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

Queens Property Owner Making Calculations at a DeskIt’s a common misconception that you must own your own home before buying investment properties. And it’s correct that in the past, living the “American Dream” meant homeownership and a nice car or two in the driveway. However, shifting ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have created major shifts in rental real estate investing.

Depending on the location and your preferred standard of living, this could 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 approach to estimate if it costs more to buy or rent a home. On the renting side, estimating your cost is easy: it’s the amount you pay in rent every month. On the homeownership side, though, things are a little more difficult. The costs of owning a residential property encompass more than merely your mortgage payment. This is where the 5% figure enters the picture. It is a technique to compare the cost of renting to owning a home more properly.

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

  • Property tax. Utilizing this simplified technique, the cost of property tax would be roughly equal to 1% of the home’s value.
  • Maintenance costs. Frequent maintenance and repairs are also something homeowners compensate for more regularly than renters do. Such as property tax, this class is also 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 words, the cost of capital is what you could be making on the money tied up in your home (usually in the form of a down payment) if it was invested in some other manner, like investment property or the stock market. It’s a cost due to 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/want 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 work better.

Why You Should Use It

Even though the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it may be a valuable tool for rental real estate investors. Not only can you use it to make personal judgments 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 make them understand the benefits of staying in your rental home longer. In markets where property values are very high, this tool might prove to be a useful resource as you make all future real estate investments.

 

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

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