A Simple Test to Know If It’s Better to Rent or Buy a House

This weekend my friend and I got into a discussion regarding the housing market; he was wondering whether current prices were still cheap enough to justify taking the plunge and buying a new home.

“It’s a good question,” I told him, “We could ask my Magic 8-Ball, but it’s in the car and I don’t feel like getting up.”

I know what you’re thinking. The portable navigation system I was using in my 1997 Honda Civic had gone on the fritz, and so I was using the 8-ball as a stand-in. Talk about a bad idea. Oh, sure … it was fairly accurate on mundane questions like, “Should I take the freeway or surface streets to Santa Monica?” But there’s nothing more frustrating than trying to shake a Magic 8-ball and then read the answer while driving a stick shift in rush-hour traffic — especially after it tells you to “Concentrate and ask again.”

But I digress.

The Price-to-Rent Ratio

Home prices in my neighborhood have recovered most of their losses since the bottom fell out of the housing market in 2009. Then again, home prices in other areas of California are a mixed bag. So, for many people, it’s hard to discern whether homes are relative bargains or overpriced money traps.

Thankfully, there are ways to get a rough idea whether a particular housing market is under- or over-inflated. Perhaps one of the better indicators is something called the price-to-rent (P/R) ratio. The P/R ratio is simply the median home price in a given region divided by the annual rent you can get for a similar home.

A low P/R ratio can be a signal that regional home prices are cheap compared to renting. On the other hand, a high P/R ratio can indicate that you’d be better off renting.

The P/R ratio is not perfect because the varied mix of homes affects the median price. It also can’t tell you if a particular house is appropriately priced.

Still I think it is a terrific way to get a back of the envelope estimate as to whether it’s better to rent or buy.

Calculating the P/R Ratio Is Simple!

Just for fun, let’s use the P/R ratio to see whether it would be better to buy or rent houses in my neighborhood.

Right now, there are three homes in my housing development with an average monthly rent of $2300. The median price of similar homes in my local area is currently $550,000.

P/R = (Median home price)/(12 x monthly rent)

P/R = ($550,000)/(12 x $2300)

P/R = 20

Okay, Len, so what does that mean? Is a P/R ratio of 20 high or low?

According to the New York Times, the average P/R ratio in the US during the ’70s, ’80s, and ’90s varied between 10 and 14. When the housing market peaked in 2007, the P/R ratio rose to 19. However, keep in mind that’s the national average — those numbers varied depending on locales. For example, even after the market tanked, in 2009 there were local regions with P/R ratios far above 19 including: Oakland (36.3), Honolulu (34.8), San Jose (32.3), San Francisco (28.4), and Seattle (28.1). As a point of comparison, in 2009 there were also markets with much lower P/R ratios, including: Pittsburgh (11.7), Detroit (12.1), Cleveland (12.6), Phoenix (13.3) and Las Vegas (13.9).

As a general rule of thumb, a P/R ratio of 15 or less indicates a reasonably-priced market, while P/R ratios above 20 suggests that renting may be the better choice. However, it’s always best to compare the current P/R ratio to the historical average for a given region; you can often get that data from your local real estate agent.

Four years ago, the P/E ratio for my neighborhood was 16. So it has increased by 25% since then.

In Conclusion

Of course, the P/R ratio is really meant to guide you on the timing of your purchase. When it comes time for deciding whether or not buying a home is right for you, you should also consider other factors including things like: the length of time you plan on living in the home, and your willingness to tackle typical homeowner duties like mowing the lawn, shoveling snow off of the sidewalk, and other general home maintenance activities. You’ll also want to make sure that you have saved enough money — not only to cover the required down payment, but also additional savings to cover surprises that will inevitably pop up from time to time.

So if you’re wondering whether or not now is still a good time to purchase a new home, take a look at the P/R ratio. It’s certainly not a foolproof indicator — but it’s definitely more reliable than a Magic 8-Ball.

Photo Credit: Casey Serin



Comments

  1. 1

    says

    I like the idea of the P/R ratio, but two other factors to think about are, 1. – Does the person have a significant down payment saved up? and 2. – Are they planning to live in the house for at least 10 years?

    Does the P/R factor in maintenance? With a P/R of 16, I’d be on the fence if there were a lot of additional costs for repair and upkeep.

  2. 2

    says

    Another problem with the magic 8 ball is that the glare from the sun can make your answer difficult to see when driving…

    Where I live (Detroit area), the ratio is pretty darn great! Too bad nobody around here has the money to buy a house. I like the idea of this factor though. The more supporting data you have for a decision, the better.

  3. 3

    says

    I can’t believe that you were consulting your magic 8-ball while driving! Some of those cities with low P/R ratios are so depressed, that you’d probably be buying into some pretty foreclosure plagued areas! Probably why the house prices dropped so much faster than the rent!

