Investing in real estate is a great way to build assets and to create regular income for yourself. However, finding the right properties to use as rentals can be challenging.
You need to be able to find the right cost to rental ratio so that you are generating a profit from day one.
Many investors like to use the 1% real estate investing rule when they are looking at properties to purchase. Some will also use the 2% real estate investing rule to gauge which properties they will buy. In this post I will explain what both of these metrics are and whether they are still valid and realistic in 2021.
What Is The 1% Real Estate Investing Rule?
The 1% rule when looking for rental properties, is to determine if the rent can cover 1% of the cost of the property each month.
For example, a house that costs $150,000 would need to rent for $1,500 a month to cover the cost of ownership.
The cost of ownership will include the following fees:
- Mortgage Payment
- HOA Fees if Applicable
- Property Taxes
- Insurance
- Management Company Fees if Applicable
- Portion to Set Back for Repairs
If you can cover all of these fees and still have money left over as a profit, then the house is worth investing in as a rental property.
Most experienced real estate investors shoot for at least $300 a month profit from their properties to make it worth their time.
So, using the above figure of a $150,000 house, you would need to be able to rent the home out for no less than $1,500 a month and keep the costs lower than $1,200 for it to be a good purchase.
The 1% Rule Is Only A Quick Rule Of Thumb
The 1% rule is something that investors use when they are trying to quickly narrow down the properties that they are going to look at for investments.
This is not the only factor that can or should be used when trying to decide on purchasing an income property. It is just a quick rule of thumb to quickly eliminate unsuitable properties.
Local Rental Rates Must Be Explored
If you are looking for rental properties, the first thing that you should do is explore the rental prices in the area you are considering. This will give you a better idea of how to calculate the highest price you want to pay for a home.
If homes are selling for $150,000 in the area you are looking, but rental rates for these homes are only averaging $1,000 per month, you will have to have very low payment obligations on this property to make a profit.
This means you will have to negotiate a much lower price or secure a very low-interest mortgage to keep payments low, or both.
Purchasing cheaper homes in the area may be a choice to retain the 1% margin. However, you may have to seriously invest in repairs to bring the house up to building code standards or make it presentable to attract renters. This is something that must be considered.
What Is The 2% Real Estate Investing Rule?
In principle the 2% rule is exactly the same as the 1% percent rule, but with a higher percentage. For example, if you purchase a $150,000 home as a rental property, under the 2% rule, you would have to secure $3,000 a month in rent.
In reality, the 2% rule does not apply to many investors. It is nearly impossible to secure that high of rent on a property compared to the investment price. You would have to buy a property very, very cheap to be able to have a 2% ratio on the property.
Sadly, properties that are that discounted are often in need of extensive repairs or are in areas that are hard to secure renters. You will take a large risk purchasing these homes because of the repair costs often associated with them.
Warning – The 2% Reality Check
You need to ask yourself, why would any property owner sell their home so cheap that the 2% rule applies? Yes there may well be some viable properties that will cashflow nicely, but the vast majority are likely to come with lots of issues.
Properties that match the two percent rule are most likely in neighborhoods that only experienced, well established investors should go.
When you add the data to your deal analyzer spreadsheet all of the green lights will start flashing positively. All of the “rules” will be met. But what the deal analyzer won’t tell you, are the problems you will face from the area the property is in or the massive maintenance bills you will end up facing.
Are these good investments for new real estate investors, probably unlikely, the really good ones will be extremely rare.
Do the 1% and 2% Rules Still Apply in 2021?
The 1% rule may still be used as a quick guesstimate tool when you are considering which properties you want to physically visit when you are shopping for rental properties. But in actuality, this ratio is not really relevant in today’s market.
Rental prices have not kept pace with real estate prices. The new ratio is probably closer to 0.8 or 0.7% instead of 1% when looking at cost vs. rent each month.
In some areas, you may still be able to secure a property at 1% or higher, but these will be harder to find and may require extensive work to make them rentable.
The 2% rule used to be really handy but in 2021 it is just not realistic. The housing market bears little similarities to the market when the 2% rule came into practice.
If you do find rental properties that match the 2% rule nowadays, I would be extremely wary of them, unless you are very experienced and really know what you are doing.
What Should I Look For In A Rental Property?
When you are looking for an investment property, the first thing that you will always look at is the price of the home. You will be able to tell a lot about the property, the neighborhood, and the local area based on the asking price.
In areas where real estate is in high demand, the prices may well exceed the fair market value of the home.
There are some areas in the US where the property prices have nearly tripled in value over the last few years, even though the housing market as a whole does not dictate that type of price increase.
You will also need to look at rental prices and if the area is a rental district. Some neighborhoods have very low rental rates, while other neighborhoods seem to be all rental properties.
A little research will provide you with valuable information as to whether the location of the property is worth the investment.
You will need to hack the physical condition of the property to see how much work is needed to bring it up to code. Sometimes you can find a very low-priced home due to foreclosure or quick sales, but the home is in desperate need of repairs.
After all, if the homeowner could not afford the mortgage, it is easy to assume they were also having difficulties paying for necessary repairs.
Investigate all the Associated Costs Before Purchase
A final thing you will want to investigate is the associated costs of the property. Some cities charge a yearly fee for rental properties. Some states have higher tax brackets for rental properties. Some homes have higher taxes because they are located on a corner lot or considered a prime location.
You will also need to consider the insurance prices for the property. Will it require flood insurance? Will you need to get special insurance riders for natural disasters such as earthquakes, sinkholes, or hurricanes?
Will any special upgrades need to be done to the house, such as adding storm shutters to bring it up to the latest building codes?
If the house is part of an HOA, what are the fees associated with that? Some HOAs will not let you rent out a property in their association unless it is professionally maintained by a management company.
The cost for a management company must be added to your expenses so you can gauge profit.
Do the Necessary Research and Due Diligence
In the end, what matters most is that you do the necessary research on the home, the neighborhood, and the tax structure of any property that you are considering.
When you have that information available, you will be able to decide accurately if a rental property will be able to generate regular income or if it will be a dead loss.
Using the 1% method is a great tool when you have that information available. Otherwise, it is just a simple trick that you can use for deciding which homes you actually want to visit and which ones will not make the list.
My Final Thoughts on the 1% and 2% Real Estate Investing Rules
Let’s just dispel something here. The 1% and 2% rules are not “rules” they are just appraisal tools to help you quickly analyze properties that might be worth visiting before purchasing.
If you have a long list of potential properties to view, you might use these metrics to eliminate the ones that really won’t work as rental properties.
That’s it. That’s all they should be used for.
There are so many other factors that you need to take into account when appraising rental properties, properties at 0.5% might work depending on your strategy and the location.
Times change and just because something was once a solid rule doesn’t mean it is so now.
The 1% and 2% rules are great places to start your rental property deal analysis process but by no means are they a substitute for solid and comprehensive due diligence.
Rental properties are large investments and you should never base a purchase on the 1% and 2% rules.
I would love to hear from you now.
Do you have any thoughts on 1% And 2% Rules In Real Estate Investing? Do you use them to analyze your rental properties?
Please comment below, I would love to hear from you. Thank you very much and have a great day.
