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When you’re investing in a property, the thing that probably matters most to you is making money.
You’re not getting into this business to have fun or to get a place where you can visit sometimes and let your friends rent at a discount. You’re in it for the net income, period.
That being the case, it’s very important to understand whether a rental property is capable of generating a strong return on investment. One way to do this is to apply the 1% rule.
What is the 1 percent rule?
The 1% rule is a calculation that lets you quickly determine if the monthly rent on a property will be more than the monthly mortgage payment.
Why the 1 percent rule is important
The 1% rule is important because it tells you if you’re in a position to break even from an investment or profit from it. Before entering a real estate market — whether that’s San Francisco, New York City, or Keokuk, Iowa — you need to know what kind of investment you’re getting into.
Some investors go into a property comfortable with breaking even for a certain period of time — that is, until market conditions change or they’re in a position to refinance their mortgage.
However, both options are risky. Economies don’t always change for the better, and refinancing is not always possible. Plus, unexpected upkeep costs can pile up, putting a bigger dent in your bottom line.
In either case, it pays to have a general understanding of what you’re getting involved with as a starting point before you dive in and buy a property.
How to apply the 1 percent rule in real estate investing
The 1% rule says that the rental rate you charge tenants should be equal to or greater than the mortgage payment you make every month. To figure that out, simply multiply the purchase price of the property in addition to repairs and other fees like closing costs by 1% (or 0.01).
For example, on a house valued at $360,000, you would want your total monthly payments to be $3,600 or less. Which means you’d want to charge tenants $3,600 or more per month.
The 1% rule is fine for a quick approximation upfront, akin to a prescreening. But the truth of the matter is that it doesn’t factor in any other economic factors (e.g., property manager expenses and interest rates).
With that in mind, here’s a more comprehensive way to go about the process to get a better estimate.
1. Find a property you like
First, find a commercial rental property that you’re interested in purchasing.
The property should be in a profitable location. It should also be in decent enough condition to either rent outright or fix without spending too much on capital upgrades. Further, it should be affordable enough to not go too far into debt when buying it.
Work with an agent to find an ideal property that aligns with your goals and looks like it could be a profitable investment.
2. Determine the average monthly payment price
Next, take the property’s sales price and have your agent or lender break it down into monthly mortgage payments, factoring in approximated property taxes, insurance, and interest.
This is important because it gives you a sense of what you can expect to pay each month in total payments. It’s also important to factor in any additional fees that you can expect to pay — including homeowners association (HOA) fees, parking, and utilities. You should also consider property management fees and even a general budget for unplanned upkeep costs.
Some people choose to factor in the 1% rule based on the mortgage alone. But that is not an entirely accurate assessment when it comes to determining a likely cap rate.
When taking the above costs into consideration, the monthly cost of your investment property could easily double.
3. Figure out how much you can rent it for
Once you get a better sense of what your place will cost you on a monthly basis, you’ll be in a better position to make a judgment about whether you can afford it.
The next step is to figure out how much you can rent the place for.
As a landlord, you’ll most likely have the option to charge whatever you want for rent. That said, you definitely don’t want to guess or pull a number out of thin air. Otherwise, you could wind up scaring away renters and finding yourself needing to deal with vacant property.
For the best results, talk with your lender and ask for a home valuation report on the property you’re looking at. The lender should be able to provide you with an expected monthly rental amount based on the property value and the location.
Run this number by your agent to get their opinion. They may tell you that the suggested rental price is too high or too low compared to what you could actually charge.
4. Consult with a contractor about repairs
Next, bring in an experienced contractor to see if you can potentially make upgrades to the property to increase the rental value. By making a few small upgrades here and there, you may be able to significantly increase the amount you can charge to renters.
Keep the agent involved in the process to get their opinion as well. The more opinions you can get, the better off you’ll be.
It’s worth noting that expensive upgrades or repairs will cut into your profits. However, they could be well worth it in the long run.
Run the numbers, figure out a course of action, and stick with it.
5. Compare your estimated expenses to what you can charge for rent
Once you have a clear idea of potential expenses and rental gains, compare how much the property will cost you each month to how much you will most likely bring in from rent.
