Let’s talk about the “rules” in real estate! You have probably heard about the 1% rule, the 2% rule, the 50% rule, and the 70% rule. But, do you really understand them? And, more importantly, when and how to use them? These rules are only effective if you apply them appropriately.
Let’s start with the 1% rule. This rule is a great way to eliminate a property without spending too much time analyzing. I use this for a very basic, preliminary check on a property I am considering as a buy-and-hold in order to decide if it’s something I want to pursue. This rule states that the monthly rent needs to be 1% of the overall purchase price. So, if you’re buying a property for $100,000, your monthly rent needs to be $1,000 a month. It’s a great way to briefly look at a property, and see if it is worth pursuing.
If it doesn’t meet the 1% rule, I typically throw it out unless I think there’s another reason to pursue that property (an appreciation play, or value-add opportunity, for example). The rental rate you used should be based on the market rent. Do not use the current rental rate if it’s low, because it won’t show you the actual value of the property. Be conservative here, though.
The 2% rule states that a property’s monthly rent should be 2% of the purchase price. So in the case above with a $100,000 property, a 2% property would rent for $2000 per month. These are harder to find but a good goal as these represent twice the return as 1% properties. I have one single property in my portfolio that meets the 2% rule. It’s a duplex I bought in Marion, IL and I paid $65,000. Each side rents for $650 a month, so it’s exactly a 2% property. So, now that I know that 2% is doable, that’s what I look for.
Next, let’s look at the 50% rule. This is a good rule to use to plan your expenses. The rule is based on the idea that 50% of your profit, or rental income, will be used toward expenses. Meaning, the property you are analyzing is going to cost about 50% of what it rents for, and that’s before you pay the principal and interest portion of your mortgage. This is another way to check on a property before spending too much time doing your due diligence.
The seventy percent rule is used when you are looking to buy something distressed. The goal is to pay 70% of the after repair value or the amount that property could be worth after you renovate it and you bring it up to other comparable market properties. Because these are higher risk and time consuming, you don’t want to pay more than 70% of the ARV once you take into consideration the renovation cost.
Let’s say you are looking at a property that’s worth $120,000, but you know that you’ll have to put $20,000 worth of repairs and renovation into it. $120,000 minus $20,000 in repairs leaves you with $100,000. To accommodate holding costs, the cost of money, contingencies, and profit, you want to pay no more than 70% of that, so $70,000.
These are good rules of thumb to analyze properties, but they have to be applied appropriately. And, again, they can only take you so far. These rules don’t consider things like taxes, which vary from state to state, or different insurance coverage requirements. So keep them in mind, but do not rely on them too heavily. They are good rules, but they should only be used to a certain point. If you want to really run numbers, check out these analysis calculators which also come with a YouTube video explaining how to use them.