Understanding the one percent rule in real estate
What is the one percent rule?
One percent rule, also known as the 1% rule, is a term that involves real estate properties that evaluates whether the investment property monthly earnings exceed the monthly mortgage payment. This rule estimates whether the property owner earns from the rent or breaks even on the property. It means that the rent should be greater than or equal to the mortgage payment.
Formulas we can use when one percent rule is involved
How do we calculate for the one percent rule? If we multiply the property's worth when bought with the added expense needed for repairs by one percent, we can get the monthly rental income. If we look at it arithmetically, it should be something like this.
Let's use these for the legends:
- R is for rent income per month
- O is for the one percent of the property's purchase price
- M is for the maximum purchase price
The formula is Rent income per month ≥ one percent of the property's purchase price or R ≥ O.
We can also reverse this one percent rule that will leave us with this equation: maximum purchase price = 100 x rent income per month or [M= 100 x R].
However, we should take note that this is only a rough estimation and not the actual figures. There are still hidden costs not included, like insurances, taxes, and upkeep.
The ideal mortgage loan for investors with a monthly fee is with a one percent figure because it somehow gives a standard for rent. It is applicable not only in residential real estate properties but also in commercial building leases.
An example scenario of the one percent rule
Sean is a civil engineer who is looking for a side income aside from his day job. He is looking for a rental property mortgage loan that has a $100,000 payoff value. If we use the reversed one percent rule (maximum purchase price = 100 x $1,000 and maximum purchase price = $100,000). Sean is looking for a mortgage loan where the monthly payments would amount to $1,000 or less.
Here, the one percent rule helped Sean know the standard that he should consider if he obtains a mortgage loan of a rental property.
But how do we know how long is it going to take before the investment becomes fully paid? Here is the part where the gross rent multiplier comes in. A gross rent multiplier identifies how much time it will take to pay the investment full through the monthly rent level.
The gross rent multiplier and the 70 percent rule
The gross rent formula is B/R, or the borrowed value in total divided by the rent income per month.
If we use our example previously, Sean would have to divide $100,000, the total borrowed money by $1,000, the rental income per month. Now, $100,000 / $1,000 = 100. He will pay that $100,000 for 100 months (more than eight years) with the $1,000 monthly rents.
A term called the 70% rule
states that investors like Sean should not pay more than the 70% estimated
value of the property after repairs.
