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. What is more, formerly, 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 resulted in significant shifts in rental real estate investing.

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

The 5% Rule

The 5% rule is an uncomplicated method to know whether it costs more to buy or rent a home. On the renting side, analyzing your cost is easy: it’s the amount you pay in rent every month. On the homeownership side, though, scenarios are a bit more difficult. The costs of owning a residential property involve more than simply 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 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 bear, and renters do not. Let’s break down each of them separately:

• Property tax. Using this simplified technique, 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 settle for more often than renters do. Including property tax, this category is also considered approximately 1% of the house’s value.
• Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In plain terms, the cost of capital is what you might gain on the cash 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 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 more than you would pay to rent an equivalent property, renting your home and investing your money in rental properties may be a better alternative.

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 excellent tool for rental real estate investors. Not only can you employ it to make personal judgments 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 recognize the benefits of staying in your rental home longer. In markets where property values are extremely high, this tool might be a valuable resource as you make all future real estate investments.

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