The 1 per cent rule, sometimes stylised as the “1% rule”, is a rule of thumb that property investors use to quickly evaluate whether a prospective real estate investment should be examined more closely.

While it is a popular guideline among investors when buying a property for income-generating purposes, there are instances where this rule might not be as helpful as most people claim it is. 

Let’s look at how this rule is applied in real estate investing and when it is best to follow this guideline. 

What is the 1 per cent rule?

The 1 per cent rule is used by real estate investors when assessing a potential property purchase. According to this rule, the monthly rental income generated from a property must be equal or greater than 1 per cent of the purchase price. The main goal of this rule is to ensure that an investor will break-even or make profit from the property.

This rule serves as a baseline for establishing the rental rate that investment property owners charge on their real estate space. This rule can be applied to both residential and commercial real estate properties. 

The 1 per cent rule also instils an income discipline mindset in investors when buying investment properties. Discipline yourself to buy only real estate investments that will have a positive cash flow, which can help you make more money and in the process prevent you from making common property investment mistakes. 

But keep in mind that the 1 per cent rule is not meant to give you a precise result, but only an educated guess. The rule’s formula does not take into account the other property expenses, like the ongoing costs (e.g. repairs and maintenance), loan and acquisition fees, exit costs, insurance, taxes etc. With this, investors are advised to take the resulting figures with a grain of salt and to use the rule as a way to set expectations about an investment property. 

How do you calculate whether a property passes the 1 percent rule? 

Under the 1 percent rule, a rental investment property should meet the follow criteria:

Monthly rental income ≥ One percent of purchase price

To calculate whether a property passes the 1 per cent rule, the formula used is:

 Rent / purchase price x 100

Here is an example of an application of the 1 per cent rule. You are eyeing an investment that is valued at $100,000. You are planning to charge tenants $1,000 per month. Your calculations should look like this: 

$1,000 / $100,000 x 100 = 1.0 per cent 

So, according to the rule, the property can provide you with a positive cash flow and can be a good investment. But if you set the rate lower, at around $800, it would not meet the rule. If the purchase price is higher and the monthly rental rate is still at $1,000, it would also not meet the rule’s criteria. 

But as we’ve discussed, the 1 per cent rule should not be used to put a “yes or no” stamp on a property. There are several factors to consider when finalising your purchase, and passing the 1 per cent rule is just the beginning. Let’s take a closer look when to use the rule and when not to. 

When should you use the 1 per cent rule?

Generally, the 1 per cent rule is best used only as a pre-screening tool. It is a good way to save time and to be disciplined as an investor. 

Let’s say your real estate agent sent you 50 properties that fit the basic criterias you have set for a potential property you are planning to buy. You choose to narrow down the choices by using the 1 per cent rule.

If narrowing which real estate properties pass the 1 per cent rule seems like a tedious process, here are ways to make it easier. First, calculate the 1 per cent of each property’s listed price by moving the decimal place two times to the left. For example, a property valued at $250,000 will result in $2,500. 

After finding the 1 per cent figure for the purchase price, you can compare the results with the average market rent for the same type of property. If the monthly rent is near the 1 per cent of the acquisition or listing price, it may be worth it to further evaluate the property. However, if the rent is significantly lower than 1 per cent, you can choose to just remove that option.

When should you not use the 1 per cent rule?

Before narrowing your list of properties, you can work beyond the 1 per cent rule and use more in-depth tools to analyse a property. It is more of a guideline rather than a rule and should not be followed blindly. 

Let’s say an investment property is worth $500,000 and rents for $500 monthly.  While it satisfies the one per cent rule, it does not necessarily guarantee that it will be a good investment opportunity. You should also take into consideration property quality, location and the potential tenants into consideration.

Another problem with the 1 per cent rule is the use of the gross income of a property (or what you collect from your tenant). But at the heart of it, rental investing’s returns are measured by the net income (or the total amount after all expenses have been subtracted). To have a better approximation of a property’s cash flow, you must take into account the other expenses that come with investment properties (property management fees, vacancy period, taxes, insurance, maintenance, capital expenses and mortgage payments).

Purchasing a piece of property for investment requires a thorough analysis of numerous factors. Properties that are below the 1 per cent threshold can still be a great investment option. So, if you are eyeing a real estate that did not pass the 1 per cent rule with flying colors, don’t easily write it off without taking into account other fundamental factors that influence overall rate of return.

Property market experts also do not recommend using the property for high-priced real estate. Let’s say you are planning to buy a property in Sydney where the average sale price is currently  $1,142,212. The average monthly rental rate in the area is estimated to be at $2,121. To pass the 1 per cent rule, you need $11,422.12 monthly rental income. This means that if you want to meet this requirement in practice, you have to buy an investment property at a much lower value than the average price to pass the rule.

The 1 per cent rule can be more applicable to certain types of properties, usually small residential rentals. If you are buying a big building with multiple units or a commercial property, you may set a bigger expected rental income than what the 1 per cent can provide.   

Conclusion

While the 1 per cent rule can be used as a screening tool for potential investment properties, it should only be used as a guide and not a make-or-break benchmark by investors. It is just one measurement tool that can help an investor gauge the risk and potential returns that might be achieved by investing in a property. Your decision to purchase must also be based on personal and financial goals as well as your set criteria as a real estate investor.