There are many ways to slice and dice the rent vs. homeowner debate. You can spend lots of time on various calculations and weighing pros/cons only to be left with no decision. But for those who aren’t as familiar with real estate, where do you even begin this debate?
That’s where frameworks come in. A framework provides a structured method for arriving at a decision. The 5% rule is such a framework. It is meant for those without any experience in real estate investing to arrive at a conclusion on renting vs. buying. The rule is simple to use and provides a quick result.
Overview of the 5% Rule
The 5% rule has three components. Each component adds up to 5% of a home’s value. From there, one can decide between renting vs. buying.
The three components with their corresponding percentages are:
- Property tax — 1%
- Maintenance costs — 1%
- Cost of capital — 3%
Let’s go over each one. Each percentage is on an annualized basis.
Property taxes should be no more than 1% of the home’s value. Property taxes vary by home value and location.
Maintenance costs include all costs related to the upkeep of the home. This also should not be more than 1% of the home’s value.
The cost of capital is the most complex component to figure out. It is the cost of debt plus the cost of equity. The cost of debt is your mortgage rate. The cost of equity is the expected annual return on the property subtracted from an opportunity cost. We can use investing in the stock market as an opportunity cost.
To figure out the cost of equity, we use a return on residential real estate of 7% and a stock market return of 10%. Subtract the real estate ROI from the stock market ROI to get 3%.
To get a result from the 5% rule, follow these steps:
- Multiply the value of the home by 5%
- Divide the result by 12
- Can you rent for less than the result?
If yes to #3, then you should rent. Otherwise, buying is better.
5% Rule Example
To see the 5% rule in action, let’s go through an example. We’ll use a home with a $500,000 value. Running the 5% rule calculation:
- $500,000 x .05 = $25,000
- $25,000 / 12 = $2,083
- Is there a property available to rent for less than $2,083?
As we mentioned, this rule is extremely simple. But it provides a small framework and starting point to figure out if renting is better than buying.
The answer can be obvious in an area where home values are far more than rent prices (i.e., rent). But when the two are close, it can be a difficult decision.
The 5% rule only factors in the quantitative aspects of the decision. Qualitative elements aren’t considered. However, qualitative elements can be very important. Renting probably isn’t an option for those who want privacy, even if it costs far less. If you don’t want to keep up a yard or maintenance on a home, renting is likely better. There are many other qualitative aspects to consider when deciding to rent or buy.
Buying a home is a big decision, and everyone’s financial situation is unique. Talking it through with a financial advisor or tax accountant can also shed new light on the decision-making process of renting vs. buying.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only.
