Understanding the 5% Rule Of Real Estate - Physician on FIRE (2024)

I’m familiar with many “rules” when it comes to investing, which are better described as rough guidelines. Then again, they say rules are meant to be broken, but if you ignore them completely, you may find yourself in a tough spot.

What rules are there? There’s the 4% rule as a safe withdrawal rate for a standard retirement. Using the Pareto Principle, you can get 80% of the results with 20% of the work.

You’ve got the 1% Rule for Spending on Luxury, a different 1% Rule for Evaluating Rental Properties, and a 10% Rule: Limiting Lifestyle Creep.

I was not familiar with the 5% rule discussed today, and I thank Ken Boyd with CPA Accounting Institute for Success for submitting today’s guest post.

Everyone knows that investing involves risk. However, successful investors know how to assess the situation and plan their actions to avoid major losses. Still, each investment is different, and when it comes to real estate, there is a wide range of factors you need to consider before making a well-informed decision.

For instance, what stand do you take in the renting vs buying debate?

Some people feel safer and more comfortable as homeowners, even if this involves a major initial investment (the down payment plus future mortgage payments) and ongoing expenses (maintenance costs, repairs, insurance, property taxes, local taxes) along the way. On the other hand, there are people who think the housing market is too expensive and would rather invest their savings in stocks while paying a monthly rent.

Renting vs Buying – How Do You Decide?

Regardless of how you see it, housing is a major decision in one’s life. It’s also a significant financial expense that influences your lifestyle and quality of life for the foreseeable future. Yet, most people don’t make this decision using logical reasons and well-studied calculations. Home-buying is usually an action driven by emotion, which is why it’s easy to get fooled when you don’t have professional support and guidance.

Let’s face it – most people don’t have the knowledge or the comprehensive framework to evaluate the rent vs buy decision.

So how do you make sure you make the right decision? As a regular person, there are a couple of steps you can take to minimize the risk, as described below:

#1: Hire a Professional (or several)

Unless you are familiar with the real estate market, home prices, and the real costs home buying involves, you will likely benefit from the help of a real estate agent, financial advisor, and maybe even a tax specialist. These are highly-trained professionals who understand the renting versus buying dilemma and can offer valuable insight into the process.

After all, in order to become a successful real estate agent, one needs to go through specialty classes, take a real estate exam, and work with a broker for several years. In doing so, real estate agents gain knowledge and experience in the field so they can help you choose the best option for your resources and make a decision based on reason, not emotions.

Of course, the same goes for financial advisors and tax specialists, but real estate experts are the most prepared when it comes to housing.

#2: Understand the Math

When you take out the emotional factor, the rent vs buy decision becomes a complex mathematics problem. In short, if you compare the cost of renting with the cost of buying, you should know which one makes more sense from a financial point of view.

However, if it’s easy to understand your costs when renting (the monthly rent and, probably, renter’s insurance), the situation changes when calculating the monthly costs of owning a home. If we oversimplify the equation, we end up with three main cost categories for homeowners:

• Cost of capital (broken into the cost of debt and the cost of equity)
• Maintenance (covers a wide range of expenses)
• Property tax (a tax you pay to own the home in a specific area)

All these cost categories can be easily explained and expanded under the 5% rule.

The 5% Rule [What It Is & How to Apply It]

The 5% rule is well-known by real estate specialists and you’ll often hear it mentioned if you plan on buying a house in the near future. The rule states that a homeowner should expect to spend, on average, around 5% of the value of the home (per year), on the costs we mentioned above.

Here’s how it should go (in an ideal world):

1. Property taxes should not amount to more than 1% of the value of the home.
2. Maintenance costs should also be around 1% of the value of the property.
3. The cost of capital should be around 3% of the value of the house.

Property Taxes & Maintenance Costs

Now, if property taxes are easy to understand and assess, the situation changes with maintenance costs. That’s because the situation is different from one house to another and labor costs (hiring professionals to do the job) differ from region to region. Still, specialists agree that it’s acceptable to set aside around 1% of the property value each year for maintenance.

Cost of Capital

Things get a bit difficult to understand when it comes to the cost of capital, but we’ll try to explain it in simple terms. This cost is a sum between the cost of debt and the cost of equity.

But what exactly are these?

Let’s break it down so it’s easy to understand. Most people who buy a house need to take up a mortgage in order to cover the full costs. Therefore, they start with a down payment (usually 20% of the property value) and finance the rest using mortgage payments.

The down payment is your equity and the mortgage is the debt. As time goes by and you pay the debt, your equity increases. However, this takes time and you may incur other costs such as mortgage insurance, homeowners insurance, and more.

The 5% Rule Applied in Real Life

Now that you know how to calculate your 5%, let’s see how to apply it to decide if it’s best to buy or rent.

Let’s say you are interested in buying a house that costs $300,000. Start by calculating 5% ($15,000) to get a rough estimate of your yearly investment that includes property taxes, maintenance, and cost of capital.

Now, divide the value by 12 ($15,000/12=$1,250) and you will get the monthly investment you will have to direct towards the house. This value is also called the monthly breakeven point and gives you a clear result in the rent vs buy debate. If you can rent a similar property for the same amount or lower, then you’re better off as a renter. Otherwise, if rent is higher, this is a solid investment, and you should seriously consider buying.

Plus, the 5% rule can also be used to assess the value of rent.

For instance, if you own a rental property for which you pay $2,000/month in mortgage, you need to set the rent to at least $2,200/month (5% for maintenance and other costs and the rest for your profit). However, $100 in profit may not be worth the hassle.

Of course, the final value of the rent is influenced by a lot of other factors, but the 5% rule can help you make an idea. Real estate investments can be used to create passive income, but only if you invest wisely and have a solid plan for the future.

Wrap Up

As useful at it may be, the 5% rule needs to be applied with caution and the results are more like guidelines. Still, it sets the right framework and allows you to consider all the costs. Plus, it’s a clear indicator of an overpriced housing market.

In this case, you may be better off investing in stocks and renting – you still get to live in your dream town and you don’t own property that may put you in the red. So before any major investment, take the time to consider the pros & cons!