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 may wish to consider the 1% or the 2% rule. These rules are often used by investors to quickly and easily understand the risk and opportunity present in acquiring a property.
The 1% rule figure is a straightforward calculation. Simply calculate 1% of the acquisition price plus any immediate and necessary improvements or repairs. The result can be used as a baseline for rental income. If a property generates more income than this calculation, that means it is likely to be profitable.
The 2% rule uses the exact same formula, except calculated to 2% of the total sale price and immediate improvements. The use of this rule can be controversial, and finding a property that clears this threshold can be extraordinarily difficult. Generally, only assets at the low end of the quality spectrum tend to near or clear this rental income hurdle.
How the 1% and 2% Rules Work in Practice
If, for example, an investor is considering purchasing an office property for $1 million, a monthly rental income of $10,000 would clear the 1% rule threshold. But the revenues would need to be $20,000 every month to meet the 2% requirement.
Of course, the above example assumes that there are no immediate repairs or work to be done on the asset. If you need to immediately inject $200,000 into the property to make it attractive to potential tenants, the 1% and 2% thresholds would raise to a respective $12,000 and $24,000 per month.
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:
GRM = Purchase Price ÷ Gross Annual Rents
If we take the example of the office building priced at $1 million and say that it has $10,000 in gross monthly rents (to meet the 1% rule), that would equal $120,000 in gross rents per year.
$1 million ÷ $120,000 = 8.33 GRM
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 can recoup the initial investment.
Limitations of the 1% and 2% Rules
While the 1% rule (and, to a lesser extent, the 2% rule) 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 dated, Class C industrial property), and thus might not be very profitable in the long run.
While these two calculations can offer a good, quick look at an investment opportunity, investors should never use these tools exclusively to make a final decision. Their main utility can be found in initially screening properties to determine which ones merit a closer look.