See It In Action: What is the “5% Rule” in Real Estate Investing?

Source: On-sale listing on Zillow

If you’ve been in the real estate game for a while, you’re probably familiar with using "rules" when it comes to investing in real estate. While these are closer to guidelines than rigid rules—ignoring them will only lead you to challenges down the line.

What are these rules? Well, if you’re starting out, some of the most well-known ones are:

• The 4% Rule determines the safe withdrawal amount for traditional retirement.
• The Pareto Principles that you should try to, get 80% results with 20% effort.
• The 1% Rule for rental properties generates positive cash flow.

But one rule you may have missed is the 5% Rule that encourages property buyers only to spend 5% of the home's value annually.

And so today, let's discuss the purpose of this rule.

What’s Included in the 5% Rule of Real Estate?

The 5% Rule includes multiple factors that add to the final 5%. Here's how the percentage is broken down in a promising investment situation:

1. Your property taxes aren't more than 1% of the property value.

To start from a bigger picture, local and state governments use property taxes to fund neighborhood services like education, parks, recreation, transportation, libraries, and more. These efforts lead to increased livability and appeal to the local community, which also benefits you as an investor.

How do you know your property tax amounts?

Take the mill rate and multiply it by the property value. In other words, you’ll have to assess the market value of your property—either by performing a sales evaluation, the income method, or the cost method—and multiplying that figure by an assessment rate to arrive at an accurate assessed value.

2. Your maintenance costs are also around 1% of the property value.

While property taxes are relatively easy to determine, the maintenance cost will differ from one property to another, and labor costs will vary from region to region.

In other words, you need to hire professionals to help you estimate the maintenance and labor costs required. Still, industry experts agree that the best course of action is to set aside 1% of the property value annually for maintenance.

3. Your capital is around 3% of the property value.

The cost of capital is the sum of the cost of debt and the cost of equity.

For example, you’ll probably purchase a home with a mortgage to cover all the expenses. You’ll start with a down payment, which is usually 20% of the property value, and finance the rest via mortgage payments. Now, the down payment is your equity, while the mortgage is your debt.

Your equity increases as you continuously pay your debt. This takes time, however, and you’ll have to consider other expenses like mortgage insurance and homeowners insurance.

Applying the 5% Rule in Real-Life Situations

There are two ways that the 5% rule comes in handy in real estate investing. Both of these benefits will help you become a better rental property investor. Here is precisely how you can use the 5% rule as a real estate investor:

Determining Your Tenant Pool

Now that you know how to calculate your 5%, you’ll use the results to determine if it’s better for residents to buy or rent a home. As a rental property investor, you’ll want to put your time and money in an opportunity and neighborhood where it’s best for the resident to rent a home.

Let’s have a real-life example.

Take a look at the property below with an asking price of $150,000:

Source: Listing on Zillow

You’ll calculate 5% (which is $7,500) for a rough estimate of your yearly investment, which includes the cost of capital, maintenance, and property taxes. Next, divide the value by 12 for the monthly investment you’ll have towards the house, resulting in $625.

If they can purchase a similar home for the same monthly fees, locals will lean towards buying instead of renting a home. However, if the cost to buy a home is significantly higher than renting, then it’s a good place for you to provide rental properties for locals to live in.

In this case, the estimated rent according to Zillow is $900. This is a tad higher than the monthly cost of purchasing a property, which means you might have a more difficult time attracting renters to your home, as it costs more to rent than to purchase the property itself.

Assessing the Value of Rent

The second benefit that the 5% Rule provides is for real estate investors to assess the value of rent.

Let’s go back to the example we gave earlier. Assuming that you bought this home and are paying a monthly $1,200 fee for the mortgage, you need to set the rent to at least $2,200 per month—which is 5% for maintenance, operating costs, and the rest of your profit.

Unfortunately, $100 in profit may not be worth the hassle of keeping the rental investment property. You may want to search for other opportunities that are more lucrative in the Metro Detroit area. We have an ongoing deep dive series that evaluates the rental property investment potential in every Metro Detroit city and neighborhood for you to scout better opportunities.

Of course, the final rent value is influenced by other factors as well. But the 5% Rule is a simple and good estimate for you to see the bigger picture. At the end of the day, real estate investments are an excellent way to generate passive income, but only if you invest wisely and have a realistic plan in place.

The 5% Rule for Lucrative Rental Property Investments

The 5% Rule is one of the many other rules that guide you toward better rental property investments. As always, take these rules with a grain of salt and evaluate each opportunity according to your specific situation. The rules are meant to be broken only if it opens up lucrative deals for you.

Do you have any questions about real estate rules? Drop them in the comments below!