Do we really need another blog post explaining the 1% rule for real estate investing?
Yes! Because I’m gonna explain it using examples with ridiculously expensive, multimillion-dollar beach houses that famous people live in.
The 1 percent rule can be used in any city or state you are planning to invest in. It’s a general guide to quickly identify whether a potential investment property will generate enough cash flow to cover its own expenses.
When to Use the 1% Rule in Real Estate Investing
Let’s say you just won the Powerball lottery and have a cool $80 million burning a hole in your pocket. You want to buy a few high-end rental properties for passive income and think that Malibu, California, is a great place to look.
The typical lottery winner loses all of their money on bad investment property — but you’re smarter than that — so you’re very careful about your search criteria. You want to make sure the mansions you buy will bring in enough rental income to cover all of the ongoing expenses, especially the monstrous mortgage payments!
After reaching out to a Malibu realtor, you realize a few problems:
- First, there are over 600 beach houses listed for sale in Malibu! It will take way too long to look at and carefully analyze each potential property.
- Next, these mansions range between $4 million all the way up to a $125 million purchase price! There’s too much variety… How do you know which ones will be a good investment for positive cash flow?
- Every time you look at the beautiful photos for luxury real estate listings, you fall in love. 😍 It’s hard to separate your emotions from your logical investment brain!
Hmmm … If only there were a quick way to narrow the search down, identify the best candidates for positive cash flow, and do it all in a mathematical way with no emotions …
The 1 Percent Rule … A Quick Math Guideline
Using the 1 percent rule, you can analyze a potential investment property in less than 60 seconds. All you need is 2 data points: the purchase price and the expected monthly rent. The rule states that if the monthly rent is at least 1 percent of the purchase price, the property will likely be a good investment.
Monthly rent / purchase price = (%).
If this number is higher than 1%, this investment property has good potential! This property should be further investigated.
If the number is lower than 1%, skip over this for now as the incoming rent might not be high enough to cover all the mortgage and maintenance costs.
Keep in mind, this is not an exact rule. It’s more of a guideline. There are a ton of different factors that make a real estate investment profitable or a failure. The 1 percent rule is just a quick tool any investor can use to sift through 600 houses (or mansions) for sale and narrow it down to a select few that have the highest probability for success.
Let’s look at some real life examples and calculate whether they meet the 1% rule.
Example #1: Matthew Perry’s $15 million “Kick Ass Malibu House” (His Words)
Matthew Perry just listed his beach house for sale for $14,950,000. This has 4 bedrooms and 4 bathrooms, and is located on Malibu Road in Malibu, CA.
If we buy Matthew Perry’s house, how much can we rent it for?
Well, just a few houses down on Malibu Road, there is this comparable mansion for rent. It is also beachfront, has 4 bedrooms and 4 bathrooms. It can be leased for $45,000 per month…
Let’s use these figures to see if Matt’s house will meet the 1 percent rule…
Purchase Price: $14,950,000
Monthly Rent: $45,000
Rent / Purchase = 0.3%
Unfortunately, it looks like Matt Perry’s house doesn’t meet our minimum 1 percent rent to price ratio. In fact, the $45k per month rental income wouldn’t even cover the $65k per month mortgage payment :( This property would have negative cash flow.
Example #2: Malibu Colony $12 Million Beachfront Condo
Check out this listing on Malibu Colony Road. (I don’t know who the current property owner is, but this section of Malibu beach is the oldest and is a favorite place for celebrities. Tom Hanks, Bette Midler and Woody Harrelson all lived on this street back in the day, but now the younger famous peeps have taken it over.)
The purchase price is $11,950,000.
Let’s see what a place like this would rent for…
Holy moley! Just 8 doors down, there’s this place below … same beachfront and condo size. They are asking a whopping $175,000 per month in rent.
Let’s plug in the purchase price and estimated rent figures to see if it’s a good real estate investment…
Purchase Price: $11,950,000
Monthly Rent: $175,000
Rent / Purchase = 1.46%
Woohoo! This property meets the 1 percent rule! The incoming monthly rent will not only cover the mortgage payment, but it’ll probably also cover property tax, insurance, and all the ridiculous maintenance costs that luxury homes come with.
We’d better schedule a tour of the place and meet the neighbors. Also we should do a thorough rental property analysis before putting in an offer.
Let’s Check Some Other Malibu Homes for Sale …
- Kristen Stewart’s house: Asking price: $9.5 million. Would rent for $55,000/m = 0.6%
- James Cameron’s compound: Asking $25 million. Rent both houses for $75,000/m each = 0.6%
- 28926 Cliffside Dr: Purchase price $11.9 million, rents for $65,000/m = 0.5%
- 30370 Morning View Dr: Purchase price: $4.2 million, rents for $35,000/m = 0.8%
- 27348 Pacific Coast Hwy: Purchase price: $7.62 million, rents for $85,000/m = 1.1% Woohoo!!