  4. 5

    says

    Thanks for sharing the math with us! Definitely something to consider since I’m looking to buy my first home, live in it for a couple of years and then start renting it out.

  5. 6

    says

    @LittleHouse: Yep. Good puts. You know, I had a note to tack on a paragraph including other criteria to consider when buying a home including one of the two you mentioned (intended length of stay), but I overlooked it. I was also going to mention job stability and tolerance for lawn and general home maintenance. Oops.
    @Everyday: Well, they do make an audio 8-ball to deal with the glare, but it just isn’t the same. I’m old school in that regard. The ratio in Detroit is really good, to be sure! When it comes time to deciding when to buy or rent, I would consider this just one arrow in somebody’s quiver.
    @Khaleef: Hey, it’s cheaper than a GPS. ;-)
    @Norman: You can start a petition to get it on the ballot, but I ain’t signing it.
    @Jenna: And if you DON’T feel like doing the math, let me know if you want to borrow the 8-ball.

  6. 7

    says

    Len,

    can you check your annual income and compare it to a P/R ratio? Does a 13-16 p/R ratio mean that you need to have “this” amount of income in order to be able to afford to buy a house in that neighborhood? For instance can people who make $100,000 or more afford houses in the range of 17-20, or does it not compare that way? Sorry for my rambling, just trying to see if you can use the P/R ratio in other ways.

    -Matt

    • 8

      says

      Hi Matt. It was nice meeting you last weekend! :-)

      There is no direct relationship between the P/R and the income of the potential buyer. If you are looking to determine if a certain home is affordable for a given income, you would need to know your front-end debt-to-income ratio. The front-end ratio is your monthly mortgage payment (principal, interest, real estate taxes and insurance) divided by gross monthly income. Lenders like that number to be in the vicinity of 28 percent, but they may go higher (up to 32 percent or so). You can figure out the maximum mortgage payment you can afford by multiplying 0.28 by your annual gross income and then dividing by 12. You’ll also need to make sure your back-end ratio (which is ALL of your debt obligations – including your mortgage – divided by your gross income) isn’t excessive. That usually has to be in the neighborhood of 36 percent or less, but it too can be higher if the lender is comfortable with it. Hope that helps!

  7. 9

    says

    I loved playing with the magic 8 ball when I was younger, but I think the predominant question I asked it back then was “does he like me?”

    Thankfully I have become wiser and have better questions to ask =)

    I haven’t heard of the Price to Rent ratio, but it seems great. I just calculated for Vancouver too, and it’s about 36 (yuck!).

  8. 10

    says

    That’s the formula we used when we moved to Washington D.C. area. After we made the down payment, our monthly installment comes to be less than a typical apartment rent in the same area. Having a good-size down payment can be a major asset when buying or lack of it can be detrimental when renting. Think about it. In the long run, buying can be more beneficial. It depends what your spending life style is and sometimes carries more weight than what income you bring in.

  9. 11

    says

    Hi Len, I’ve read that the old criteria for deciding if buying was a good deal was the house should cost 100 months of rent. I doubt you can find that good a deal anywhere though.

    I like the NY Times “Is it better to buy or rent?” calculator. You can use the advanced settings to add condo fees, realtor commissions, maintenance cost and other things. Even if we have hit the bottom of the housing market (and I don’t believe so) it would still take about 20 years before buying my place over renting would make sense. As Little House mentions, I’m not sure I’m staying in this neighborhood that long so I’m happy renting.

  10. 12

    says

    Thanks for this Len. My fiancee and I were considering buying a place last year but couldn’t really find anything that we really, really loved so we decided to rent for a little while. I’m glad we decided to go that route because we really didn’t know what we were doing. We are now a lot more informed about finances and housing and are better prepared to get into buying a house. I didn’t really know about this ratio but I will take it into consideration when buying.

  11. 14

    says

    I’m a 28-year-old in marketing, and I have thought long and hard about buying vs. renting a house. Intellectually I know that buying is a better investment, especially right now when the housing market is pretty darn cheap so buying a house wouldn’t be as major an undertaking as it would have been 5 or 10 years ago.

    I do, however, have cause to hesitate because I know that the job market is volatile and I tend to skip around the state of California hopping from job to job, so I don’t want to buy a house because I will be trapped in one geographic area and my earnings may drop.

    It’s a catch-22 for someone like me.

  12. 15

    says

    I am not sure if that formula factors in the ability to move across the country to follow a job, or make more money.

    Or does it factor in maintenance. Of does it factor in the ability to move, even within the city to avoid traffic after changing jobs, and saving gas.

    Or does it factor in the chance your place could be worth less, especially factoring in selling costs.

    There is more to life than owning a home.

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