My friend and I recently got into a discussion at work regarding the housing market.
The big super-unknown for my colleague, of course, was whether or not prices had dropped far enough to make it worth buying a house again.
“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 making the long walk to the parking lot.”
I know what you’re thinking. As luck would have it, the portable GPS system I was using in my car had gone on the fritz, and so I tried using the 8-ball as a stand-in. I quickly ended that experiment after beta testing it over the previous weekend; it failed miserably.
Oh, it was fairly accurate when asking questions like, “Should I take the 405 northbound to Santa Monica?” But there is nothing more frustrating than trying to shake a Magic 8-ball and read an answer while driving a stick shift in rush hour traffic. Especially when it tells you to “Concentrate and ask again.” Believe me.
Okay, maybe not; you got me. I digress.
The Price-to-Rent Ratio
In my inland neighborhood, home prices have stabilized after dropping by as much as 40 percent since the bottom fell out of the housing market several years back.
Then again, home prices where I work in Orange County, California, still seem to be a bit overpriced. The mixed conditions are understandable because there are naturally going to be market variations from region to region. That’s just the way it is, folks.
So what’s a guy or gal to do if they are trying to gauge where a particular housing market is still over inflated and they don’t want to rely on a Magic 8-Ball?
Perhaps one of the better indicators is something called the price-to-rent ratio, P/R, (as opposed to a P/E ratio) which 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 can be a signal that regional home prices are cheap compared to renting. On the other hand, a high P/R can indicate that you’d be better off renting.
The P/R 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 that are currently offering monthly rents of between $2300 and $2350. The median home price for similar homes in my local area is currently $450,000.
P/R = (Median home price)/(12 x monthly rent), or
P/R = ($450,000)/(12 x $2300), so
P/R = 16
Okay, Len, so what does that mean? Is 16 high or low?
Well, the New York Times notes that, nationally, the average P/R through the ’70s, ’80s, and ’90s stayed between 10 and 14 before peaking at 19 at the top of the housing market in 2006.
In 2009, the regions with some of the highest P/Rs included Oakland (36.3), Honolulu (34.8), San Jose (32.3), San Francisco (28.4), Seattle (28.1) and – surprise! – Orange County, CA, (26.8).
Markets with some of the lowest P/Rs included Pittsburgh (11.7), Detroit (12.1), Cleveland (12.6), Phoenix (13.3), Riverside/San Bernardino (13.5), and Las Vegas (13.9).
Generally, a P/R of around 15 is considered by many folks to be low enough to take the plunge and buy a house. On the other hand, many people typically consider renting to be the better choice when that P/R reaches 20 or so.
In my example, with a P/R of 16, if someone were looking for a home in my neighborhood they might feel fairly comfortable buying.
Folks that want to dig deeper can also try comparing the current P/R to the historical average for a given region; you can often get that data from a local real estate agent. For a more complete list of recent P/Rs by region from the New York Times, including some limited regional trend data, click here.
Keep in mind that 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’ll need to evaluate other criteria.
For example, it is important to consider 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.
That being said, when it comes time to try and figure out whether now is the right time to rent or buy a house, you can always count on the price-to-rent ratio to get a rough answer.
It may not be foolproof, but it will certainly be a whole lot more reliable than a Magic 8-Ball.