The 1% Rule is Dead

Real Estate

Mar 29

The 1% Rule is Dead

Is the 1% rent-to-price (RTP) ratio rule dead? For years this “rule” has become popularized by real estate investors looking for a quick and easy way to estimate a rental property’s potential cash flow. But new evidence suggests that the 1% rule may not be the best way to analyze a good deal.

Real estate experts have vocalized that the 1% rule no longer carries enough weight in the current real estate landscape. Considering inflated home prices and underlying shifts in the rental market, the once prevalent method for performing cursory due diligence loses efficacy.

Throwing the 1% rule out the window in favor of more holistic calculations and analyses could prove a better measurement of whether an investment is worth pursuing or not. In fact, Here at Doorvest, we recommend other methods to determine rent prices.

How Does the 1% Rule Work?

The 1% rule leverages what is commonly referred to as the rent-to-price (RTP) ratio metric as the method for quickly estimating a property’s potential cash flow.

To perform your quick calculation, the rule requires you to take the estimated monthly rent for your property and divide that by your estimated purchase price. If you take the rule to heart, any result over 1% would be considered a good deal and anything else would be a ‘pass’

Nevertheless, there are a few flaws with using the 1% rule as your initial benchmark determinant for whether a deal is a go or a no-go. Specifically, the lack of market factors and depth of analysis are explicit concerns.

To start, it’s important to understand that the 1% rule was developed and adopted when market conditions supported its use, namely when median rents were proportionately higher than home prices.

Today, markets have hit an inflection point where home appreciation rates are beginning to outpace rent growth, which, when using the 1% rule, can skew decision-making by over or understating a property’s potential performance. Adding in other market data to help solidify your initial calculation is ideal for helping steer you down the right path.

That leads us to the second issue with the 1% rule in that, in a vacuum, the 1% rule is only one singular measure of performance (and a quick one at that). When judging a good deal, the 1% rule shouldn’t be used as the end-all-be-all. It’s a rule of thumb, not a law, and should be considered in conjunction with other data points to really be effective.

What’s a Better Way to Determine Rent Prices?

For years the 1% rule has done a decent job of helping investors make snap decisions about new real estate investment opportunities. But ultimately there are better ways to determine rent prices and whether a deal is good.

First, consider revising your rule to better suit the current rental environment. Instead of 1%, use 0.5% or a weighted metric that considers trends in the neighborhood you’re looking to invest in. In fact, looking at comparable rentals throughout the target area will provide you with a more accurate picture of where your deal stands.

Furthermore, consider adding a quick cap rate calculation to your analysis. You can figure out your cap rate by deducting your estimated operating expense from your gross annual rent (to get your net operating income or NOI) and dividing that by the estimated purchase price. Use that in combination with your revised 1% rule for a better insight into your deal.

Better yet, consider a less cash flow-centric investment strategy in favor of a deal’s total return above all else. If you are investing in real estate, you should understand the importance of looking at deals holistically. That means factoring in appreciation, amortization, and taxes alongside cash flow.

In some cases, you might determine an appreciation strategy is more suited to your investing model. But no matter how you go about investing in real estate, Doorvest can help make it easier to build wealth by helping you identify, purchase, and own rental properties.