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

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.

In Conclusion

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.

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

  • 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.

  • 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.

  • 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!

  • Similar to the no-cell phone while driving laws, do we need to push for no-magic eight balls while driving law?

  • 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.

  • @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.

  • 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

    • 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!

  • 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!).

  • 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.

  • 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.

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