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Renting or Buying an Apartment The 5% Rule

Renting or buying an apartment has often been under debate. However, we have split it down into simple calculations. Before we get to the 5% rule, we need to lay out the assumptions that have gone into it. The unrecoverable expenses are in the form of a cost you pay with no associated residual value. The number is elementary to find when we talk about the total unrecoverable cost of renting. It’s just the amount that you’re paying in rent. The unrecoverable costs are more challenging for a homeowner to pin down. A homeowner has a mortgage payment, which feels like rent, making it a manageable number to compare to rent.

Beware of Mortgage Costs

Some apartment projects are available on the mortgage installment plans. However, it is not a meaningful comparison. A mortgage payment is not an unrecoverable cost. It is a combination of interest and principal repayment. The unrecoverable costs for a homeowner are property taxes.

Further, it may include maintenance costs and the cost of capital. It is these costs that we need to compare to rent. Property taxes are easy for most people to grasp. You pay the tax to own the home. And there is no residual value. Property taxes are generally 1% of the value of the house. That’s the first piece of the 5% rule.

Maintenance Cost

In the following section, we have to think about maintenance costs. Maintenance costs cover a vast range of expenses. It can be large items like replacing a roof or renovating a kitchen to maintain the home’s value. Nonetheless, it can also be small things like redoing the caulking in the bathroom. Pinning down the correct number to estimate maintenance costs takes work. The data on average maintenance costs are not readily available. However, most people suggest using an average of 1% of the yearly property value. This is the second piece of the 5% rule.

Cost of Capital

Finally, the last and most crucial piece to the 5% rule is the cost of capital. This unrecoverable cost needs to be split down into two categories the cost of debt as well as the cost of equity. Many homeowners finance the purchase of their home, opting for a mortgage. Let’s quote a new homeowner as a case study of buying and renting a home or apartment. Say the homeowner buys 20% as an upfront cost and finances the remaining 80% with a mortgage. However, 80% of that has been funded with a mortgage, which will result in interest costs. As of April 2019, you can easily find the mortgages online for just under and above 3%. Let’s call mortgage interest a 3% unrecoverable cost.

Final Thoughts

Until the final point, all of the inputs to the 5% rule are pretty intuitive. Property taxes, maintenance costs, and mortgage interest. Lastly, the cost of equity capital is a bit less intuitive and requires digging into some data. In our example for the mortgage, we put 20% down. It’s on that 20% that there’s a cost of equity capital. When you put 20% down, you choose to invest in a real estate asset.

 

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