units, you would likely expect to submit a down payment of $62,500 (25%). That would leave you with a mortgage of $187,500. One percent of $187,500 is $1,875, so, according to the 1% Rule, you would need to rent that property for at least $468.75 per unit per month (1875/4) to remain solvent.
If you’re familiar with the community in which the property is located, you should be able to determine with a fair degree of accuracy whether or not you can expect to secure rent at that amount. If the answer is no, then the property is likely a risky investment and you can move on without wasting any more of your time considering it. If you feel confident in renting at the one percent value or higher, it may be time to break out the financial calculator.
Don’t Forget Due Diligence
The 1% Rule is a simple, quick means of assessing an investment, but it is by no means a comprehensive verdict on the soundness of that investment.
After all, the 1% Rule does not take into account property tax at the location, the condition of the property, your own cash flow at the time of purchase, rental trends within the community, etc. In fact, post-pandemic inflation has been noted to make the 1% Rule less realistic due to increased home prices. For these reasons, it’s crucial to thoroughly vet the investment by looking at a wide range of factors before moving forward with any purchase.
That being said, the 1% Rule can still be a useful tool to keep in your belt as you sift through the many investment opportunities you will inevitably see as a local landlord.
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