# The 1% Solution–How to Determine if a Rental Property is a Good Investment

When I first began looking into real estate investing, I spent a lot of time trying to figure out what criteria I would use in selecting which property to buy. I have built many Excel spreadsheets with mind-numbing calculations and data, all geared to finding that perfect investment property.

The biggest question is always this–how to determine if a rental property is a good investment. Having now purchased four rental properties over two years, I’ve developed a much easier way to evaluate whether a property will generate positive cash flow or not. I call it the 1 percent solution, and it works like this–

Will the property generate monthly gross rent equal to at least 1 percent of the total cost of the property?

## How the 1% Solution Works

The total cost of the property includes four things: (1) purchase price of the property; (2) fix-up costs; (3) financing costs; and (4) carrying costs from the time of purchase until the first tenant moves in. Of course, this requires making a reasonable estimate of what the rent will be and the cost to fix-up the properties. With enough experience and research, I’ve found that these estimates can be made with good accuracy.

On estimated rent, for example, I usually estimate within a range of \$100 and calculate the 1 percent using the mid-range of this estimate. Because my investment properties are all in the same area, I’ve got a very good idea of how much rental income a given property will generate.

## A Case Study

Let’s look at an example based on the last single family home I bought. The home was a HUD Foreclosure. It was a small three bedroom, one bath home in a good school district. Here are the numbers–

Purchase Price: \$42,000
Rehab & Other Costs: \$25,800
Total Investment: \$67,800
Rent: \$895
Monthly Mortgage Payment: \$403.69 (P&I)
Taxes: \$156.00
Insurance: \$33.00
Estimated Repairs: \$66.58 per month
Estimated Annual Vacancy \$74.55
Total Monthly Outflows: \$733.82

Monthly Positive Cash Flow: \$161.18

I few things to note about these numbers. First, we include the rehab and financing costs in the total. This is particularly important where, as here, there were significant repair costs. This is common with HUD foreclosures.

Second, always include estimates for repairs and vacancy. Both are a reality for landlords. We estimate vacancy as one months rent, although we look to reduce this be offering long-term leases of 2 or 3 years. Whatever you methodology for making this estimate, be sure to include these costs in your analysis.

In this example, our rent is actually higher than 1%. It comes in at 1.32%. Why?

The main reason is that we bought an older home in an older neighborhood, and the home need substantial repairs. In my experience, these types of homes generate higher rents compared to the cost. On the downside, they tend not to appreciate as quickly as newer properties in newer neighborhoods.

In this example, we have a positive cash flow of over \$160. In addition, the tenant is effectively paying the mortgage each month, reducing the mortgage balance. And finally, we benefit from the appreciation of the property value of time. The result is a profitable property that will generate income for years to come.

## Things to Consider

As you evaluate real estate investments using this rule of thumb, there are several things to keep in mind.

First, we’ve purchased successful properties that fall below the 1% rule, although not by much. The point is that this is a guideline. Just because a property meets this rule doesn’t mean it’s a good investment. Likewise, a property that falls below 1% doesn’t mean it’s a bad investment. If it falls significantly below 1%, however, it’s a good bet that you should pass on the investment.

Second, be sure to include all monthly expenses in your calculations. One expense not included in the above analysis is Homeowner’s Associate fees (HOA). We tend to avoid properties with HOA fees. But if you are considering such a property, be sure to include the expense in your calculations.

Finally, in many areas of the U.S., finding a property that meets the 1 percent rule is next to impossible. I invest in the mid-west, and given the high rate of foreclosures, have been able to find properties that generate rents at or near 1 percent of total cost. I am able to finance nearly 100% of the total cost on a 30-year fixed rate mortgage that enables me to generate positive cash flow immediately, even after factoring in an allowance for repairs and vacancy.

I live in Northern Virginia, an area of very expensive real estate. It’s impossible to find a single family home that can be rented for 1% of the cost. The result is that I don’t invest in this area. Many certainly do, but they rely more on increasing property values for their returns. They are also forced to invest more cash in each property.

I’d be interested in hearing if anybody else uses this or another guide to evaluate potential real estate investments. But I’ve found the 1% solution to be a great way to make profitable real estate investments.