The goal here is to figure out what your gross rental income might be. In the best case scenario, you will be able to get your tenants to essentially pay your mortgage and property taxes while leaving a bit of money leftover on the other side.
Tips for getting a better deal on a rental property
Buying a rental property can be a very expensive, time-consuming process. There are some tricks, however, that you can use to control costs and maximize profitability.
Avoid going overboard
Be cautious about buying properties that are overly expensive to the point where they would strain your budget.
In some cases, it can make more sense to value a property that costs less but is in a great location. For example, a prime spot near a ski mountain or a beach house in a warm, popular destination is almost guaranteed to produce a steady stream of rental income.
As you begin figuring out what kind of property to buy, put yourself in a vacationer’s shoes. Most of the time, people aren’t looking for world-class lodging on vacation. They just want something clean and affordable.
That’s why it pays to consult with experienced real estate professionals during this process. They’ll be able to understand your goals and help you find properties that enable you to drive profits without spending an arm and a leg in the process.
Don’t be afraid to negotiate
You and your agent may determine that the asking price is way too high. Consider lowballing the offer and trying to meet somewhere in the middle.
As a tip, use an inspection to find things that need repair or replacement and use that information to get the price down to a reasonable level.
People are often more willing to negotiate after information comes back from an inspection that they were previously unaware of or thought would go unnoticed. This may include electrical, environmental, or structural issues that could require repairs.
At the very least, it’s better to lose a negotiation than to risk paying too much for a property. And don’t worry if you lack strong negotiation skills. That’s what you pay an agent for.
Think about long-term value
Take a look at the long-term value of a rental property and try to determine what the value will be down the line. A lender should be able to give you some clues about what the property’s future value might be in a valuation report.
You may be able to get a great value on a mortgage for a property that’s set to skyrocket in value in the years to come due to changing market conditions.
At the same time, you may overpay for a property that’s set to plummet, causing what you can charge in rent to fall and making you lose out on your investment.
Of course, the goal here is to make a profit. So do your due diligence and only invest in a property you think has long-term value.
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Frequently Asked Questions
Can a rental property produce a strong cash flow?
A rental property can produce a positive cash flow. The general rule is to find a place that’s easy to rent in a desirable location near lots of amenities like bars, restaurants, and stores.
If you find a decent place for an affordable price in a popular area, you should have no problem generating rental income and profiting from your investment.
Of course, nothing is certain in real estate investing. As such, you should do your due diligence to make sure you know what you’re getting into before signing a contract.
How much should you put into a down payment on a rental property?
Unless you want to pay mortgage insurance, set aside at least 20% for a down payment on your rental property. It’s always better to come to the table with more than you think you’ll need.
What if the property doesn’t pass the one percent rule?
The 1% rule is only a quick estimate. It’s essential to go through the above steps to get a better understanding.
The total purchase price can often change significantly by the time you complete the buying and refurbishing process.
That said, if at first glance you’re way off in your estimate, it could be an indicator that a property is not a good fit and you should steer clear to avoid a financial disaster.
Are you guaranteed to make money from a commercial property?
When it comes to buying investment properties, nothing is certain. The best you can do is try and make a good investment and look for a place that will produce a strong monthly cash flow with low operating expenses.
Don’t jump on the first opportunity you see unless it’s an unbelievable deal. Most investors should definitely check out as many potential properties as possible to find the best ones.
Is a multi-family home better than a single-family home for making money?
It largely depends on how many families you can fit into the house compared to what your mortgage payment will be.
If you can find an affordable place that can fit two or three families, it could make for a nice real estate investment because you’ll bring in more income to make your payments.
Serious real estate investors should consider buying multi-family homes to maximize income and produce a strong cash return.
The Bottom Line
The 1% rule can be helpful for determining rental property costs. However, it’s just a surface-level metric.
To make sure you make the best decision, look deeper into a property to determine whether you can afford it before moving forward with the buying process.
Buying an investment property can be one of the best personal finance decisions you make, leading to passive income and financial freedom. However, it can also be extremely costly.
Do your research and scour your investment options before deciding to buy. Before you know it, you can build a robust real estate investment portfolio, putting yourself that much closer to financial independence.