When you make an investment, you want to turn a profit. Historically, real estate can be a pretty solid hedge against inflation and a sound investment strategy – but how do you really know if a deal is good or bad, especially if you’ve never purchased rental property before?
The 1% rule can help. While it’s not a guarantee, it is one metric that potential investors use as a guideline to assess whether a rental property is worth the cost.
What is the 1% rule?
The 1% rule states that the monthly rental income of a property should be approximately 1% of its total acquisition cost or market value – including any upgrades, remodeling or repairs that have to be made to attract the tenants you want.
This means that if you purchase a property for $500,000, the anticipated sum total of your monthly rental income should be around $5,000 (1% of $500,000). If the monthly mortgage on the rental property is likely to exceed $5,000, then the property is a bad deal. If the property can be rented for more than $5,000 a month, the difference gives you an idea of the property’s overall potential for a positive cash flow.
Limitations exist
The 1% rule serves as little more than a quick initial screening tool, however, because it does have some limitations. It doesn’t take into account the cost of regular repairs, property management services, taxes or insurance – all of which will, naturally, have a major impact on your bottom line.
In addition, the 1% rule also assumes that you won’t have any vacancies, which may be difficult to gauge. In some commercial rental markets, for example, there are plenty of office buildings standing empty, and apartment complexes often have high turnover rates. You have to take a good look at the local market trends and vacancy rates for the type of property you’re considering in order to have a clearer idea of the investment’s viability.
It’s important to take any improvements or upgrades into account when purchasing commercial property.