The “One Percent Rule” is a common real estate investing rule of thumb that commands that in order for a deal to be worth pursuing, the target gross monthly rent for a property should be equal to 1% of the cost to acquire the property. So for example, a single family house that can be acquired for $220,000 would need to command a gross rent of $2200 per month in order to meet the 1% rule.
Income-Producing Real Estate Analysis Basics
Understanding the Cleveland Market For those who are already a bit more well-versed in real estate investing concepts, you might be thinking that this sounds like a dumbed down version of the Gross Rent Multiplier (GRM)… and indeed it is, in reality! A property’s GRM is its ratio of the price to acquire a property to its gross scheduled rent (typically expressed in annual terms, though occasionally expressed in monthly terms).
All else equal, the higher the GRM, the lower the return for the investor. To illustrate the GRM in relatable terms, a duplex that can be acquired for $160,000 would have a GRM of 6.06 if each of the units rented for $1100 per month (160,000 divided by the total annual scheduled income of 26,400), and would have a GRM of 8.89 if the monthly rent was $750 for each unit (160,000 divided by the total annual scheduled income of 18,000). You can also think of the GRM as the number of years a property would “pay for itself” with gross income (excluding all expenses).
Analysis, Meet Reality
What the 1% rule is really saying is that the GRM of a residential investment property should be at least 8.33 (i.e. the gross annual expected rent multiplied by 8.33 would be the acquisition cost of the property). The 1% rule is touted all over the internet as a commandment for real estate investors seeking out their deals… but should it be as widely revered as it is?
While I do agree that the 1% rule can be a good starting point in SOME cases, I believe this is only a suitable target to pursue when dealing with ‘A’ grade areas (check out the rating guide here if you want to learn more about that!). For lower grade areas it is advisable to seek out a somewhat tweaked set of rules, with a lower GRM.
With a lower grade area typically comes a higher set of risks: greater likelihood of tenants causing damage, shorter tenancies, more potential for non-payment/eviction, crime issues, etc. The higher up the area grade spectrum investors go, the less likely they are to encounter problems and drama in their investment portfolio.
Know When to Revamp
So it stands to reason that the same rule of thumb applied to higher grade areas probably does not quite apply the same way to lower areas. It’s time for a rule revamp! Personally, in my own investing I have sought out at least a 2% rule (i.e. a GRM of 4.17) when pursuing properties in a ‘C’ grade area. And though I don’t personally currently invest in ‘D’ or ‘F’ grade areas, I would recommend that anyone who is considering doing so seek out at least the 3% rule (i.e. GRM of 2.78) in order to hedge for the inherent risk associated with these investments.
To illustrate these points, I have conjured up 3 imaginary, but very plausible, Cleveland area investment property opportunities…
The first imaginary but plausible property is an early 1900s triplex just downhill from GE Lighting’s headquarters, off of Euclid Avenue in East Cleveland, an inner-ring suburb on Cleveland’s east side. It’s well maintained and has two renovated/updated spacious 2-bedroom units on the first and second floors, and a tiny 1-bedroom unit in the finished attic on the third floor; there’s a shared driveway with a large paved parking area in the back. We’ll say that the 2-bedroom units will rent for $550/month per unit, and the 1- bedroom third floor unit will rent for $400/month.
The second imaginary property is a 1970s duplex in Euclid (another east side inner-ring suburb), just off of Euclid Avenue in the neighborhood southeast of the new Amazon distribution center. It has two modern 2-bedroom units on the first and second floors, and it has a shared driveway with a 2-car detached garage in the back yard. Each of the units here would rent for about $750/month.
Lastly, our third imaginary property is a charming 1950s ranch in the further-out east side suburb of Mayfield Village, off of Wilson Mills Road and not far from the Progressive Insurance corporate headquarters. It’s a renovated but compact 3-bedroom single family house on a fairly large nicely landscaped lot, with a long driveway and an oversized 2-car garage in the back yard. The house would fetch about $1500/mo on the rental market.
Each of these imaginary properties brings in $1500/month… so each property is worth about the same $150,000, right? Nope. Not in my investment lens at least. Taking a look at where each of these properties is located will quickly tell us that the levels of risk associated with each of these properties will vary wildly. The East Cleveland property is in solid ‘F’ territory, whereas the Euclid property is in a ‘C’ area and the Mayfield property is in an ‘A’ area.
Using the tweaked rule set, with the 1% rule applying to ‘A’ areas, the 2% rule applying to ‘C’ areas, and the 3% rule applying to ‘F’ areas, the maximum valuation I would give to the Mayfield Village house is $150,000, but for the Euclid and East Cleveland properties those values are $75,000 and $50,000 respectively.
While any even remotely simple search of comparable sold properties will confirm that the imaginary East Cleveland triplex is not worth $150,000 based on standard appraisal practices, it’s important to bring this up because investors who are new to the real estate game often seem to underestimate the amount of risk involved in investing in certain areas. While this triplex probably would not ever even be listed for $150,000 on the MLS [by any broker who is in touch with reality] anytime in the foreseeable future, there could be a scenario where it is listed for $70,000-$80,000… surpassing the 1% rule and potentially luring in those who lack the savvy to appropriately adjust their rules based on the area’s grade.
Reset your Analysis Mindset
Lately I have found it very concerning to see potential investors (usually newbies, who lack familiarity with the Cleveland area) thinking they’re finding a great deal because it meets the 1% rule, when it’s actually a mediocre property in a rough area. My goal with this post is to reframe and revamp the 1% rule so investors understand the need to adjust that rule upward (i.e. adjust your GRM expectations downward) when moving from ‘A’ grade areas to lower grade areas. I am hopeful that this will help to steer these investors away from making imprudent investment choices that might kill any hope of a decent return. Note
that I am not saying to necessarily refrain from investing in lower grade areas — I am simply saying to adjust your evaluation rules accordingly or else you’ll probably end up getting a sad wake-up call when a property fails to perform as your investment analysis spreadsheet predicted.
Finally, it’s also worth noting that for the purposes of applying the 1% rule or calculating the GRM, the simple purchase price of the property should only be used when the property is already rented and needs no immediate repairs, or when it is truly “move-in ready”. In cases where improvements or repairs are being made to the property immediately after purchasing it in order to make it rent-ready, the cost of those things should be included in the acquisition cost as well (so if you buy a property for $75,000 but need to immediately put $25,000 into repairs and renovations before it is rented, your acquisition cost is $100,000).
Obviously, the 1% rule, GRM, or any other rule of thumb for that matter, is just a preliminary analysis tool, for quick back-of-the-envelope calculations when you’re out on the prowl for properties. Further analysis, including a detailed look at potential revenues and expected expenses, should always be undertaken before any investment decision is made. But for your quick back of the envelope calculations, erase that oversimplified 1% rule from your mind today, and replace it with the 1-2-3% rule from now on!