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

There’s a common misconception where it is recommended to own your own home before buying investment properties. And it’s true that in the past, living the “American Dream” meant homeownership and a nice car or two in the driveway. However, new ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have caused massive shifts in rental real estate investing.

It may make more sense to rent your home while you build an investment portfolio, based on the area and your preferred standard of living. To recognize whether you should rent or buy your primary residence, you can (and have to) utilize what’s known as the 5% rule.

The 5% Rule

The 5% rule is an easy way to determine whether it costs more to buy or rent a home. On the renting side, knowing your cost is simple: it’s the amount you pay in rent every month. On the homeownership side, however, conditions are somewhat more muddled. The costs of owning a residential property entails more than just your mortgage payment. This is when the 5% figure becomes useful. It is a more accurate tool to compare the cost of renting to owning a home.

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 spend, and renters do not. Let’s break down each one:

• Property tax. Employing this straightforward method, the cost of property tax would be roughly equal to 1% of the home’s value.
• Maintenance costs. Frequent maintenance and repairs are also something homeowners compensate for more often than renters do. Like property tax, this category is also presumed to be approximately 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 making on the money tied up in your home (usually in the form of a down payment) if it was invested in some other type, including an investment property or the stock market. It’s a cost as a result of the interest you pay on your mortgage, often around 3%.

Applying the 5% rule would seem such as this:

• Multiply the value of the property you own/want to acquire by 5%.
• Divide by 12 (to get a monthly amount).
• If the resulting amount is costlier than you would spend to rent an equivalent property, renting your home and investing your money in rental properties may be the ideal choice.

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 critical tool for rental real estate investors. You may use it not only to conduct personal selections regarding your personal residence; if you own rental properties in areas where the cost of living is high, you can also teach it to your tenants to make them see the benefits of staying in your rental home longer. In markets where property values are quite high, this method may prove to be a great resource as you make all future real estate investments.

Are you ready to make your next move as a rental real estate investor? Our Central West End property managers are here to help! Contact us online for more information on finding and evaluating investment properties.