What Is the 5 Rule in Real Estate? A Clear Guide for Commercial Property Buyers

When you're looking at commercial properties-office buildings, retail spaces, or industrial warehouses-you don’t just want to know the price tag. You need to know if it’s going to make money. That’s where the 5 rule comes in. It’s a simple, practical way to quickly tell if a commercial property is worth serious consideration. No complex spreadsheets. No financial jargon. Just a quick check that saves time and avoids bad deals.

What Exactly Is the 5 Rule?

The 5 rule says: If the annual gross rental income is at least 5% of the property’s purchase price, it’s worth looking at deeper. That’s it.

Let’s say you’re eyeing a small retail building priced at $1.2 million. Multiply that by 0.05, and you get $60,000. If the property is bringing in $60,000 or more in rent each year, it passes the 5 rule. If it’s only bringing in $45,000? That’s a red flag. Not necessarily a deal-breaker, but you need to dig into why.

This rule isn’t about profit. It’s about cash flow potential. It filters out properties that look cheap on paper but won’t cover basic expenses like property taxes, insurance, maintenance, and vacancy. You’re not trying to get rich overnight-you’re trying to avoid losing money.

Why 5%? Why Not 4% or 6%?

Five percent isn’t magic. It’s a baseline that works for most U.S. commercial markets in 2026. Here’s why:

• Commercial properties usually have higher operating costs than residential ones-HVAC repairs, roof replacements, tenant improvements, and property management fees add up fast.
• Vacancy rates in commercial spaces can hit 10-15% in slower markets. You need a buffer.
• Interest rates are still above 5% for commercial loans. If your gross rent doesn’t exceed your debt service, you’re paying out of pocket.

Some investors use a 4% rule in high-demand urban areas like downtown Los Angeles or Chicago, where tenant demand is strong and turnover is low. Others use 6% in secondary markets with higher risk. But 5% is the standard starting point. It’s conservative enough to protect you, but not so strict that you miss good opportunities.

How to Calculate It-Step by Step

Here’s how to apply the 5 rule in real time, whether you’re touring a property or reviewing a listing:

1. Find the purchase price of the property. Use the listed price or recent sale data from public records.
2. Get the annual gross rent. This is what the tenant pays before any deductions. Don’t use net rent. Don’t guess. Ask for lease copies or tax records.
3. Multiply the purchase price by 0.05.
4. Compare the result to the annual gross rent.
5. If rent ≥ 5% of price → move to next step. If rent < 5% → walk away or dig deeper.

Example: A 10,000 sq. ft. warehouse in Riverside, CA, is listed for $1.8 million. The tenant pays $7,500 per month. That’s $90,000 a year. 5% of $1.8 million is $90,000. It hits the rule exactly. That’s a green light to run a full cash flow analysis.

Another example: A strip mall in Fresno is priced at $2.1 million. Rent is $84,000/year. 5% of $2.1 million is $105,000. The property falls short by $21,000. That’s a problem. Is the building under-leased? Are rents outdated? Is the location declining? You need answers before proceeding.

When the 5 Rule Doesn’t Apply

The 5 rule is a filter, not a rulebook. There are times when you might accept a property that doesn’t meet it:

• Value-add opportunities: A property with low rent because it’s outdated. You plan to renovate, raise rents, and re-lease. The 5 rule doesn’t apply to future potential-it applies to current income.
• Long-term appreciation: You’re buying in a zone that’s about to be rezoned or has a major infrastructure project coming. The rent might be low now, but the land value will spike.
• Owner-occupied properties: If you’re buying a building to house your own business, the 5 rule isn’t relevant. You’re not investing for rent-you’re investing for space.

But here’s the catch: even in these cases, you still need to make sure you can cover costs. If the rent doesn’t meet the 5 rule, you’re relying on external factors-market shifts, renovations, or personal funds-to make it work. That’s riskier.

What to Do After the 5 Rule Passes

Passing the 5 rule doesn’t mean buy it. It just means you’ve cleared the first hurdle. Now it’s time for the real work:

• Check the lease terms. Is the tenant locked in for 5 years? Are there rent escalations? Is the tenant creditworthy?
• Review operating expenses. Property taxes, insurance, maintenance, utilities, management fees. Get actual numbers from the seller or property manager.
• Calculate net operating income (NOI). Gross rent minus operating expenses. Then divide by purchase price-that’s your cap rate.
• Compare to market cap rates in the area. In Southern California, 6-8% is typical for well-leased commercial properties.
• Look at tenant turnover history. Has the property sat empty for 6+ months in the past three years? That’s a warning sign.

Let’s say you found a property that passes the 5 rule and has a cap rate of 7.2%. That’s strong. But if the main tenant is a single retail store with a 1-year lease and no renewal option? You’re one bankruptcy away from a vacancy. The 5 rule told you it’s cash-flow capable. Now you need to assess risk.

Real-World Example: A Los Angeles Retail Property

A client of mine bought a small retail building in Culver City in late 2025. The price was $1.6 million. The rent was $90,000/year. That’s 5.6%-above the 5% threshold.

But here’s what we found after digging:

• The tenant was a pharmacy chain with a 10-year lease and 3% annual rent increases.
• Property taxes were $38,000/year. Insurance was $12,000. Maintenance averaged $8,000.
• NOI was $32,000. Cap rate was 2%. Wait-that’s not right.

Turns out, the seller had included the property’s mortgage payment in the “expenses.” That’s wrong. NOI doesn’t include debt. We recalculated: $90,000 rent minus $58,000 operating costs = $32,000 NOI. $32,000 divided by $1.6 million = 2% cap rate. That’s low for commercial real estate.

Why? Because the seller had financed the property with a low-interest loan. The 5 rule passed, but the actual return was weak. We walked away.

That’s the lesson: the 5 rule is a starting point. It doesn’t replace due diligence. It just keeps you from wasting time on deals that can’t possibly work.

Common Mistakes When Using the 5 Rule

Even experienced investors mess this up. Here are the top three errors:

1. Using net rent instead of gross rent. Net rent is what the landlord takes after paying expenses. You need the full amount the tenant pays.
2. Ignoring vacancy rates. If the property is 90% occupied, don’t assume it’ll stay that way. Use 85% occupancy in your calculation.
3. Applying it to residential properties. The 5 rule is for commercial. For single-family rentals, the 1% rule (monthly rent = 1% of purchase price) is more common.

One investor I know bought a small office building in San Diego because it passed the 5 rule. He didn’t check the lease. The tenant was a freelance graphic designer who paid $3,000/month. The building had three units. Two were empty. He thought the $3,000 was the total rent. It wasn’t. He lost $1,200 a month for six months before realizing his mistake.

Final Takeaway: Use the 5 Rule as a Gatekeeper

The 5 rule isn’t a guarantee of success. It’s a way to avoid failure. In commercial real estate, most losses come from overpaying for income that doesn’t cover costs. The 5 rule forces you to ask: Is this property generating enough to even have a shot?

Use it early. Use it often. Don’t fall in love with a building before you’ve checked the numbers. Walk away from anything below 5%. You’ll save months of wasted time and tens of thousands in lost cash flow.

And when you find one that passes? That’s when the real work begins. But at least you know you’re not starting from a hole.