The price to rent ratio is used by both real estate investors and prospective homebuyers to determine if it is cheaper to rent or own in a specific market.
In this article we’ll look at how to calculate the price to rent ratio and the best ways for real estate investors to use the price to rent ratio when analyzing a potential single-family investment property.
What is a Price to Rent Ratio?
The price to rent ratio compares the annualized gross rent in a specific area to the price of houses in the same area. Investors use the price to rent ratio as a metric to determine whether it is more cost effective for someone to buy or rent property.
In effect, the ratio indicates the potential demand for rental property based on the cost of homeownership.
If the price to rent ratio is high, the market could be better for rental property investment. On the other hand, if it’s cheaper for people to own a home than rent, then demand for rental property -- and the price to rent ratio -- will be lower.
How to Calculate Price to Rent Ratio
Now let’s take a look at how to calculate the price to rent ratio:
- Median Home Price / Median Annual Rent = price to rent Ratio
- $150,000 Median Home Price / $12,000 Median Annual Rent = 12.5
The price to rent ratio can also be used to calculate what a home price should be based on the ratio, and what the annual rent should be.
Using price to rent ratio to calculate home price
- Price to Rent Ratio = Median Home Price / Median Annual Rent
- Median Home Price = Median Annual Rent x price to rent Ratio
- $12,000 Median Annual Rent x 12.5 price to rent Ratio = $150,000 Median Home Price
Using price to rent ratio to calculate annual rent
- Price to Rent Ratio = Median Home Price / Median Annual Rent
- Median Annual Rent = Median Home Price / price to rent Ratio
- $150,000 Median Home Price / 12.5 price to rent Ratio = $12,000 Median Annual Rent
Best Uses for The Price to Rent Ratio
The price to rent ratio is an easy calculation that real estate investors use to estimate the potential demand for rental property. They do that by estimating whether it is cheaper to rent or own. In general, the higher the price to rent ratio is the greater demand there will be for rental property.
However, there are a few things to keep in mind when using the price to rent ratio:
- It compares the economics of buying vs. renting, but not the affordability. If home prices are out of reach for most people in a specific market, then their only option will be to rent, regardless of whether the price to rent ratio is high or low.
- Historically, price to rent ratios rise and fall as the housing market heats up or cools down. The Bureau of Labor Statistics has put together an excellent analysis of housing prices and expenditures before, during, and after the last recession in 2007.
- Price to rent ratios should be used to compare similar properties in the same market or submarket. Later in this article we’ll discuss why a high or low price to rent ratio in and of itself doesn’t necessarily mean a potential investment is either good or bad.
Where to Find Price to Rent Ratio Data
Finding accurate price to rent ratio data for a specific area requires a little bit of work. Fortunately, Zillow and the United States Department of Labor have already done a lot of the heavy lifting.
Zillow provides a free online report of current U.S. home prices and values, while Zillow Research provides all of the data that real estate investors need to analyze potential rental property investments in every market in the U.S.
Based on these reports, on October 16, 2019, the current median home value in the U.S. was $229,600 and the current monthly rent was $1,569.
This means that the median annual rent is: $1,569 x 12 months = $18,828 and the price to rent ratio in the U.S. is: $229,600 median home value / $18,828 median annual rent = 12.2 (rounded up).
The Zillow Research page is an excellent resource to use to drill down on housing data by metro area, state, county, city, zip code, and neighborhood. Housing data reports available online include:
- Home values
- Home listings and sales
- Rental values
- Rental listings
- Mortgage and rent affordability
- Mortgage rates
- Median household income
- Price-to-income ratios
United States Department of Labor
Real estate investors looking to compare real-time housing data from Zillow to historical housing market and economic trends will find everything they need from the Bureau of Labor Statistics at the United States Department of Labor.
