Do we really need another blog post explaining the 1% rule for real estate investments?
Yes! Because I’m going to explain it using examples of ridiculously expensive multi-million dollar beach houses that famous people live in.
The 1 percent rule can be applied in any city or state you want to invest in. It is a general guide for quick identification whether a potential investment property is generating enough cash flow to cover its own expenses.
When does the 1% rule apply to real estate investments?
Let’s say you’ve just won the Powerball lottery and have a cool $ 80 million burning a hole in your pocket. You want to buy some high-end passive income rentals and think Malibu, California is a great place to look.
The typical lottery winner loses all of their money on bad investment property – but you are smarter than that – so be very careful with your search criteria. You want to make sure that the villas you buy are generating enough rental income to cover all ongoing expenses, especially the monstrous mortgage payments!
After contacting a Malibu real estate agent, you encounter a few issues:
- First, there are over 600 beach houses for sale in Malibu! It will take far too long to look at and carefully analyze every potential property.
- Next up, these villas range from $ 4 million up to a purchase price of $ 125 million! There’s too much variety … How do you know which ones are a good investment for positive cash flow?
- Every time you look at the beautiful luxury real estate photos you fall in love. 😍 It’s hard to separate your emotions from your logical investment brain!
Hmmm … If only there was a quick way to narrow down your search, identify the best candidates for positive cash flow, and do it all in a mathematical way with no emotion …
The 1 Percent Rule … A quick math guideline
The 1 percent rule allows you to analyze a potential investment property in less than 60 seconds. You only need 2 data points: The buying price and the expected monthly rent. The rule is that the property is likely a good investment if the monthly rent is at least 1 percent of the purchase price.
Monthly rent / purchase price = (%).
If that number is higher than 1%This investment property has good potential! This property should be further investigated.
If the number is less than 1%Skip this for now as the incoming rent may not be high enough to cover all mortgage and maintenance costs.
Note that this is not an exact rule. It’s more of a guideline. There are a ton of different factors that can make or fail a real estate investment. The 1 percent rule is just a quick tool any investor can use to search 600 homes (or villas) for sale and narrow it down to a few with the highest likelihood of success.
Let’s look at some real life examples and calculate if they meet the 1% rule.
Example 1: Matthew Perry’s $ 15 million Kick Ass Malibu House (His words)
Matthew Perry only listed his beach home for sale for $ 14,950,000. It has 4 bedrooms and 4 bathrooms and is located on Malibu Road in Malibu, CA.
If we buy Matthew Perry’s house, how much can we rent it for?
Well, just a few houses down on Malibu Road there is this comparable mansion for rent. It’s also right on the beach, has 4 bedrooms and 4 bathrooms. It can be leased for $ 45,000 per month …
Let’s use these numbers to see if Matt’s house meets the 1 percent rule …
Purchase price: 14,950,000 USD
Monthly Rent: $ 45,000
Rent / purchase = 0.3%
Unfortunately, it looks like Matt Perry’s house doesn’t meet our minimum rent-to-price ratio of 1 percent. In fact, the $ 45,000 monthly rental income wouldn’t even cover the $ 65,000 per month mortgage payment 🙁 This property would have negative cash flow.
Example 2: Malibu Colony $ 12 Million Beachfront Condo
Check out this list on Malibu Colony Road. (I don’t know who the current owner is, but this section of Malibu Beach is the oldest and a popular spot for celebrities. Tom Hanks, Bette Midler, and Woody Harrelson all used to live on this street, but now the younger famous people have it it taken over.)
The purchase price is $ 11,950,000.
Let’s see what such a place would rent for …
Holy Moley! Just 8 doors down is this place down … same beach and condo size. They charge a whopping $ 175,000 a month in rent.
Let’s enter the purchase price and estimated rental numbers to see if it’s a good property investment.
Purchase price: $ 11,950,000
Monthly Rent: $ 175,000
Rent / purchase = 1.46%
Woohoo! This property fulfills the 1 percent rule! The incoming monthly rent covers not only the mortgage payment, but likely also the property tax, insurance, and all of the ridiculous maintenance costs associated with luxury homes.
We’d better plan a tour of the place and meet the neighbors. We should also do a thorough analysis of the rental properties before making an offer.
