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. Plus, it’s true that formerly, living the “American Dream” meant homeownership and a nice car or two in the driveway. But altering ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work has created significant shifts in rental real estate investing.

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

The 5% Rule

The 5% rule is a straightforward tool to decide whether it costs more to buy or rent a home. On the renting side, identifying your cost is not difficult: it’s the amount you pay in rent every month. On the homeownership side, however, things are a bit more complicated. The costs of owning a residential property involves more than simply your mortgage payment. This is where the 5% figure comes into play. 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 do, and renters do not. Let’s break down layers each layer:

• Property tax. Employing 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 another something homeowners spend more often than renters do. This category, like property tax, is similarly considered to be about 1% of the house’s value.
• Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In basic terms, the cost of capital is what you might 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 kind, incorporating 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/prefer to purchase by 5%.
• Divide by 12 (to get a monthly amount).
• If the resulting amount is higher than you would spend to rent an equivalent property, renting your home and investing your money in rental properties may be 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 an advantageous tool for rental real estate investors. Not only can you employ it to make personal decisions 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 aid them in realizing the benefits of staying in your rental home longer. In markets where property values are very high, this tool could prove to be an invaluable resource as you make all future real estate investments.

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