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

Minneapolis Property Owner Making Calculations at a DeskIt’s a common misconception that it is vital to own your own home before buying investment properties. And it’s undeniable that at one point, living the “American Dream” meant homeownership and a nice car or two in the driveway. Yet, changing ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have generated significant shifts in rental real estate investing.

Depending on the place and your preferred standard of living, it may make more sense to rent your home while you build an investment portfolio. To distinguish if you should rent or buy your primary residence, you can (and have to) use what’s known as the 5% rule.

The 5% Rule

The 5% rule is a simple tool to determine whether it costs more to buy or rent a home. On the renting side, defining your cost is effortless: it’s the amount you pay in rent every month. On the homeownership side, though, things are much more challenging. The costs of owning a residential property involve more than just your mortgage payment. This is where the 5% figure becomes applicable. It is a tool to compare the cost of renting to owning a home more precisely.

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 pay, whereas renters do not. Let’s break down every one of them:

  • Property tax. Utilizing this simplified way, the cost of property tax would be roughly equal to 1% of the home’s value.
  • Maintenance costs. Continous maintenance and repairs are also what homeowners pay more often compared to renters. For example, property tax, this classification is also presumed 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 be earning on the money tied up in your home (usually in the form of a down payment) if it was invested in some other form, 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/want to purchase 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 make more sense.

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 valuable tool for rental real estate investors. Not only can you apply it to make personal choices about your personal residence, but if you own rental properties in areas where the cost of living is high, you may also teach it to your tenants to assist them in realizing the benefits of staying in your rental home longer. In markets where property values are quite high, this method might prove to be the best resource as you make all future real estate investments.

 

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

We are pledged to the letter and spirit of U.S. policy for the achievement of equal housing opportunity throughout the Nation. See Equal Housing Opportunity Statement for more information.