By Christopher Hoeffel, President CoreVest Finance This article originally appeared in Scotsman Guide. The commercial…
by Stefan Malmlund
What is the 1% and 2% Rule?
When investors look at real estate, they tend to consider many different factors, but the 1% or 2% rule are often on their minds. Real estate investors use these rules as a general guideline for estimating their rental property cashflow and subsequent purchase decisions. The 1% rule states that the monthly rent rates should be equal or greater than 1% of the purchase price of that property. The 2% rule states that the rent should be equal or greater than 2% of the purchase price of the property. It is a simple and quick way for investors to decide if a property will generate adequate cashflow.
An example of the 1% rule would be if you are purchasing a property for $200,000 and the expected rent on a property is $2,000 or higher. For the 2% rule, the rent would need to be $4,000 or higher for a property that is selling for $200,000. You might be asking how a property selling for $200,000 can rent for $4,000? Well, the major use of the 2% rule is for multifamily properties versus single-family rentals. Some might counter that there are single-family properties that sell for $40,000 or $50,000, but you can rent for $800 or $1000 a month which would meet the 2% rule. This brings me to my next point.
Risk vs. Return
As stated above, you may be able to find a single-family rental selling for $40,000 that garners $800 per month in rent, but investors (and lenders) also need to factor in the risk of that property. Due to the lower price points, many single-family investment properties that meet the 2% rule might be often fall in the higher risk category because of location, property condition and higher vacancy or tenant turnover. These properties may generate a higher yield, but they also come with higher risk. If you are looking to secure your equity with investments that carry lower risk, targeting a rental property that is just above or below the 1% rule might better fit your risk profile.
Alternatives to the 1% and 2% Rule
Recently, investors (CoreVest borrowers) have reported that there is limited inventory for property that meet the 1% or 2 % rule. Many of them have stopped looking for turn-key properties that meet the 1% criteria, and instead look for properties with value-add potential and upside in rents. This means that they will find a property on the market that is considered below market rents and purchase that property with the goal of bringing rents up to market. When deciding to do this, investors often evaluate the remainder of the current lease and calculate how long they can absorb the rent being lower than their expectations. Another alternative to the 1% path would be to purchase property with no tenants occupying the building, rehab it and rent the property out after, while at the same time building equity into the property to acquire more. This is commonly known as the BRRR strategy which stands for buy, rehab, rent, repeat.
When is looking at the 1% or 2% Rule Important?
If location is not everything, it is at least a good place to start. Using the 1% or 2% rule can help investors decide if a property is a good investment within specific markets. For example, markets that have a smaller demographic, have a higher likelihood of reaching the 1% threshold than the larger MSA’s. Investors purchasing properties in secondary and tertiary markets have a more realistic chance of hitting that 1% rule in comparison to properties in the big city. This does not mean that if a property meets the 1% rule in a specific market that it is a perfect property. The 1% rule does not consider property taxes, capex, insurance, maintenance, and market vacancy rates, among others. Those are just a few things to keep in mind when looking to purchase a property.
In conclusion, the 1% and 2% rule are helpful when initially trying to decide if a property is worth diving deeper into. Beyond that, there are a myriad of factors that investors need to take into account.
For more information about how CoreVest can help you grow your rental and rehab business, please call Stefan Malmlund at 949.356.7264 or email email@example.com.