A colleague of mine recently mentioned that their parents were ardent renters. They felt that real estate continues to be an overpriced commodity and that one would be far better off financially by renting (setting aside the emotional aspects of home ownership). My colleague’s counter argument is that in an economy geared to trying its best to make you consume, for many people, especially under 40, paying down the mortgage may be the only forced savings vehicle they have.
One of the after-effects of the credit crisis has been to spark conversations such as my colleagues whereas 4-5 years ago most middle class families were conditioned to believe to buy a home or go bust. With the real estate market correcting itself to historical norms, it may be time to revisit what the appropriate tipping point is between buying a home or renting a home.
The conventional analysis on buying a home or renting a home begins with the price-rent ratio. The price-rent ratio is determined by finding the median listing price for a home in a particular area and divide by 12 times the median monthly rental price for a home in the same area. For example, a 3 bedroom home in a particular community sells, on average, for $300,000 and rents for $2,000 month or $24,000 per year. The price-rent ratio is $300,000/$24,000 = 12.5.
What is an acceptable price-rent ratio? Price-rent ratios are often called the price-earnings ratio (p/e ratio) of real estate for a reason. Most experts believe that a price-rent ratio of 15 is acceptable which is also approximately the same p/e ratio most experts recommend is a reasonable valuation for a non-start-up/small cap stock.
Or, to look at it another way, take the average rent of the type of real estate you are looking at and multiple that figure by 180 (the number of months in 15 years- although William Bernstein likes 150 months better). If the selling price is way over this figure, it may be over-priced.
Price-rent ratio has several limitation though. As rightfully pointed out in Zillow’s real estate blog, the methodology assumes that the underlying value of a home to purchase is approximately the same as a home to rent. As most sophisticated real estate investors know, the analysis for purchasing rental property is not the same as purchasing a principal residence. For example, when was the last time you saw a rental home with a pool in the backyard? Thus, it is not a pure apples to apples analysis in calculating price-rent ratio.
This would suggest then that a price-rent ratio works best in real estate classes that interchangeably bought by owners or landlords. For example, condos are purchased both as primary residences and rental units. For this real estate class, a price-rent ratio analysis would seem to be the most effective since the data is easily comparable. Where the property is quite up-scale and not typically used by renters, the price-rent ratio tends to spring some methodological leaks although it is still an useful analytical tool.
The second limitation for price-rent ratio is it relies upon a readily available and recent pool of data to come up with a figure. If a location experiences some structural change in its local economy, using data before such change may give the wrong result. Think of Fort McMurray, Alberta circa 2005; oil sands extraction has fundamentally changed how to value real estate in that part of the world. Conversely, think of a mid-western city closing a car plant, steel mill or lumber yard.
In both situations, the context is moving so fast that the pool of available information is quite shallow or changing too rapidly to predict trending. Price-rent ratios work best in larger regions where there is a lot of pricing information available which is relatively recent (I would argue anything over 180 days in large metropolis is no longer recent).
Nevertheless, it is a useful ratio to keep in your back pocket if you are deciding between renting or buying and are worried you may come out of the wrong side of real estate trends.
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