Price-Rent Ratio

by Dennis Bradford

in financial well-being

Why consider the price-rent ratio?

You need shelter. Either you rent a place to live or buy a place to live.

Let’s suppose that you understand that the real estate bubble for housing in the U.S. burst in 2007 and that prices for single family houses have been falling ever since. Let’s also suppose that you are wondering whether you should rent a house for you and your family or purchase one.

Have prices fallen enough for purchasing a house to be a good deal or not?

There’s no point offering you a straight answer for three reasons. First, with respect to any particular deal many factors are involved. Second, since the market is always changing, there’s no one answer that will work well all the time. Third, I don’t know what you should do because, like everyone else, I don’t know what the future consequences of whatever decision you make will be.

Instead, let’s simplify things by assuming that you are going to investigate this unemotionally as a real estate investor would. My thesis is simple: consider the price-rent ratio before making a decision.

Why? What is the price-rent ratio? Why is it important? What’s a good one?

Whether you are considering purchasing a house to live in or to rent out, the price-rent ratio is the average cost of ownership divided by the rent you would receive from a tenant.

Suppose that you find a house for sale in a good location that you are considering purchasing. It’s easy to find the owner’s asking price. Next, answer two questions:

First: What is the yearly cost (principle, interest, taxes, insurance, and maintenance) of owning that house? Let’s say it is “X” dollars.

Assume you’ll be getting a fixed rate, 30-year mortgage at the going interest rate. Its owner can show you recent tax receipts or you can look them up at the county court house. Any insurance agent can give you quotes on either homeowner’s or landlord’s insurance. A real estate agent can help you estimate yearly maintenance costs, which will vary with the age and condition of the house. So, after you do your due diligence, you determine it is “X” dollars.

Second: What is the average annual rent for a similar house? Let’s say you estimate it to be “Y” dollars.

To determine the price-rent ratio, simply divide X by Y.

If X is $1000 and Y is $1000, the price-rent ratio is 1. Roughly, that is about where it should be – or perhaps slightly higher such as 1.05.

If the ratio is lower, the price of the house is low. For example, if the price-rent ratio were .8, the positive cash flow for an investor owning that rental house would be about 20%, which is very high.

If the ratio is higher, the price of the house is high. For example, if it were 2, an investor owning that rental house would have an “alligator,” which is a property with a very negative cash flow that may eat you alive.

As Michael Maloney argues, it’s important to understand the history of the price-rent ratio for the average single family home in the U.S. if you are thinking of buying one.

For example, in the residential real estate bubble of 1989-1990, the national price-rent ratio was 1.25. Housing prices were too high.

In the recession of 1996-7, the price-rent ratio was .90. That was a great time to purchase a house – if you had the money or could get a loan, which was very difficult.

Then there was the greatest real estate bubble in history that didn’t begin to deflate until 2007, when the ratio was 1.85 or 1.90! That was a crazy time to buy a house!

What about more recently? The great real estate bubble hasn’t yet deflated. It fell and then bounced up to 1.25, which was the same as the ratio during the bubble of 1989-90!

The timing won’t be right until it drops below 1.05.

In fact, usually, when there is a market bubble, it doesn’t just burst down to fair value: the higher the bubble, the farther below fair value it usually goes until another bubble begins. So you might want to hold off buying a house until you see a ratio at .9 or lower.

Either rents must increase or prices must decrease. Since we are in a deflationary period (as I write this post in January 2012) in terms of both the stock market and real estate (when compared to real money, namely, gold or silver), rents are not going to go up. That means that housing prices are going to decline farther.

Why buy a house at a higher price now when you can purchase a similar house later at a lower price?

So, there is a conclusion from our looking at the price-rent ratio: it’s a good time to be a renter.

That, though, will change. Right now, rent a house and invest in gold and silver.

All bubbles burst! The gold and silver bubble will eventually burst. If it didn’t, you’d eventually be able to purchase a house for an ounce of gold or, even more absurdly, all the real estate in the world for an ounce of gold!

If so, as real estate decreases in value while gold and silver increase in value, investing in gold and silver now will enable you to use them to purchase more real estate later.

All that being said, though, this does not mean that you should not purchase a house right now.

That may seem to contradict everything else in this post, but it doesn’t. The point: the price-rent ratio is just one factor to consider. If it were the only factor to consider, it would follow that this is a poor time to purchase a house.

Again, this discussion has been over-simplified. My thesis is only that it’s a good idea to consider that ratio before purchasing a house.

If you agree with that now and didn’t before, excellent! You’ve absorbed some information that may be important to you.

Income from rents is similar to personal incomes and corporate incomes that are closely tied to price and supply fundamentals.

What are the most important fundamentals regarding real estate? Everyone knows the answer: location, location, location.

There are always good real estate deals available. Just please don’t be in such a hurry to purchase real estate that you forget the price-rent ratio.

(Have you read the related post about Your House?)

 

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