Topics: Real Estate Investing

### 16 Responses to “The 1% Solution–How to Determine if a Rental Property is a Good Investment”

1. I would not use that as a property searching tool. My 4-family doesn’t meet the criteria. It is true that if I had purchased in a seedier part of town, I could have bought an 8-family and set myself up for greater potential monthly cash flow.

But I bought this building as a long-term, low-headache investment. It’s in a great neighborhood – in fact, it’s in my neighborhood, right across the alley from my house. Houses in my neighborhood range from \$200,000 up to \$500,000, and I’m in the Midwest. So it’s a very decent neighborhood. I’ll trade a little less cashflow for a beautiful solid building that will be a great long-term asset for my family.

2. Q, you make a good point. I’v found, generally speaking, that the better the neighborhood and nicer the home, the lower the cashflow. On the upside, not only is the property generally less of a management headache, but appreciation is generally better. That said, I’m surprised that a 4-unit property doesn’t generate combined rents equal to or greater than 1% of the cost of the property. Multi-unit properties generally generate higher cashflows.

3. How are you able to finance nearly 100% of the purchase price? The only way I know how to do that is with 10% – 12% hard money, which will sustain the property but not cashflow or allow principle reduction. With 2-5 year balloon dates it is not a feasible investment if an equity position can not be carved out for re-finance in the future.

Thank You!

Logan

• I use local banks that don’t sell the mortgages into the secondary market. They are called portfolio lenders, and they have a lot more flexibility than the big banks. An experienced real estate agent should be able to point you in the right direction.

4. can you share some of those properties you may not be buying? I am in the northeast and there are properties not even close to that..they never cash flow. realtors say, “oh they do not cash flow, but you will cover most of your expenses, and get equity upside”…what a joke

• Location does make a huge difference. I don’t invest in real estate in Northern Virginia. Prices are just to steep in relation to rents. For me, a property must cashflow to make sense. I never buy on the hope that prices will rise. So the key may be to invest in locations other than where you live.

5. I made the mistake of buying a condominium in a nice neighborhood of Montreal before knowing anything about cash flow. However, after making the purchase, I found out that my investments didn’t make sense. The property cost me about \$230K and the most I could ask for rent was about \$1500. This translates to 0.6%. For sure, this property did not meet the 1% rule.

The only way in which I was able to salvage the situation was to completely furnish the property, add internet and electricity and rent the property to tourist. Now I get about \$2500 per month, but I have to work constantly on the property by cleaning it up after each set of tourist leave.

In spite of not making 1%, I feel that I have learned a lot and now I know what to look for.

6. With the real estate markets rising pretty well, it seems harder and harder to find the no-brainer type investments that were there for the taking just a few years back. Having a strategy that works for you is key to making sure you’re not getting in over your head with an investment property.

• Couldn’t agree more. That’s one of the reasons we haven’t bought any new properties in several years.

• I was planning on doing a 1031 Exchange to avoid paying \$40,000 capital tax gain but after reading all the comments on rental investment I am not sure if it is wise to proceed.

7. For a long time now I’ve been trying to figure out where the 1% rental rule came from. I know it dates back to at least the 1980’s or so as I remember my father citing it back then. I’m really curious to know the logic that lead someone to this 1% rule of thumb and what it was based on.
There are so many variables that matter and vary that 1% may be too high or low depending on the details. But I’ve never been able to find the origins or logic behind the 1% figure.

8. If you’re buying long-distance, doesn’t that add to your costs? Or are you having someone else do all the repairs, upkeep and management? We’re about to get our 2nd rental, and I like to do the painting, husband can do the appliances and basic electrical. Can you talk about using a management company or however you are managing that?

9. Question… let’s say I inherited a property and thus my cost was \$0. I put in about \$10,000 to fix it up and the market purchase/sell rate of this apartment is \$100,000. Also, let’s say the rent I can get now is \$600/month. Would I apply the “1% rule” to the \$10,000 I invested or to the \$100,000 it would cost to buy it?

• Harry,

Ideally, your goal would be to get up to 1% of the value of the home. Of course, you’re at an advantage having inherited the property, so resting a bit below that threshold won’t harm you the same way it would someone having purchased a property outright. Getting rent up near the 1% line (~\$1,000) should be where you set your sights for the future, though.

Warmly,
Stephanie

10. \$895 (rent per month) is 1.32% of \$67,800 (total investment)