What Are The 1% and 2% Rules in Commercial Real Estate?
If you're a commercial real estate investor deciding whether a property is a good fit for your portfolio, you might have heard of the 1% or the 2% rule. The 1% rule states that a property's monthly rent must be at least 1% of its purchase price in order for the owner to break even. The 2% rule states that a property's monthly rent needs to be at least 2% of its purchase price in order for the owner to make a sustainable profit.
How the 1% and 2% Rules Work in Practice
If, for example, an investor is considering purchasing an apartment building priced at $200,000, that property would need to generate gross rents of $2,000 a month in order to meet the 1% rule. And, it would need to generate $4,000 a month in order to meet the 2% rule.
Investors can also look at the 1% and 2% rules to evaluate deals for distressed commercial properties. For example, if a property is going to be purchased for $100,00, and requires $50,000 in renovations, it would need to generate $1,500 in gross rent to meet the 1% rule, and $3,000 in gross rent to meet the 2% rule.
Gross Rent Multiplier and The 1% and 2% Rules
The 1% and 2% rules are basically the inverse of a property's gross rent multiplier (GRM). Remember, the formula for GRM is as follows:
Purchase Price/Gross Annual Rents = Gross Rent Multiplier
If we take the example of the apartment building priced at $200,000 and say that it has $4,000 in gross monthly rents (to meet the 2% rule), that would equal $48,000 in gross rents per year.
$200,000/$48,000 = 4.17 GRM
Looking at the example above, we see that the GRM of any property that meets the 2% rule is 4.17. In other words, it would take 4.17 years for the gross rents of the property (not factoring in any expenses) to cover the cost of the initial purchase. Since GRM and the percentage rules have an inverse relationship, the higher the percentage goes, the lower a property's GRM will be. And, the faster (in theory) that an owner/investor can recoup their expenses.
Limitations of The 1% and 2% Rules
While the 1% and 2% rules can be good rules of thumb, they're far from perfect. One of the biggest shortcomings of the 1% and 2% rules is the fact that they only look at revenues, but not at expenses. So, while a property could meet or exceed the 2% rule, it could require significant repairs and maintenance and be located in a bad area (for example, a Class D multifamily property), and thus might not be very profitable in the long run.
Plus, in many cases, it can be difficult to find properties that meet the 2% rule in today's market. So, just because a property doesn't meet the 2% rule doesn't mean it's a bad investment. However, properties that don't meet the 1% rule are unlikely to generate enough income for the investor to cover their expenses. Either way, investors should never use these tools to make a final decision-- only to screen out properties to determine which ones require a closer look.