The 1% Rule vs. the 2% Rule in Real Estate Investing

The 1% rule and 2% rule are two common metrics used by real estate investors to determine the viability of a rental property investment. Both rules provide a simple framework for evaluating rental income and expenses to help determine the expected return on investment (ROI) for a rental property. But in today’s evolving real estate market, are these longstanding rent price-setting rules still relevant? Keep reading to learn the pros and cons of the 1% and 2% rules in real estate investing. 

What is the 1% rule?

The 1% rule states that a rental property's rental income should be at least 1% of the purchase price. For example, if a rental property is purchased for $200,000, the monthly rental income should be at least $2,000. This rule is a quick and easy way to determine if a rental property is likely to generate enough income to cover the costs of owning and operating the property and create a profit for the investor.

What is the 2% rule?

The 2% rule states that the expected monthly rental income should be equal to or greater than 2% of the purchase price. Using the same example, a $200,000 rental property should generate a monthly rental income of at least $4,000. 

Pros and cons of the 1% and 2% rules

The 1% and 2% rules in real estate should simply be viewed as a rule of thumb — not an ironclad investing strategy. Landlords use them because they’re easy to calculate, provide a rudimentary benchmark for expected rental income, and can help identify undervalued properties. 

That said, investors should be cautious and take other important factors into account when determining whether to purchase a property. The 1% and 2% rules may not provide a reliable benchmark for rental property investments in areas with high cost of living or high rental demand. They also do not account for fluctuations in the local real estate market, such as changes in supply and demand, which can impact the potential rental income of a rental property.

Setting the right rent price: Other factors to consider

While the 1% rule and 2% rule can be useful starting points for setting your rental rate, they are not a guarantee of how the property will actually perform. Following are important factors to consider when determining rent prices: 

1. Operating costs: A major downside of the 1% and 2% rules is that they do not take into account all of the costs associated with owning and operating a rental property, such as property management fees, repairs and maintenance, property taxes, and insurance. Rental property owners should consider these costs when determining the expected profits for a rental property.
2. Local rental market: Local market conditions — such as the availability of similar rental properties in the area, the demand for rental properties in the area, and the cost of living in the area — have a significant impact on rent prices. In San Francisco, where the average home value is over $1.4 million, the 1% rule dictates that rent should be $14,000. But since the actual median San Francisco rent price is $3,600, landlords applying the 1% rule would have a hard time finding potential tenants. 
3. Property conditions: If a property is in a high-demand area but is outdated and in need of an upgrade, you may not be able to follow the 1% or 2% rule. The property’s age, appliances and fixtures, and any recent renovations or repairs impact a landlord’s ability to charge certain rental rates. 

How to research local rental rates

Rental property owners have a variety of tools to find out the range of rent prices for properties in their area. First off, start by reviewing the local regulations to understand whether your area has laws around rent control and rent increases. These regulations will help you create a maximum cap for your rental rate. 

Next, research the rent prices of similar homes in your area. There are a number of resources to help you do this. You can simply look up apartments or houses for rent on listing sites such as Zillow, Redfin, Apartment List, Apartments.com, or the many other websites available. You can also use Rentometer to quickly check if your proposed rent price is in range with other properties in your area. 

It’s also a great idea to talk to real estate agents and property managers in your area, who have heaps of current knowledge on the local housing market, and expertise on determining a home's value.

"The right real estate agent can be an invaluable asset when it comes to researching rental rates and giving renters access to the most up-to-date and accurate information," explained Matt Ward, a knowledgeable figure in Nashville's real estate industry. "From understanding the current market trends to helping negotiate the best deal, a reliable real estate agent can offer expertise and guidance throughout the entire process."

Rent prices can change throughout the year, so it’s best to do this analysis close to when you’re looking to fill your unit so your rental rate is based on the most up-to-date information. 

Applying the 1% and 2% rules with other rent price factors

Let’s use an example to demonstrate how to use the 1% or 2% rule as a starting point for setting a rent price, then adjusting it based on the factors listed earlier in this article. 

Say you purchased a three-bedroom, two-bath apartment in Evanston, IL, a suburb just outside of Chicago, for $500,000. The 1% rule would dictate a rent price of $5,000 per month, and the 2% rule would be $10,000. But both of these are unrealistically higher than the median rent price in this zip code, which according to Zillow, is about $2,600. 

Next, you'll think about the property’s features and amenities. For this example, let's say the building was built in the 1970s and the kitchen and bathrooms are a little outdated, so you might consider setting a lower rent price. But, the location is quite desirable — it’s walking distance to the beach, has nearby restaurants and grocery stores, and importantly, is close to the metro station that goes into downtown Chicago. You know that Chicago’s economy is flourishing (thanks to its growing tech sector), attracting many young individuals and families to the area and making it a competitive rental market. You then calculate a budget for your monthly operating costs, knowing that maintenance expenses will be higher for an older apartment, and Chicago’s property insurance rates are increasing as well. 

Factoring in the unit’s desirable location and job market, as well as the high operating costs, you can confidently set a rent price that’s slightly higher than the average for the area, and you ultimately list the unit at $2,900. 

The 1% rule and 2% rule in real estate investing

There are many factors that can impact the performance of a rental property, including the local real estate market, fluctuations in the economy, and the property conditions. While the 1% rule and 2% rule serve as a useful starting point, landlords should consider all factors that can impact a rental property’s performance before making a purchase decision.