- 26940 Malibu Cove Colony Dr: Purchase price $7.3 million, rents for $75,000/m = 1.0% Sweet!!
Using this method we can quickly sift through the 600 listings and narrow it down to about 20 of the best mansions worth looking at closely.
You’re on your way to becoming a successful landlord … and might even attract a fancy celebrity tenant! :)
Remember, Rules Are More Like Guidelines
If you are an existing homeowner or real estate investor, you might already be wondering, “Hey, my current home doesn’t meet the 1% rule … does that mean I made a bad investment?”
Don’t worry. The 1% rule is just a quick guideline for cash flow investors. It was made way back in the day when interest rates were higher and purchase prices were low. There are hundreds of different factors that determine whether you’ll be successful at rental property investing.
I know from experience. Take my TX rental property for example: When I bought it, the incoming rent was $1,800 per month, and I paid $189k for it. (0.95% price ratio). But although it didn’t meet the 1% rule, I can safely say the incoming rent covers the mortgage loan, tax, insurance, property management expense, AND provides me a positive cash return each year!
What If None of the Places in Your Search Area Meet the 1 Percent Rule?
There will always be some markets that have high real estate prices and much lower rent ratios. Typically these are in high cost of living cities and areas like Boston, New York, Bay Area, Seattle, etc. (actually Los Angeles and Malibu typically don’t have real estate properties that meet the 1% rule … the addresses I found above are extreme outlier examples only!).
Here are a few things you can do if you can’t find any properties that meet the 1 percent rule in your area:
First off, you can invest in a different market! That’s why I started investing in Texas properties, because I couldn’t find anything in my search criteria where I live in California. Fair warning — managing a rental property while living in another state has a number of challenges associated, and certainly isn’t for the faint-hearted.
Another option is, you might be able to force the 1 percent rule by offering a lower purchase price. Take for example, this place here at 7221 Birdview Ave, Malibu.
They are asking $15.5 million …
A similar place on this street will rent for about $130,000 per month. (0.8%) So unfortunately, it doesn’t meet the 1 percent rule with these numbers.
BUT… What if we could buy this mansion for $13 million, instead of $15.5 million? At a $13 million price point, the ratio would increase to (1.0%). Thus, meeting the 1 percent rule.
Do you think the owner will give us a $2.5 million discount on the purchase price? It certainly doesn’t hurt to ask! Depending on how hot or cold the market is, you might get lucky and be able to force a better price to meet the 1 percent rule.
One last option is to knowingly break the 1 percent rule. If there are no properties that make the cut, there’s probably a reason why. Typically higher cost of living areas have faster property value appreciation. The yearly income that you are knowingly giving up in rent could be made up for in other areas. This is a risky strategy and needs to be carefully calculated!
What If You Know the Property Value But Don’t Know How Much It’ll Rent For?
This scenario happens a lot. You might want to buy a house but have no idea what it will rent out for. Where can you get reliable rental data?
First off, your realtor might have a general idea. But, remember they are trying to sell you the home, so they may be tempted to inflate the “potential rent” numbers just to get you more excited. Expect their estimate to be on the high end!
Next, call a few property management companies in the area. Tell them the address of the house you are looking to buy, and ask what they could rent it out for. In my experience, property management companies are more knowledgeable about gross rent rates because they sign the leases with tenants. That’s their full time job, so they know exactly how much a tenant would pay.
Also, check online sites and advertisements. Craigslist is a favorite of mine! Be sure to check out Map View when looking at Craigslist postings — it’s the quickest and easiest way to gauge the rental market. Zillow is decent (I used it in the Malibu examples above) and Rentometer is great, too. Whatever you use, it doesn’t hurt to cross-reference multiple reputable sources.
Get Out There and Find Some Deals!
Searching for the right rental property can be exhausting and overwhelming. That’s why these types of tools like the 1% rule exist — so you can save time and effort identifying the best rental properties.
Obviously my Malibu examples are ridiculous, but the 1 percent rule is the same no matter which area you are researching. Time to get out there and find some deals!
For you real estate experts out there, do you use the 1% rule currently? If not, what is your investment criteria? How would you spend your $80 million lottery money? :)
Joel is a 35 y/o Aussie living in Los Angeles and the guy behind 5amjoel.com. He loves waking up early, finding ways to be more efficient with time and money, and sharing what he learns with others. Rise Early | Retire Early!