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

It’s a common misconception that you have to own your own home before buying investment properties. And it’s clear that in former times, living the “American Dream” meant homeownership and a nice car or two in the driveway. But switching ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have made tremendous shifts in rental real estate investing.

Contingent upon where you stay and your targeted standard of living, it may make more sense to rent your home while you build an investment portfolio. To discover whether you should rent or buy your primary residence, you can (and must) utilize what’s known as the 5% rule.

The 5% Rule

The 5% rule is a simple strategy to calculate if it costs more to buy or rent a home. On the renting side, knowing your cost is basic: it’s the amount you pay in rent every month. On the homeownership side, however, situations are a bit more challenging. The costs of owning a residential property incorporate far beyond just your mortgage payment. This is where the 5% figure enters the equation. It is a technique 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 face and renters do not. Let’s break down each one:

• Property tax. Using this simple procedure, the cost of property tax would be roughly equal to 1% of the home’s value.
• Maintenance costs. Periodic maintenance and repairs are also something homeowners pay for more often than renters do. Like property tax, this category is also assumed 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 simple words, the cost of capital is what you could be receiving on the money 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/wish to acquire by 5%.
• Divide by 12 (to get a monthly amount).
• If the resulting amount is bigger than you would reimburse to rent an equivalent property, renting your home and investing your money in rental properties may probably better.

Why You Should Use It

While the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be a useful 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 help them know the benefits of staying in your rental home longer. In markets where property values are particularly high, this tool could prove to be a vital resource as you make all future real estate investments.

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