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

Lebanon Property Owner Making Calculations at a DeskIt’s a common misconception that you should own your own home before buying investment properties. Also, it’s right that years back, living the “American Dream” meant homeownership and a nice car or two in the driveway. Yet, changing ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have generated enormous shifts in rental real estate investing.

Depending on the area and your anticipated standard of living, it may make more sense to rent your home while you build an investment portfolio. To identify whether you should rent or buy your primary residence, you can (and need to) employ what’s known as the 5% rule.

The 5% Rule

The 5% rule is a straightforward way to determine whether it costs more to buy or rent a home. On the renting side, calculating your cost is simple: it’s the amount you pay in rent every month. On the homeownership side, however, things are a bit more complex. The costs of owning a residential property is comprised of more than just your mortgage payment. This is when the 5% figure takes place. It is a more precise strategy 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 have to consider, whereas renters do not. Let’s break down each one:

  • Property tax. Employing this simple technique, the cost of property tax would be roughly equal to 1% of the home’s value.
  • Maintenance costs. Regular maintenance and repairs are also something homeowners settle for more often compared to renters do. Including property tax, this type is also projected to represent around 1% of the house’s value.
  • Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In simple definitions, the cost of capital is what you could be earning on the funds tied up in your home (usually in the form of a down payment) if it was invested in some other kind, including 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 appear like this:

  • Multiply the value of the property you own/like to acquire by 5%.
  • Divide by 12 (to get a monthly amount).
  • If the resulting amount is higher than it would charge to rent an equivalent property, renting your home and investing your money in rental properties may make perfect sense.

Why You Should Use It

While the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be an excellent tool for rental real estate investors. Not only can you utilize it 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 know the benefits of staying in your rental home longer. In markets where property values are really high, this tool might serve as a vital resource as you make all future real estate investments.

 

Would you like to make your next move as a rental real estate investor? Our Lebanon property managers can assist you! Contact us online for more information on finding and evaluating investment properties.

We are pledged to the letter and spirit of U.S. policy for the achievement of equal housing opportunity throughout the Nation. See Equal Housing Opportunity Statement for more information.