“That’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.”
Let me explain: My car’s navigation system was on the fritz — so I decided to have some fun and see if the ol’ 8-ball was smart enough to act as a reliable alternative.
Okay … at least semi-reliable.
Anyway, 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 read the answer while driving in rush-hour traffic — especially after it tells you to “Concentrate and ask again.” But I digress.
The Price-to-Rent Ratio
With home prices continuing to rise, it’s hard to discern whether homes are still 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 $2900. The median price of similar homes in my local area is currently $725,000.
P/R = (Median home price)/(12 x monthly rent)
P/R = ($725,000)/(12 x $2900)
P/R = 21
Okay, Len, so what does that mean? Is a P/R ratio of 21 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 still 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, at the same time 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.
Five years ago, the P/E ratio for my neighborhood was 20 — but in 2010, the P/E ratio for my neighborhood was 16, so it has increased by a little more than 25% over the past decade.
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, recreational benefits of your community, 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