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

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

It could make more sense to rent your home while you build an investment portfolio, depending on where you reside and your desired standard of living. You may (and must) utilize what’s known as the 5% rule to determine whether you should rent or buy your primary residence.

The 5% Rule

The 5% rule is a simple method to determine whether it costs more to buy or rent a home. On the renting side, determining your cost is straightforward: 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 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 compensate and renters do not. Let’s break down each of them individually:

• Property tax. Using this easy approach, the cost of property tax would be roughly equal to 1% of the home’s value.
• Maintenance costs. Daily maintenance and repairs are also something homeowners compensate for more often than renters do. Like property tax, this class is also estimated to represent 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 might earn on the money tied up in your home (usually in the form of a down payment) if it was invested in something else, like an 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 look like this:

• Multiply the value of the property you own/wish to purchase by 5%.
• Divide by 12 (to get a monthly amount).
• If the resulting amount is pricier than you would spend to rent an equivalent property, renting your home and investing your money in rental properties may be a better option.

Why You Should Use It

While the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be an effective tool for rental real estate investors. Not only can you use it to make personal selections 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 see the benefits of staying in your rental home longer. In markets where property values are incredibly high, this tool might be an important resource as you make all future real estate investments.

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