The 5% Rule – A quick equation for deciding whether to buy a home or rent

Learn how you can determine whether buying versus renting real estate makes sense financially

We often hear that buying a home is always better than “throwing money away” on rent, and that if you can get a mortgage with payments equal to your rent, it’s a sign you should buy real estate.

Real Estate / Buy or Rent
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Most of us intuitively understand that black-and-white rules like these aren’t always going to be true. It’s easy to imagine situations where buying a home is worse than renting – for example, if you’re overwhelmed by the unforeseen costs of homeownership, or if you buy a home at the top of the market and go underwater on your mortgage during an economic downturn.

So what we really need is a rule to help us evaluate whether or not it makes sense to buy a specific house in a specific market, or if it’s better to rent. It’s even better if the rule is easy enough to use for investors who are just starting out on their real estate journey. That’s where the 5% rule comes in.

What is the 5% rule?

5% Rule of Real Estate Investing
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There are a lot of complicated factors when you try to analyze buying versus renting real estate. For example, home buyers are laying out a lot of money up front – but that outlay can be softened by government programs and rebates for home buyers.

Renters gain a lot of freedom by not buying, but there’s also an opportunity cost of not investing in real estate in a historically booming market. The 5% rule is a way to cut through that confusion and meaningfully compare the benefits of buying versus renting by looking at unrecoverable costs.

What are unrecoverable costs?

Real Estate / Unrecoverable Costs
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“Unrecoverable costs” is a term for money that, once paid, is gone forever. (Contrast this to the portion of your mortgage payment that comes back to you as equity.) For renters, the unrecoverable costs are rent, since you’re not getting any future benefits from that money. For homeowners, it’s a little more complicated. A homeowner’s unrecoverable costs fall into three main categories: maintenance, property taxes, and the cost of capital, expressed as debt plus opportunity costs.

  • Property taxes, once paid, don’t return any kind of value. On average, these come to around 1% of the property value. The 5% rule doesn’t consider capital gains taxes, as those aren’t paid until after the property is sold – although even then, savvy investors can use a 1031 exchange to defer their capital gains indefinitely.
  • Maintenance is the work and money you put into your home to prevent its deterioration – think of it as the cost of treading water. Maintenance, on average, is about 1% of the home’s value annually.
  • Cost of capital is described as the cost of equity and debt. In this example, the cost of debt is the interest rate on your mortgage (let’s say around 3%). Cost of equity is the profit you could be making if you put that money into some other investment. For example investing in stocks, crypto or gold.
Investment Opportunities
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Using the previous century of stock market performance, experts estimate that you’re leaving around 3% on the table by putting your money into real estate instead of stocks. 

“We now have a cost of equity capital of 3%, which is conveniently equal to the cost of debt capital”, said Ben Felix, the portfolio manager who pioneered the rule. “So no matter how you finance the home, the cost of capital is 3%”. Add up property taxes (1%), maintenance (1%), and the cost of capital (3%), and you get 5%. Hence the name, the 5% rule.

How do you use the 5% rule?

Real Estate Investing / 5% Rule
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To analyze a potential real estate investment with the 5% rule, simply follow these steps:

  • Multiply the property value by 5%
  • Divide by 12 (since rent is paid monthly, this lets us do an apples-to-apples comparison)
  • Compare the number to average rent in the area

Example: Let’s say you’re considering buying a $1 million home. Multiplying $1 million by 5% gets you $50,000. Dividing $50,000 by 12 gets you a little more than $4,166. That number – $4,166 – is your break-even point. If you can rent for less than that, per month, then renting is going to make more financial sense for you. However, if average rent is more than that, it probably makes more sense to buy.

Applying the 5% rule in actual markets

Real Estate Valuation / 5% Rule of Real Estate Investing
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Of course, home prices and average rents vary wildly across the United States. Let’s apply the 5% rule to a few state markets and see what it reveals. The average home value in Alabama is just under $195,000, according to Zillow, and the average Alabama rent for a 2 bedroom apartment, according to Rentdata.org, is about $726. If you were looking to buy an average home in Alabama, a 5% rule analysis would look like this:

$195,000 x 5% = $9,750
$9,750 / 12 = $812

Comparing Real Estate Properties
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So according to the 5% rule, it would be narrowly better to rent in Alabama than to buy, though it is really close. Of course, Alabama is a pretty inexpensive housing market, so let’s apply the 5% rule to an expensive market. San Francisco, a notoriously expensive real estate market, has an average home value of $1.57 million, and an average rent of just over $3,200, according to RentCafe.

$1,570,000 x 5% = $78,500
$78,500 / 12 = $6,541

So according to the 5% rule, buying a house in San Francisco is an extremely bad investment and likely not a good idea – even though it has some of the highest rents in the country. Applying the 5% rule like this shows how useful it can be to cut through the noise of a market, and reveal some basic values.

There’s an exception to every rule – even the 5% rule

Real Estate Investment
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Remember what we said at the beginning of this piece about black-and-white rules always having a few exceptions? The 5% rule is no different, if you zoom in. Looking at the different components of the 5% rule, it’s obvious that the “opportunity costs” of putting your money into real estate is going to provide the most variability. That’s because you can’t know what investments you’re missing out on.

If you use your existing investment portfolio as a benchmark, you can adjust the 5% rule accordingly. If you’re a very aggressive investor with a lot of stocks, the 5% rule is probably going to work well for you; you may even want to experiment with a 6% rule. On the other hand, if you’re an extremely conservative investor with just a few stocks, you might want to use something more like a 4% rule.

But even with variables to account for, the 5% rule provides a useful, accurate way to quickly evaluate renting vs. buying real estate. It’s not a substitute for an in-depth financial analysis, but if you want to do some quick back-of-the-envelope calculations on a new listing, it’s an investor’s best friend.

Personal Finance, Business & Investing Blog | InvestOpen.com
About Luke Babich
Luke Babich is the Co-Founder and CEO of Clever Real Estate, a real estate education platform committed to helping home buyers, sellers and investors make smarter financial decisions. Luke is a licensed real estate agent in the State of Missouri, and an active real estate investor since the age of 22.

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