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

Weber County Property Owner Making Calculations at a DeskIt’s a common misconception that it is necessary to own your own home before buying investment properties. And it’s undeniable that before, 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 huge shifts in rental real estate investing.

Depending on where you live 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) apply what’s known as the 5% rule.

The 5% Rule

The 5% rule is an easy way of determining whether it costs more to buy or rent a home. On the renting side, calculating your cost is basic: it’s the amount you pay in rent every month. On the homeownership side, however, things are slightly more challenging. The costs of owning a residential property goes further than your mortgage payment. This is when the 5% figure plays its part. It is a tool 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 cover, whereas renters do not. Let’s break down each one:

  • Property tax. Utilizing this basic method, the cost of property tax would be roughly equal to 1% of the home’s value.
  • Maintenance costs. Daily maintenance and repairs are significantly more costly for homeowners than for renters. For example, property tax, this category is also assumed 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 terms, the cost of capital is what you might make 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 kind, like 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 like this:

  • Multiply the value of the property you own/want to buy 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 enough.

Why You Should Use It

Although the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it may be a significant tool for rental real estate investors. Not only can you employ it to make personal assessments 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 assist them in appreciating the benefits of staying in your rental home longer. In markets where property values are really high, this method might show to be an effective resource as you undertake all future real estate investments.

 

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

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