Renting vs. Buying Real Estate – A Definitive Guide to the 5% Rule
When it comes to the choice of housing, there are so many crucial decisions to make. It is a serious investment and it isn’t to be taken lightly. As a great financial decision, it can also emotionally affect people, especially if they are first-time home buyers. As a leading real estate agency in NYC, our mission is to make sure the new generation of home buyers finds the safest way to find a home, so that’s why this post is partially targeted towards Millennials, and we’ll explain why.
The Millennials Situation
Following the Millennial Generation for quite some time now, there’s been a shift in the past few years when it comes to the home-buyers generations. Today, Millennials make up most of this demographic, at 37% being recent home buyers, followed by Gen X at 24%. However, although most Millennials are of age of becoming first-time homeowners, many hesitate to take such a drastic move.
Why don’t Millennials Buy Real Estate?
The reason lies behind a lot of strife and financial debt, whether it be student loans, credit card debt, lack of job opportunities, and the decision to hold off marriage, therefore, staying home with parents. This puts a pressure on all of the real estate professionals who want to create an equal opportunity for this generation to become homeowners as well. That’s why this post is dedicated to the famous 5% rule that can overall help you decide what to do when it comes to real estate investing. It’s very simple to understand and applicable to almost any situation in which you’re unsure whether it’s better to rent or own a property.
What is the 5% Rule?
This post is dedicated to everyone, regardless of your generation or occupation. If you’ve considered buying or renting a home, and you can’t figure out which is better, the 5% rule can help. The 5% rule is the process of determining whether or not it’s better to opt for renting or buying based on the amount of unrecoverable costs. It has been coined in 2019 by a Canadian Portfolio Manager Benjamin Felix, who created a simple and elegant equation that can help anyone determine the benefits of renting vs. buying a home. Before we dive into this equation and see how it works in practice, we have to set up some basic factors and explain them in detail.
The Age Old Question: Buy or Rent?
The majority of the population might think along these lines: “Well, if you rent a place, you’re certainly throwing money down the drain.” Buying a home is a secure investment, and a better choice for the future.” Although this might be true in some cases, the problem is that the situation is very nuanced and can be susceptible to a lot of factors.
As we’ve already mentioned, Millennials (as the main home-buyers of the next few decades) do not have the same needs and lifestyles as their predecessors. They relocate more frequently due to career and education demands, and settle for marriage later than the last generations, which means that buying a home may sound like a huge financial commitment (and we already know that they’re in debt as it is). Having said all that, it might sound like we’re speaking in favor of renting a home, but that’s far from it. Let’s talk about the expenses that go into renting/buying property.
The Total Unrecoverable Cost
The total unrecoverable cost we’re talking about in this scenario isn’t just a non-refundable commodity or service. It’s much more than that. To get to the core of the 5% rule, we have to lay down the baseline which is this: Basically, it’s money you spend that’s unrecoverable – whether through rent or in exchange for a house. Now, for renting, it’s quite simple – the total unrecoverable cost per month equals the monthly rent you’re paying to your landlord.
Now, the first misconception is to compare the monthly rent to the mortgage payments, and based on that determine whether or not it’s better to buy or rent. But, that’s incorrect, as the mortgage payment isn’t entirely unrecoverable. The real unrecoverable cost of owning a home is a little more complicated than that.
The Total Unrecoverable Cost of Buying a Home
Every homeowner has an unrecoverable cost that can be determined by 3 factors:
- 1. Property taxes
Property taxes generally amount to 1% of the total value of your home annually.
- 2. Maintenance cost
All expenses that cover maintenance costs of the home, generally amount to also 1% of the total value of your home, annually.
- 3. Cost of capital
The cost of capital consists of two major components: costs of debt and equity, and they amount to 3% of the home value.
Where did that 3% come from?
The cost of capital is a little more complicated to calculate. In Benjamin’s words, comparing the numbers for real estate investing and stocks, allows for the calculation of the opportunities lost cost. What does that mean? How about if you decided to rent, and use the down payment (20% of the total home value) to invest in stocks? Putting your money in stocks creates an opportunity cost. The estimation of that cost is where it becomes more liberal and accuracy is not guaranteed. But, by collecting data for both returns on investment in real estate and stocks, there is a 3.57% difference in favor of stocks. Rounded down to 3%, this is how we get the cost of capital.
Rent vs. Buy – The Final Challenge of the 5% Rule
This is where we come to the fun part. By calculating the unrecoverable costs, you can easily find out whether it’s better to buy or rent a home.
- 1st step – Take the value of the home
- 2nd step – Multiply the value by 5%
- 3rd step – Divide that by 12 to make it comparable as a monthly expense
Let’s say for example that you want to buy a house for $500.000. The annual unrecoverable costs for that type of home amounts to $25.000. Divide that by 12, and you get $2083. So, if you found an apartment or house that costs less than that – congradulations, you just saved yourself a ton of money. The same thing can go the opposite way: Take the monthly rent, multiply it by 12, and then divide by 5%.
Thanks to innovative thinkers like Benjamin, we are able to shape the future of the real estate market and create new opportunities for new generations. But of course it doesn’t all come down to this. It’s way more than just an equation – there are many other costs like the costs of buying and selling, hiring a lawyer, real estate agent, insurance, and much more. Not to mention the mental process and time lost on buying a home. Although this 5% rule is kind of a generalization, it’s pretty insightful and helpful – especially to the future first-time buyers or investors. Having that in mind, and with AA Real Estate NYC by your side, there’s no doubt you’ll be able to find yourself a home – whether it be a permanent or a temporary one.