1% Rule, 2% Rule, 3% Rule, 4% Rule, Rule of 72, Rule of 144, and many more… if you’re interested in learning more about all the different real estate investing rules of thumb, then you’ve found the right place.
Below is a list of each rule of thumb along with a very brief description of what the rule is and how it is used.
The 1% Rule suggests that a rental property should have monthly rent that exceeds 1% of the purchase price.
For example, if you’re buying a duplex for $280,000, you would need to have the total of the gross rents equal to at least $2,800 ($1,400 per side).
There are a number of real estate markets where it is possible to find a decent selection of properties that meet the 1% rule. In some other real estate markets, it is incredibly difficult to find properties that meet this 1% criteria.
The 1% rule tends to work better on lower priced properties.
In some cases you may be able to change the characteristics of the investment to take a property that wouldn’t normally meet the 1% rule and force it. For example, you might be able to take a property where rent for a typical year long lease would not meet the 1% rule. However, if you use that property as a short-term rental instead of a year-long lease, you might be able to easily get a full 1% of the purchase price in monthly rent.
Property taxes tend to be higher (as a percentage of purchase price) in markets where you can more easily find properties that meet the 1% rule.
Buying properties at a discount will help you find properties that meet the 1% rule.
The 2% rule is similar to the 1% rule. Instead of the monthly rent exceeding 1% of the purchase price, the rent for the 2% rule must exceed 2% of the purchase price.
If you thought finding properties that meet the 1% rule was difficult, the 2% rule raises the bar even higher.
Previous comments about the 1% rule concerning property taxes, changing the characteristics or use of the investment and buying at a discount still apply for the 2% rule.
3% Rule for Estimating Rental Property Depreciation
If you take 3% of the purchase price of the property, it should approximately estimate the gross depreciation benefit of owning that property as a rental property.
Let’s look at an example.
If we were to buy this example new construction property in Windsor, Colorado for $350,000… we might estimate our gross depreciation benefit to be 3% of the purchase price. That would be:
However, what happens if we do a more thorough calculation for the gross depreciation?
We can only depreciate the value of the building—not the value of the land. So, first we need to estimate what the value of the building is.
In our spreadsheet input you can see that we estimate that the land to be worth 15% of the purchase price or $52,500.
The remaining 85%, or $297,500, is the value of the building.
On residential rental properties, the value of the building can be depreciated over 27.5 years.
So, take the $297,500 and divide by 27.5 years and you get a gross depreciation of $10,818. We can see this on the spreadsheet as well.
Estimating your gross depreciation benefit as $10,500 using the 3% rule when it really is $10,818 is close enough for what we’re using it for.
Speaking of using it, how do you use this rule of thumb? When out looking at properties, you can use this rule to quickly estimate how much gross depreciation you will get by owning this property as a rental.
Then, if you know your top tax bracket (or more conservatively… your effective income tax rate), you can multiply the gross depreciation amount by your tax rate to determine how much cash flow from depreciation you will receive.
Continuing with our example above, if you estimate you’re paying an effective tax rate of 20% (across all your tax brackets), you can take 20% of $10,500 or about $2,100 and that’s how much cash flow from depreciation you will receive.
This means you’re property will appear to be cash flowing about $2,100 more per year when you take into account the tax benefits of owning the property. So, this property will give about $175 more in cash flow (from depreciation) than you think you’re getting from your traditional cash flow calculation.
The actual cash flow from depreciation calculation (when using the $10,818) in the spreadsheet is $2,163.64. That’s pretty close to the $2,100 we’d get by estimating it with the 3% rule.
The cash flow from depreciation is the number in yellow, in the bottom right corner of the Return on Investment Quadrant™. In the image below it is shown as a percentage return on your initial investment in year 1.
4% Safe Withdrawal Rate Rule
If you have a million dollars invested for retirement, how much can you safely withdraw each year if you want to make reasonably sure you don’t run out of money?
That’s what the 4% Safe Withdrawal Rate Rule tells us.
The 4% safe withdrawal rate is based on a study done by three Trinity University professors (commonly called the Trinity Study if you want to look up more info on it).
It basically states that:
So, as an example, if you started with a million dollars invested in stocks and bonds, you can withdraw $40,000 per year in the first year. In the second year, you can safely withdraw $40,000 plus an adjustment for inflation. Each subsequent year the original $40,000 is adjusted for inflation so that you maintain the same “buying power”.
A few interesting points about this rule of thumb.
- First, it does not apply to real estate investments. It was intended to be used when investing in stocks and bonds. For real estate, we typically look at a combination of cash on cash return on investment (when we have a mortgage on the property) and cap rate once the property is paid off.
- Second, it only looked at a 30 year retirement period. If you plan to retire early or live longer, this rule of thumb may no longer apply.
- Third, in a large number of the test scenarios to evaluate the 4% rule, you end up with more money than you started with. In a small number of the test scenario cases, you do run out of money. If you continued to live beyond 30 years and needed to continue to withdraw money, you’d run out of money in a larger number of cases.
70% Rule of After Repair Value on Cash Offers
In many real estate markets, the formula for the Maximum Allowable Offer (MAO) you can make when buying a property for cash (or with a hard money loan) is defined by the 70% Rule:
(70% of After Repair Value (ARV)) – Cost of Repairs
For an example, let’s assume the following:
- After Repair Value (ARV) is $200,000 – the property will be worth $200,000 once you’re done fixing it up
- The property needs $30,000 in repairs
So, the Maximum Allowable Offer you could make to purchase this property would be:
It is important to realize that is the maximum offer you could make. You may want to start lower than this.
