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 buying a new home.
“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.
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, 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
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?
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.
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: 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.
@Norman: You can start a petition to get it on the ballot, but I ain’t signing it.
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!
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.
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.
It sounds interesting. I like the P/R method. My aunt is confused about what is better, renting or buying a house. Well I recommend your post to her. Thank you!
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.
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.
I completely agree that an individual should be financially stable enough to purchase a house. Information given in this article helps others to learn the pros and cons associated with the house rent and house ownership. Besides, a lot of other aspects should be taken into consideration while purchasing a house. The location, quality, and price associated with the deal play a detrimental role in such kinds of investments.