In a recent Beyond The Numbers report, the BLS compiled data from the National Bureau of Economic Research and the U.S. Census Bureau. The report tracks housing market performance metrics and economic data from 1995 to 2016 (the most recent year available):
- Median and average prices of new homes
- Homeownership rates by region
- Homeownership rates by MSA (metropolitan statistical area)
- Homeownership rates by urban and rural areas
- Average monthly mortgage outlays
- Average monthly homeowner housing expenditures by MSA
- Percentage of individuals who rent by region
- Average monthly rent paid by renters by region
- Monthly rental expenditures for urban, central city, and rural areas
- Monthly rental expenditures by MSA
How Real Estate Investors Use The Price to Rent Ratio
Big picture data on a city-level provides valuable insight on potential rental property investment opportunities. However, drilling down and analyzing data in smaller geographic areas, such as neighborhoods and zip codes, provides investors with the valuable information they need when researching a specific real estate market area.
Here’s an example of how you can use all of the housing data you’ve compiled to research and target cash flowing properties for investment. To use this method, you’ll need a very basic understanding of how to use spreadsheet software like Excel or OpenOffice.
- Download the Zillow ZRI (Zillow Rent Index) spreadsheet report for single-family rentals by zip code or neighborhood.
- Download the Zillow ZHVI (Zillow Home Value Index) spreadsheet report for single-family home values by zip code or neighborhood.
- Save the ZRI spreadsheet by another name such as ‘Price to Rent Index’ (PRI) so that you’ll still have the original ZRI spreadsheet to refer back to, if needed.
- Insert a column in your PRI spreadsheet next to the most recent rent data.
- Cut and paste the most recent home value data from ZHVI into the new column on your PRI spreadsheet.
- Create another new column on your PRI spreadsheet and enter the calculation to divide ZHVI home values by ZRI rents.
- Your PRI spreadsheet now has the price to rent ratio for each zip code or neighborhood on the report, depending on the report type you are using.
Using Price to Rent Ratio to Identify Investments
Knowing the price to rent ratio in your target area allows you to quickly narrow down potential single-family investment property. For example, let’s say the median home price in your target market is $135,000 and the median annual rent is $16,800 ($1,400 per month) for a price to rent ratio in your target market of 8.0:
- $135,000 Median Home Value / $16,800 Median Annual Rent = 8.0 (rounded)
If you see a rental property for sale with a price to rent ratio of 7.4 that means one of two things: 1) Property may be underpriced, or 2) Rent on that specific property is above market:
- $125,000 home value / $16,800 annual rent = 7.4
- $135,000 home value / $18,243 annual rent = 7.4
In the first example, the price to rent ratio is lower than the market norm because the property is underpriced, potentially offering a good opportunity for the investor.
In the second example, the price to rent ratio is low because the annual rent is above market. This creates the risk of the tenant not renewing the lease or of having to reduce the rent to keep the tenant.
Other Calculations and Factors to Consider
The price to rent ratio is just one of several formulas investors should use to analyze the financial performance of single-family rental property. Other investment property metrics to consider include:
- Cash flow: The amount of money remaining after all expenses, including the mortgage, have been paid
- Net Operating Income = Rental income + Other income – Vacancy loss – Operating expenses (except mortgage payment)
- Cap Rate = NOI / Property value
- Gross Rent Multiplier = Property price / Gross annual rental income
- ROI = Annual return / Total investment
- Cash-on-Cash Return = Annual pre-tax cash flow / Total cash invested
Investors should also research the general economic performance of each target market. Characteristics of a strong real estate market for rental property include:
- Consistent population growth above the national average
- Diverse economy with an expanding job market
- Low crime rate and good neighborhood ranking
- A high proportion of renters to homeowners
Looking For a Realistic Price to Rent Ratio Is Important
Some of the best rental markets have price to rent ratios that are mid-range. That’s because a low ratio may be a sign of weak demand for rental property. On the other hand, a ratio that’s very high can make it difficult to turn a profit due to a high purchase price.
The Roofstock Investment Property Marketplace is a great way to start learning about price to rent ratios in the markets you’re thinking about investing in. Property data also includes the current rent, cap rate, and total return.