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Real Estate’s 5% Rule (and Why Investors Should Use It!)

Bethel Heights Property Owner Making Calculations at a DeskIt’s a common misconception that it is necessary to own your own home before buying investment properties. And it’s true that previously, living the “American Dream” meant homeownership and a nice car or two in the driveway. But transforming ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have created significant shifts in rental real estate investing.

Based on where you dwell and your preferred standard of living, it may make more sense to rent your home while you build an investment portfolio. To realize whether you should rent or buy your primary residence, you can (and must) use what’s known as the 5% rule.

The 5% Rule

The 5% rule is an easy process to assess whether it costs more to buy or rent a home. On the renting side, establishing your cost is uncomplicated: it’s the amount you pay in rent every month. On the homeownership side, though, factors are a bit more complex. The costs of owning a residential property contain more than just your mortgage payment. This is when the 5% figure comes into action. It is a tool to compare the cost of renting to owning a home more precisely.

How It Works

The three main components of the 5% rule include property tax, maintenance costs, and the cost of capital. These are costs that homeowners bear, and renters do not. Let’s break down one after another:

  • Property tax. Using this uncomplicated approach, the cost of property tax would be roughly equal to 1% of the home’s value.
  • Maintenance costs. Regular maintenance and repairs are significantly pricier for homeowners than for renters. This category, such as property tax, is believed to be around 1% of the house’s value.
  • Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In simplified terms, the cost of capital is what you could be earning on the money tied up in your home (usually in the form of a down payment) if it was invested in some other form, such as an investment property or the stock market. It’s a cost because of the interest you pay on your mortgage, often around 3%.

Applying the 5% rule would look like this:

  • Multiply the value of the property you own/like to obtain by 5%.
  • Divide by 12 (to get a monthly amount).
  • If the resulting amount is costlier than you would pay to rent an equivalent property, renting your home and investing your money in rental properties may work better.

Why You Should Use It

Although the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be a vital tool for rental real estate investors. You may use it not just to make personal choices regarding your personal residence; if you own rental properties in areas where the cost of living is high, you could also teach it to your tenants to help them understand the benefits of staying in your rental home longer. In markets where property values are pretty high, this tool could prove to be a good resource as you make all future real estate investments.

 

Are you keen to make your next move as a rental real estate investor? Our Bethel Heights property managers can guide you! Contact us online for more information on finding and evaluating investment properties.

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