There are a few different metrics you can use to determine the “success” of an investment property, but there’s none that’s more critical than cash flow.
Owning and managing a rental property isn’t cheap. There is a significant number of costs (like loan payments, maintenance, repairs, insurance, and property taxes, to name a few) and if you don’t anticipate those costs, you could find yourself in the red.
Luckily, there are a few rules you can follow that will help you accurately plan and make decisions around your property and keep it profitable — namely, the 1% rule and the 5% rule.
What are those rules? How do they work? And how can you use them to keep your investment portfolio profitable?
The 1% Rule
Let’s start with the 1% rule. The 1% rule has to do with how much you charge for a tenant to rent your property; it states that the rent should be 1% or more of the total price of the home.
For example, let’s say a home cost $100,000. According to the 1% rule, you would need to rent that property for $1,000 per month for it to be a good investment.
The 1% rule has to do with how much you charge for a tenant to rent your property; it states that the rent should be 1% or more of the total price of the home.
Now, you can’t just buy a property, figure out 1% of the total cost, and then slap that number on a lease agreement and expect to attract tenants. Rent is determined by the market; in order to rent a property, it needs to be priced competitively with other similar properties in the area.
But you can use the 1% rule as a way to determine whether a property is a good investment. Let’s go back to that $100,000 home. If similar homes in the area are renting for $500, it’s not a great investment — that’s just .5% of the total price, a far cry from the 1% standard.
You can also use this rule in reverse order if you’re trying to determine how much to offer on a property. If a house is on the market for $100,000 but is only renting for $500, you wouldn’t want to come in at offer price. Instead, you could divide $500 by 1% (500/.01) to get an offer price that would be more profitable for you — in this case, $50,000.
Keep in mind — it can be a challenge to meet the 1% rule in a lot of areas, and in some markets it’s near impossible. That’s why it’s important to consider all the factors (like market conditions, rental opportunity, and competition) when evaluating a property. Use 1% as a benchmark; try to hit it every time, but evaluate each market individually to see what’s realistic.
The 5% Rule
Onto the second rule: the 5% rule. The 5% rule in real estate is about spending. This rule states that you should reasonably expect to spend 5% of your total income on repairs and property maintenance – your "Maintenance Reserve Rate."
Now, the 5% rule isn’t steadfast; there are months when your maintenance expenses will be significantly higher than 5% and there are other months where they’ll be lower. But 5% is a good (if conservative) average.
For example, let’s say you own a rental property that rents for $2,000. Five percent of that – $100 – will need to go to maintenance every month, which leaves $1,900 for your mortgage and profit (if you’re not sure how much your monthly expenses will be, talk to a property manager to get a realistic estimate on operating costs).
Obviously, if your mortgage is $1900, this property wouldn’t be a good investment; not only would it leave you with no profit, but it would actually put you over budget and in the red. However, if your mortgage was $1000, that would leave $900 per month in profit, making it a good investment choice.
Aim to Follow These Rules — But Don’t Beat Yourself Up if the Numbers Don’t Quite Work
You should always aim to have every rental property you own satisfy both the 1% rule and the 5% rule. But no one’s perfect, and depending on different variables, it might not always be possible. Striving to follow these rule will keep you thinking about profits and help you make better choices when it comes to your investment properties.
