Many direct real estate investors like to use the 1% rule for screening properties for possible purchase for rental income. The idea is that if the monthly rent is not 1% of the price of the property, it isn't a good deal.

- So if a property costs $100,000, you'd want to be able to charge at least $1,000/month in rent.
- For a $200,000 property, $2,000/month.
- For a $1M property, $10K/month etc.

Like anything, this strategy/rule of thumb has its strength and weaknesses. The main strength is that it is quick and easy to calculate in your head as a basic screen. The main problem is that a property with a higher percentage isn't necessarily going to provide a higher return than a property with a lower percentage. Let's take a look at what it really means.

**Following the 1% Rule for Real Estate**

Let's say you buy a $100K rental property that rents for $1,000 a month. In order to keep things simple, let's say you buy it Dave Ramsey Style, i.e. all cash.

**45% Rule**

Another reasonable rule of thumb, sometimes called the 45% rule or the 55% rule, is that 45% of rent will go toward the non-mortgage expenses including insurance, taxes, repairs, vacancy, maintenance and management.

**Cap Rate**

So this property has a gross rent of $12,000 per year and a profit of $6,600, i.e. it has a Capitalization Rate of 6.6.

**Appreciation**

If the property also appreciates at a reasonable 3% per year, the overall return should be 9.6%, not counting the benefits of depreciation.

**Depreciation**

Since you can depreciate the property over 27.5 years, and let's say the land is worth $30K and the building is worth $70K, and $70k/27.5 = $2,545. So of that $6,600 you made, $2,545 is not taxed. It may or may not be taxed later. But if you have a 42% marginal tax rate like I do, that depreciation could be worth as much as an extra $2,545*42% = $1,069, basically another 1.1% on the return. So 10.7%. Leverage could potentially add more return to the investment, but many investors would consider 10.7% a reasonable return on their investment.

**Leverage**

In the real world, where most purchased rental property is leveraged, following the 1% rule can help you ensure your property has positive cash flow. If you leverage the whole thing (i.e. 0% down) at 5% for 30 years, your payments will be $6,500 per year. So that first year you take in $12,000 in rent, you pay out $5,400 in non-mortgage expenses, and you pay out $6,500 in mortgage expenses. That leaves you with $100 in cash flow (totally sheltered by depreciation), $3,000 in appreciation, and a mortgage paydown of about $1,475. You ended up making over $4,500 despite not putting anything down!

More realistically, you'll put perhaps 30% of the value of the property down. Now your mortgage expenses are $4,554, your mortgage paydown in that first year is $1,033, and your cash flow is $12,000 – $5,400 – $4,554 = $2,046, all of which is depreciated. With $3,000 in appreciation plus $2,046 in cash plus $1,033 paid off the mortgage, your rate of return is just over 20% on your $30,000 down payment. Not a bad investment, right?

**Not Following the 1% Rule for Real Estate**

So what happens if you don't follow the 1% rule? Because it turns out in many areas of the country (usually the high cost of living areas) you simply cannot find a property for sale that meets these criteria. For example, let's take a look at a random property in San Francisco:

For simplicity, we'll just use the Zillow estimate of what the property is worth and what it will rent for. This two bedroom property rents for $5,809/month ($69,708/year) and is worth $2,324,798. It doesn't pass the 1% rule. In fact, it doesn't even pass the 0.25% rule without rounding up. What would it take for this property to actually be a worthwhile investment? How much would you have to put down to be cash-flow positive? How much would it have to appreciate to provide you a 10 percent return? Let's take a look.

Total rent is $69,708/year. Following the 45%/55% “rule”, after paying all of your non-mortgage expenses you will have $38,339 that could go toward your mortgage. How large of a mortgage at 5% could that pay on a 30-year fixed? About $585,000. That would mean you would need to put down $2,324,798 – $585,000 = $1,739,798, about 75%. Now, will you really have $31,368 in non-mortgage expenses? Maybe not.

Let's say you've done a really, really great job selecting and managing a property and can cut those in half. How much larger can your mortgage be now and still be cash flow positive? You could now get an $830,000 mortgage. You would still need to put down $2,324,798 – $830,000 = $1,494,798 or 64% of the value.

If you only put 30% down, again following the usual 45%/55% rule, you would need to feed this property to the tune of over $67,000 per year ($5,600 per month.)

What kind of appreciation would you need to see in order to have a 10% return on your investment if you put 30% down? Let's look at each component in turn:

- Your investment is $2,324,798 * 30% = $697,439.
- Your cash flow was a negative $67,000.
- The mortgage was paid down by $24,000.
- Since there was no income from the property, there is no income to depreciate.
- You need to make $697,439*10% = $69,744 in order to get a 10% return. Instead, you lost $24,000-$67,000 = -$43,000.
- $43,000 + $69,744 = $112,744 in appreciation in order to get a 10% return. $112,744/$2,324,798 = 4.8%.

Is that impossible? Absolutely not. In fact, in San Francisco over the last 20 years, appreciation has averaged 5.3%. At 5.3% appreciation, the property had a first-year return on investment of 11.5%.

The point is that a property need not follow the 1% rule in order to provide an acceptable investment return, but the lower the rent to price ratio, the more appreciation you will need to hit a given rate of return. In addition, the more skilled you are at buying real estate for less than it is worth and managing it well, the better your returns at a given rent to price ratio.

Be careful assuming past rates of appreciation will continue. Even the mighty San Francisco real estate market lost 27% in 2008-2011. It would be really painful to be feeding a property to the tune of $67,000 per year AND watching it fall in value by $200K+ a year.

*What do you think? If you buy individual properties, do you use the 1% rule as a screen? Why or why not? Do you think it is safe to count on appreciation in some markets for the lion's share of your investment return? Join our Facebook Community and comment!*