This rule was originally designed for lower priced properties.
In more expensive markets—and especially competitive or hot markets—some investors will use alternative formulas for making offers.
For example, they might do something like this: Maximum Allowable Offer = After Repair Value – $30,000 Profit – Cost of Financing – Cost of Closing Costs – Cost of Repairs.
Rule of 72 for Compound Interest
If you have $100,00 invested in something earning 10% annual return, how long will it take for your $100,000 to double in value to be worth $200,000?
That’s what the Rule of 72 can tell us. It states:
So, to continue with our opening question. Here’s how the math would work for our example:
It will take 7.2 years for our initial $100,000 investment to be worth $200,000 if it is earning 10% per year.
Rule of 144 for Compound Interest with Regular Periodic Investments
The Rule of 72 works great if you have a lump sum amount of money you’ve started with and want to know how long it will take to double.
However, what if you’re investing $1,000 per year and earning 10% per year on it? How long will it take for you to have twice as much as you invested?
That’s what the Rule of 144 deals with: periodic investments at a fixed rate. It states:
144 ÷ Yearly Interest Rate
To continue with our example, if you’re investing $1,000 per year and earning 10% per year, how many years will it take for you to have twice as much as you’ve invested?
144 ÷ Yearly Interest Rate
So, it will take you 14.4 years before you have twice as much as you’ve invested in your account.
We then need to figure out how much you’ve invested to that point. If you’re investing $1,000 per year for 14.4 years, then you’ve invested $14,400. So, at the 14.4 year point, you should have approximately $28,800 total in your account using the Rule of 144.
2:1 Rule of Creative Deal Structuring
The 2:1 Rule with creative deal structuring is best explained with an example.
Let’s say you’ve been sending out postcards to get motivated seller calls. A seller calls you in the following situation:
- Property is worth $300,000
- Seller owes $250,000
- You can offer the seller $280,000 if you can buy the property subject to the existing financing
What are some offers you could make to the seller?
One offer is that you offer to buy the property subject to the existing financing (taking over the payments on their mortgage) and pay the seller their equity of $30,000 in payments of $100 per month until paid.
This would be a nothing down deal for you.
What if the seller wants to some money? How do you adjust your offer?
That’s what the 2:1 Rule addresses.
If the seller insists on getting $10,000 from you up front, you expect to get a discount for having to come up with money up-front. For every dollar you need to give the seller up front you need to reduce the price by a dollar. So, you get $2 for every $1 you give the seller up-front.
Using the 2:1 Rule and the $10,000 the seller would like up front, the new offer might be: you will buy the property subject to the existing financing, pay the seller $10,000 up front and ask the seller to accept payments of $100 per month on the remaining $10,000.
The final offer price would be $270,000:
- $250K on original loan
- $10K in cash
- $10K financed at $100 per month
This rule is helpful when negotiating with a seller face to face as a really quick way to adjust your offer numbers depending on how much cash they need when buying properties creatively.
$50 Rule of 30-Year Financing
When I was a teenager my father taught me that the payments on a house were about $7 per $1,000 borrowed on a 30 year amortizing loan. With this rule of thumb in mind, you can quickly estimate how much monthly payment principle and interest payment would be when buying a property with, let’s say, $80,000 in debt (80 times $7 = $560 per month).
However, this rule changes with the current mortgage interest rate.
In our current, lower-interest-rate environment, the rule is more like $5 per $1,000. I like to explain it to clients as $50 for every $10,000 borrowed.
When I taught a class on this, someone in the class suggested based on the chart below, that it really is the interest per $1,000 borrowed. That’s a really rough approximation.
With interest rates in the low 4% range (which is where they are at the time of this writing), you can see that the payment for every $10,000 borrowed is $50 per month. That’s $5 per $1,000.
It is important to note that this is just the principle and interest part of the payment. It does not include taxes or insurance or private mortgage insurance (PMI).
It also assumes you’re getting a 30 year mortgage. Mortgages of different durations will have differing rules of thumb.
Additional Real Estate Investing Rules of Thumb
- $50 Rule of 30-Year Financing
- 8:1 Rule of Showings and Offers
- 1/3 of Rent and Expenses and 2/3 Rule of Free and Clear Properties
- Rule of Future Dollars Today
- Off-Market Deal Finding Rule of Thumb
- Motivated Seller Calls To Deals Done Rule of Thumb
- Motivated Seller Postcard Response Rates
- 80/20 Rule aka Pareto’s Principle
- 1.25 Debt Service Coverage Ratio (DSCR)
- $100 Per Door
- Debt Paydown Return on Investment
- Deal Analysis Rules of Thumb
- Rules of Thumb for Estimating Repairs
- Balanced Real Estate Market
Debt Paydown Return on Investment
Here’s a sneak preview of the rules of thumb for debt paydown depending on down payment for your loan.
Real Estate Investing Rules of Thumb Class Recording
On September 4, 2019 I taught a special 2 hour class on these real estate investing rules of thumb for our local club that caters to people interested in investing in Fort Collins investment real estate. Check it out in the video below or on… what I consider to be… the best real estate investing podcast.
If you want to apply these rules to analyze your investment strategy, check out the best real estate investment analysis software available anywhere.