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

It’s a common misconception that you need to own your own home before buying investment properties. And it’s undeniable that at one time, living the “American Dream” meant homeownership and a nice car or two in the driveway. But changing ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have brought significant shifts in rental real estate investing.

Depending on where you reside and your intended standard of living, it may make more sense to rent your home while you build an investment portfolio. To decide whether or not you should rent or buy your primary residence, you can (and need to) use what’s known as the 5% rule.

The 5% Rule

The 5% rule is a straightforward way of determining whether it costs more to buy or rent a home. On the renting side, figuring out your cost is simple: it’s the amount you pay in rent every month. On the homeownership side, however, circumstances are a bit more problematic. The costs of owning a residential property go beyond your mortgage payment. This is when the 5% figure plays a great role. It is a way to compare the cost of renting to owning a home more accurately.

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

• Property tax. Using this basic technique, the cost of property tax would be roughly equal to 1% of the home’s value.
• Maintenance costs. Usual maintenance and repairs are significantly more expensive for homeowners than for renters. Like property tax, this class is also believed 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 layman’s words, the cost of capital is what you might earn on the money you have tied up in your home (usually in the form of a down payment) if it was invested in some other form, 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 seem like 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 more than you would pay to rent an equivalent property, renting your home and investing your money in rental properties may make more sense.

Why You Should Use It

While the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it may be a beneficial tool for rental real estate investors. Not only can you use it to make personal decisions about 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 make them realize the benefits of staying in your rental home longer. In markets where property values are primarily high, this tool could prove to be an effective resource as you undertake all future real estate investments.

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