Let’s look at some other Malibu homes for sale …
- Kristen Stewart’s house: Asking Price: $ 9.5 million. Would rent for $ 55,000 / m = 0.6%
- James Cameron’s connection: Ask for $ 25 million. Rent both houses for 75,000 USD / m each 0.6%
- 28926 Cliffside Dr: Purchase price 11.9 million USD, rent for 65,000 USD / m = 0.5%
- 30370 Morning View Dr: Purchase price: 4.2 million USD, rent for 35,000 USD / m = 0.8%
- 27348 Pacific Coast Hwy: Purchase price: 7.62 million USD, rent for 85,000 USD / m = 1.1% Woohoo !!
- 26940 Malibu Cove Colony Dr: Purchase price USD 7.3 million, rent for USD 75,000 / m = 1.0% cute !!
This method allows us to quickly search through the 600 listings and narrow it down to around 20 of the best villas worth looking at.
You’re on your way to becoming a successful landlord … and might even attract a posh celebrity renter! 🙂 🙂
Remember, rules are more like guidelines
If you’re already a homeowner or a real estate investor, you may already be asking: “Hey, my current home doesn’t meet the 1% rule … does that mean I made a bad investment?”
Do not worry. The 1% rule is just a quick guideline for cash flow investors. It was done a long time ago when interest rates were higher and purchase prices were low. There are hundreds of different factors that will determine whether you will be successful in investing in rental properties.
I know from experience. To take my TX rental property For example: when I bought it the incoming rent was $ 1,800 per month and I paid $ 189,000 for it. (0.95% Price ratio). While the 1% rule has not been met, I can safely say that the incoming rent covers the mortgage loan, taxes, insurance and property management costs AND gives me a positive return on money every year!
What if none of the locations in your search area meet the 1 percent rule?
There will always be some markets that have high house prices and much lower rental rates. Typically these high cost of living cities and areas like Boston, New York, Bay Area, Seattle etc (in fact, Los Angeles and Malibu usually don’t have properties that meet the 1% rule … the addresses I found above are only extreme outlier examples!).
Here are some things you can do if you can can’t find any properties that meet the 1 percent rule in your region:
First of all, you can invest in another market! This is why I started investing in real estate in Texas because I couldn’t find anything in my search criteria where I live in California. Fair Warning – Managing a rental property in another state comes with a number of challenges and certainly not for the faint of heart.
Another option is that you may be able to Power the 1 percent rule through a lower purchase price. Take this place here for example 7221 Birdview Ave, Malibu.
They’re asking for $ 15.5 million …
A similar location on this street rents for about $ 130,000 per month. (0.8%) Unfortunately, with these numbers it does not correspond to the 1 percent rule.
BUT … what if we could buy this mansion for $ 13 million instead of $ 15.5 million? At a price of USD 13 million, the ratio would be (1.0%). This means that the 1 percent rule is met.
Do you think the owner will give us a $ 2.5 million discount off the purchase price? It sure doesn’t hurt to ask! Depending on how hot or cold the market is, you might be lucky enough to force a better price to meet the 1 percent rule.
A final option is to knowingly break the 1 percent rule. If there aren’t any properties that make the cut, there’s probably a reason for it. Typically, higher cost of living translates into faster real estate appreciation. The annual income that you knowingly give up on rent could be offset in other areas. This is a risky strategy and needs to be calculated carefully!
What if you know the property’s value but don’t know how much it is renting for?
This scenario happens a lot. You might want to buy a home but have no idea what it’s renting for. Where can you get reliable rental data?
First of all, your broker might have a general idea. Keep in mind, however, that they are trying to sell you the home so they may be tempted to add up the “potential rent numbers” to make you more excited. Expect their estimate to be in the upper range!
Next, give some property management companies in the area a call. Tell them the address of the house you want to buy and ask what they could rent it out for. In my experience, property management companies are more knowledgeable about gross rental rates because they are entering into the leases with tenants. This is their full time job so they know exactly how much a renter would pay.
Also check online sites and advertisements. Craigslist is one of my favorites! Be sure to check out Map view Looking at Craigslist postings is the quickest, easiest way to gauge the rental market. Zillow is decent (I used it in the Malibu examples above) and Rentometer is great too. Whatever you use, it doesn’t hurt to refer to multiple reputable sources.
Get out there and find some deals!
Finding the right rental property can be exhausting and overwhelming. That is why such tools as the 1% rule exist. This saves you time and effort in identifying the best rental properties.
Of course, my Malibu examples are ridiculous, but the 1 percent rule is the same no matter what area your research is in. Time to get out there and find some deals!
Do you currently use the 1% rule for your real estate experts? If not, what are your investment criteria? How would you spend your $ 80 million lottery money? 🙂 🙂