The secret to success with real estate investment is numbers. Not knowing about these numbers might make you end up settling for the wrong real estate investment out of all the available deals out there.
The price to rent ratio is among the first and most critical metrics every real estate investor should calculate before he makes an investment decision.
This is a metric that helps in the analysis of a particular housing market and evaluates its profitability.
This ratio, together with other metrics, can help investors make wise investment decisions every time they purchase a rental property.
Read on to know more about price to rent ratio and its importance in the real estate market.
What is the Price to Rent Ratio?
Price to rent ratio is used for measuring a property’s value compared to the potential income it can earn from the rents received.
This basically indicates the possible earnings for a specific investment. This also comes in handy when comparing different properties.
The market prices fluctuate based on the local economy.
Watch the Price to Rent Ratio Lesson Here:
However, once the prices move away dramatically from the income the property can earn, over time, prices will deviate in a way that price to rent ratio will go back to the average.
Similarly, if there is low price to rent ratio, there is a higher chance that the purchase is going to be a wise investment.
How to Calculate the Price to Rent Ratio
Based on the definition, you can already see the formula to calculate the price to rent ratio. This is quite straightforward and will not take up too much of the investor’s energy and time.
Here is a short breakdown of how you can calculate the price to rent ratio:
- Gather the important information.
The details you will need are the average price of the property and the average price of the annual rent. You could get this data by searching online about the housing market in your area.
- Divide the numbers.
Just take the average housing market price then divide this by the average price of the annual rent.
How to Use Price to Rent Ratio for Investors
By just reading the definition of price to rent ratio above, you will be able to tell how real estate investors use this metric to their advantage. It basically answers three important questions:
- Will you be able to afford the rental property investment in the specific market?
- Is the location good enough for investment?
- Is now the best time for you to make a purchase?
Seasoned investors know that timing and location are the most important factors for the success of any real estate deal.
The last thing you want is to buy a property you cannot really afford only to lose potential profits and your investment. This is why it is crucial to calculate the price to rent ratio, so you can make wise investments.
Being an easy calculation, real estate investors use the price to rent ratio to estimate the possible demand for a given rental property.
This is done by estimating if it would be cheaper to own or rent. Generally speaking, if the price to rent ratio is higher, the rental property will have greater demand.
But there are several things you need to remember every time you use the price to rent ratio:
- This compares the economics of renting vs. buying and not really the affordability. When the prices of homes are not within reach for majority of people in a particular market, renting will be their sole option whether there is a low or high price to rent ratio.
- Price to rent ratios historically fall and rise as the housing market cools down or heats up.
- Price to rent ratio must be used to compare similar properties within the same submarket or market.
Where to Find Information for the Price to Rent Calculation
It takes a bit of work of find the accurate data for price to rent ratio for a particular area.
Good thing the United States Department of Labor and Zillow have done most of the legwork for you.
- United States Department of Labor
The United States Department of Labor’s Bureau of Labor Statistics contains all economic trends. It also has historical housing market that real estate investors need to compare the real time housing data available on Zillow.
The Bureau of Labor Statistics gathered data from the United States Census Bureau and the National Bureau of Economic Research.
The report tracks the performance metrics of the housing market and the economic data from 1995 through 2016, which is the latest year available:
- Rates of homeownership per region
- Average and median prices of new houses
- Rates of homeownership by Metropolitan Statistical Area or MSA
- Average mortgage outlays per month
- Rates of homeownership by rural and urban areas
- Percentage of people who rent per region
- Average homeowner housing expenditures per month by MSA
- Average rent per month that renters pay per region
- Rental expenditures per month by MSA
- Rental expenditures per month for rural, central city, and urban areas
Zillow offers a free report online of the existing values and prices of homes in the United States.
The Research provides all the data needed by real estate investors for the analysis of possible investments on rental properties in every US market.
According to these reports, on ctober 16th, 2019, the current US median home value was $229,600 with $1,569 being the existing monthly rent.
Zillow Research page is a good resource that can be used for drilling down on the housing data by neighborhood, zip code, city, county, state, and metro area.
