Multifamily real estate investments are among the most reliable ways to build wealth. However, navigating through investment options can be challenging, especially when trying to determine which properties will generate positive cash flow. One tool that investors often use to simplify this process is the 1% rule. This rule provides an easy way to assess potential investment properties by calculating whether the expected rental income covers the property’s purchase price.
In this blog, we will break down the 1% rule and how it applies to multifamily real estate investments. We’ll explore what it is, how to use it, and when it works best.
What is the 1% Rule in Multifamily Real Estate Investments?
The 1% rule is a guideline used by real estate investors to determine if a property is likely to generate positive cash flow. According to the rule, the monthly rent of an investment property should be at least 1% of its purchase price. This ratio helps investors quickly evaluate whether the property’s rental income can cover its operating expenses and yield a profit.
For example, if a multifamily property is priced at $500,000, the monthly rent should be at least $5,000 (1% of $500,000) to meet the 1% rule. This rule is not a strict requirement but provides a good starting point for evaluating potential deals.
How the 1% Rule Works
To apply the 1% rule, follow these simple steps:
- Determine the Purchase Price: The total cost of the property, including any necessary repairs or renovations.
- Multiply the Purchase Price by 0.01 (1%): This will give you the minimum amount of monthly rent that the property should generate to meet the rule.
- Compare to Monthly Rent: If the property’s expected rental income meets or exceeds the calculated 1% value, it passes the 1% rule.
Example of How the 1% Rule Works
Let’s say you’re looking at a multifamily property that costs $300,000. To apply the 1% rule:
300,000×0.01=3,000300,000 \times 0.01 = 3,000300,000×0.01=3,000
This means that, to satisfy the 1% rule, the property should generate $3,000 per month in rent.
Now, if the property requires $10,000 in repairs, add that to the purchase price:
300,000+10,000=310,000300,000 + 10,000 = 310,000300,000+10,000=310,000
Multiply by 1%:
310,000×0.01=3,100310,000 \times 0.01 = 3,100310,000×0.01=3,100
Thus, you should expect to charge $3,100 per month in rent to meet the 1% rule.
Why the 1% Rule Matters in Multifamily Investing
The 1% rule is important for several reasons:
- Quick Property Evaluation: The 1% rule allows you to evaluate whether a property is likely to provide positive cash flow without needing a detailed financial analysis.
- Cash Flow Indicator: If the property meets the 1% rule, it suggests the potential for cash flow. If not, it may be a sign that the property’s rent won’t cover its expenses.
- Investment Strategy: Using the 1% rule helps you stay aligned with your investment strategy by focusing on properties that meet your cash flow requirements.
Benefits and Limitations of the 1% Rule
While the 1% rule is a helpful tool, it’s important to recognize its limitations:
Benefits:
- Easy to Calculate: The 1% rule is straightforward and quick to apply.
- Great for Screening: It helps investors weed out deals that are unlikely to produce good cash flow.
Limitations:
- Doesn’t Account for Operating Expenses: The rule doesn’t factor in ongoing costs like property taxes, insurance, or maintenance, which can affect profitability.
- Market-Dependent: In high-cost markets, the 1% rule may not always apply, as rents may be much lower relative to property prices.
- Doesn’t Consider Appreciation: The rule focuses on cash flow but doesn’t account for potential property appreciation, which can also play a major role in long-term returns.
1% Rule vs. Other Real Estate Investment Metrics
While the 1% rule is useful, it’s not the only method to evaluate investment properties. Let’s briefly compare it with other popular metrics.
Cap Rate
The capitalization rate (Cap Rate) is another common metric used by real estate investors. It measures the property’s potential return based on its net operating income (NOI) relative to its price. Unlike the 1% rule, which focuses on rent, the Cap Rate accounts for all operating costs.
ROI (Return on Investment)
ROI measures the profitability of an investment, considering both the initial investment and the returns. While ROI is more comprehensive, it requires a more detailed financial analysis compared to the 1% rule.
2% Rule
The 2% rule is similar to the 1% rule but suggests that the monthly rent should be at least 2% of the property’s purchase price. This rule is more aggressive and may work better in certain markets but is not as commonly applied as the 1% rule.
Real-World Scenarios: Applying the 1% Rule in Different Markets
Urban vs. Rural Markets
In urban areas with high property values and rental prices, the 1% rule may not apply. For example, in cities like New York or San Francisco, property prices are high, and rental rates may be far below 1% of the purchase price. In such cases, investors may need to rely on other metrics like Cap Rate or ROI to assess profitability.
Emerging Markets
In emerging or secondary markets where property prices are more affordable, the 1% rule may be a more reliable indicator of potential cash flow. For example, in smaller cities or suburban areas, you may find multifamily properties that meet the 1% rule and offer strong returns.
When the 1% Rule Doesn’t Work
While the 1% rule can serve as an excellent starting point, there are situations where it may not be sufficient:
- In Expensive Cities: As mentioned, high-cost areas often have rental rates lower than 1% of the purchase price, which may make the 1% rule less effective.
- Property Condition: If a property needs extensive repairs, the 1% rule doesn’t account for these additional costs. Always consider repair costs separately.
- Location Factors: The 1% rule doesn’t factor in location dynamics, such as neighborhood desirability, employment rates, and overall rental demand.
How the 1% Rule Fits Into Multifamily Real Estate Investments Strategy
For investors looking to build a portfolio of multifamily real estate investments, the 1% rule can serve as a first step in the evaluation process. It’s important to follow up with a more in-depth analysis, including examining the property’s net operating income, expenses, and market conditions.
Conclusion
The 1% rule is a helpful tool for quickly evaluating potential multifamily real estate investments. It provides a straightforward way to assess whether the monthly rent aligns with the purchase price, helping investors filter out properties that are unlikely to be profitable. However, it’s essential to consider other factors like operating expenses, location, and market conditions before making an investment decision.
If you’re looking to dive deeper into Multifamily Real Estate Investments, Aarcstone Capital offers a range of resources to help you get started on your investment journey. Learn more about our investment opportunities.
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FAQs
- Does the 1% rule apply to all types of real estate?
No, the 1% rule is primarily used for rental properties, especially multifamily real estate. It’s a guideline to help investors determine potential cash flow from rent relative to the purchase price. - Can the 1% rule be used for single-family homes?
Yes, the 1% rule can be used for single-family homes, but it’s most commonly applied to multifamily properties where rental income is more consistent and predictable. - Is the 1% rule the only metric I should use when evaluating properties?
No, it’s a good starting point, but other metrics like Cap Rate, ROI, and Cash-on-Cash Return should also be considered for a more comprehensive analysis.