Testing The 1% and 2% Rules For Real Estate Investing

By 

Ben Mizes

Updated 

May 9th, 2020

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This article explains the 1% and 2% rule, and then tests how accurate they are by modeling the financials of actual properties.

Within the real estate investing community, people often talk about the "1% rule" or "2% rule" as hard-and-fast criteria a property must meet to be considered a good deal.

At the same time, you might be hearing others say things like, "The 2% rule doesn't work in this market," or, "This property meets the 1% rule so it's a hot buy."

Over the course of building my portfolio, I modeled hundreds and hundreds of deals. I quickly came to realize that while the 1% and 2% rules can be good for napkin math, they only make sense in certain situations.

In many cases, a prudent investor should ignore them altogether.

What is the 1% Rule?

In real estate investing, the 1% rule stipulates that:

  • Your monthly rent divided by the purchase price of the property should be great than or at least equal to 1%

For example, if you purchase a property for $100,000, it needs to rent for a minimum of $1,000 per month to meet the 1% rule.

Expressed as a formula, it looks like this:

1,000 monthly rent ÷ $100,000 purchase price = 1%

What is the 2% Rule?

The 2% rule follows the same concept as the 1% rule, except rent needs to equal 2% or more of the purchase price.

Expressed as a formula, it looks like this:

$2,000 monthly rent ÷ $100,000 purchase price = 2%

At first glance, it might seem like a 2% deal is always better than a 1% deal. However, that can actually be a dangerous assumption, as you'll see once we start modeling properties further down the page.

Are the 1% and 2% Rule Always Good Advice?

The 1% and 2% rules are great for napkin math, but that’s pretty much it. They’re really just a handy trick you can use to quickly assess a deal, and nothing more.

The main problem with these rules is they don’t account for key factors like taxes, age of property, insurance, and utilities, which can vary wildly by market — just like the average rent price.

The 1% rule might work in a market with lower taxes and rents that average $1,000, but wouldn't in one with higher taxes, older buildings, and lower rent prices.

That said, once you learn your market and start to understand how things vary in different neighborhoods, the 1% or 2% rule might start being a fairly accurate guide.

For example, in some of the St. Louis City neighborhoods I've invested in, I won't touch a deal unless it passes the 2% rule; however, in other parts of the city, if I can get rents for over $800 in an apartment, I'm ok with the 1% rule.

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Situations where you can mostly ignore the 1% and 2% rule

As I've grown my portfolio, I've come across several situations where either the 1% or 2% rule doesn't make sense as a guideline, and I wanted to highlight them here.

Ignore the 1% rule when properties rent for less than $650 

In my experience, paying $65,000 for an apartment — especially a house that rents for $650 — will not cash flow in the long term.

The cost of maintenance and repairs are the same on a property that rents for $650 as they are on a property that rents for $900. As you’ll see in the model below, these kinds of properties are traps if you use the 1% rule

Ignore the 2% rule when a property rents for more than $1,500

I've never seen an MLS-listed property that rents for over $1,500 pass the 2% rule test. It's possible to get a property there by renovating then raising rents — but in my experience, the chances of finding something at that rent that meets the 2% rule out of the box are slim to none.

That said, you can still net a great return on these kinds of properties; however, if you're looking to meet the 2% rule, specifically, you might be sitting on the sidelines for a while.

Be mindful of both rules when you’re buying a fixer-upper

If the property you’re considering needs significant renovations, you need to determine:

  • How much additional investment will be required and
  • What the property will rent for once work is complete.

It’s a good idea to use the 1% and 2% rules when making these projections.

Example Property #1 - Low Rent

For this example, we're going to model a typical property in an area locals refer to as "South City" in St. Louis. Here are some of the facts:

Property 1 Stats

Property Type
4plex
Purchase Price
$140,000
Average Rent Per Unit
$525
Property Age
100 years
Property Condition
Fair
Property Taxes
Low

Based on these stats, I can enter the information into our Rental Property Calculator and get the following results.

In St Louis, properties in neighborhoods like this don't appreciate very quickly. So I’m not very excited about the prospect of spending over $30,000 on a property with less than 7% cash-on-cash return in a low-appreciation area with tenants that may be difficult to manage.

This deal meets the 1% rule, but is not something I would consider purchasing — unless I could purchase the property for $100,000, as the cash-on-cash return would increase to ~17%.

Example Property #2 - High Rent

The next property we're going to look at is in a better neighborhood that's primed for appreciation, and has significantly higher rents.

Property 2 Stats

Property Type
4plex
Purchase Price
$600,000
Average Rent Per Unit
$525
Property Age
90 years
Property Condition
Good
Property Taxes
High

Putting these numbers into the rental property calculator, we get some interesting results.

While this property is exactly a 1% deal — whereas the one we modeled above is a 1.5% deal — this property actually has a higher cap rate and better cash-on-cash return.

This is because many of the expenses on both of these properties will be very similar — i.e., painting a 900-square-foot apartment is similar in cost to a 1,500-square-foot apartment — but will account for a smaller portion of income on the property that generates more revenue.

This also doesn't take into account that Property 2 is in a better area that will appreciate faster, and is more likely to have tenants that will stay longer who will take better care of the units.

Example Property #2 - High Rent

The financial models above paint a pretty clear picture: the 1% and 2% rules can be good for napkin math to quickly judge a deal, but they're not set in stone. In reality, they don't work in every market and are often wildly inaccurate.

If you're looking to purchase a rental property, the best way is to do your homework, stick to your numbers, and make a ton of offers until you find a deal that hits your target returns — regardless of whether it meets the 1% or 2% rule.

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