The available reports on housing data include:
- Home sales and listings
- Home values
- Rental values
- Rental listings
- Rent and mortgage affordability
- Median household income
- Mortgage rates
- Price to income ratios
How to Use Price to Rent Ratio in Real Estate to Find Properties
While price to rent ratio is a simple metric, it is also telling. The price to rent ratio can be used in the following to make wiser decisions on your real estate investments:
- Determine the demand for a rental property.
The rental demand is among the key features you can use to find real estate properties to invest in.
As an investor, you must pay attention to the demand for the rental properties.
This affects the rental price you can set for your investment property, your rental income, and rates of vacancy and occupancy, which can all have an impact on your cash flow every month.
- Study the trends in the housing market.
You can also use the price to rent ratio to study the trends in the market based on the rental rates and property prices.
You can search for historical data on rental rates and home prices in the housing market or city where you are planning to purchase an investment property.
Use this data to calculate the historical price to rent ratio to check if there are trends are worth looking into.
- Reduce your investment location.
The investment property’s location plays a big role in the amount of potential profit you will earn.
This means that if you wish to find an investment that can give you the most profits, you need to look for a profitable location before anything else.
There are various metrics that can be used for calculating the market level to have an estimate of the profitability of rental properties in a particular housing market with price to rent ratio being one of them.
- Choose the best strategy for real estate investment.
There are several factors that affect the price to rent ratio as far as real estate investment is concerned, and these include your budget, type of property, and strategy on real estate investment.
Examples of the Price to Rent Ratio in Rental Property Investing
There are three general classifications of price to rent ratio:
- High or 21 and up – It suggests that renting a house is better than buying one.
- Moderate or 16 to 20 – It suggests that renting is often better than buying a house.
- Low or 15 and below – It suggest that buying a house is better than renting one.
Here are some examples of using price to rent ratio when investing in real estate properties:
- A residential home has the price of $200,000 and a monthly rental price of $1,000. $1,000 multiplied by 12 months gives it an annual rental price of $12,000.
Thus, the price to rent ratio is calculated by dividing $200,000 by $12,000 to give an average price to rent ratio of 16.67.
- The average price of a for-sale property in your housing market is worth $300,000 with properties renting for $2,000 per month.
The price to rent ratio here is $300,000/$24,000 (2,000 x 12) = 12.5, which is considered low.
What is a Good Price to Rent Ratio for Investors?
Just like most of the questions frequently asked when it comes to real estate investments, there is really no definite answer as to what a good price to rent ratio is for investors.
The truth is that this is dependent on several factors, the most important of which is the personal criteria of the investor looking for investment properties.
Beginners often ask what the good price to rent ratio is when their real estate venture is just getting started.
This is an applicable question to almost all other metrics used by investors when estimating the profitability of making an investment in a specific rental property for sale or housing market.
For instance, most investors usually ask about a good cap rate, good cash on cash return, or a good return on their real estate investment.
While experts often arrive at a consensus on what is a good ROI, cap rate, and cash return, there is really no straight answer as far as a good price to rent ratio for investors.
Price to Rent Ratio Depends On the Property and Investor
Since the price to rent ratio for houses has been divided into three different categories, it is impossible to say that a particular number represents the best or a good ratio for real estate investors to use as the basis of their decisions.
A good price to rent ratio will instead depend on various factors such as your budget, what you are personally searching for in a location for investment, and your strategies in real estate investment.
For instance, if you are looking for a potential rental property within a market with high demand and your budget allows you to make a purchase, anything more than twenty-one can be considered as a good ratio.
Your property search will be concentrated in cities that have the highest price to rent ratio.
Meanwhile, let’s say that flipping homes is your real estate investment strategy.
You buy investment properties for sale at a cheap price, renovate them to improve their market value, and sell them for higher price.
Here, a good ratio is less than fifteen since houses for sale in cities with the lowest price to rent ratio are cheaper, and there will be a huge pool of buyers you can choose from once the time comes for you sell.
So, some investors may say that a lower ratio is the best, but some might disagree and favor a higher ratio instead. It means that a good price to rent ratio will depend on what exactly you are searching for.
The Bottom Line of Price to Rent Ratio
The price to rent ratio is helpful if you want to compare different areas for potential real estate investments.
However, it is important to keep in mind that this is not the ultimate metric in the world of real estate.
This only indicates the demand for a specific rental property in a certain market and doesn’t make up everything investors search for in a particular location. Always do your research first to make a wise decision.
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