To invest or not to invest, that is the question.
Choosing the right property to invest in can be a challenge. That’s why South Florida property management companies rely on certain metrics, such as the cash flow, cap rate, gross rent multiplier (GRM), net operating income (NOI), and more. If you’re a first-time property investor, one of the metrics you should study is the price-to-rent (PTR) ratio. It’s one of the easiest metrics to measure and it can tell you a lot about a prospective property.
In this article, we’ll walk you through the specifics of the price-to-rent ratio, so that you can decide whether or not to purchase a property.
What is the price-to-rent ratio?
In real estate, the price-to-rent ratio is used to determine the demand for rental properties in a particular market. It answers the question, “Would it be cheaper for someone to buy or rent a home in this area?”
The PTR ratio is calculated by dividing the median house price by the median annual rent. For example, if homes are sold for around $300,000 and are rented out for around $1,500 a month, then the calculation would look like this:
$300,000 / ($1,500 x 12) = 16.66
In this example, the price-to-rent ratio would be 16.66. So, what does this number mean?
If the price-to-rent ratio is high, that means that it would make more financial sense for someone to rent. On the other hand, if the price-to-rent ratio is low, it would be more favorable to buy a home. Here’s a cheat sheet for your reference:
- If the price-to-rent ratio is < 15, it would be cheaper to buy than to rent.
- If the price-to-rent ratio is between 16 and 20, it’s probably better to rent than to buy.
- If the price-to-rent ratio is > 21, it would be better to rent than buy.
As a real estate investor, you should purchase properties in markets with a high price-to-rent ratio. This is because the market is better for rentals. So, in our example, 16.66 indicates that it’s cheaper to buy than to rent, so you should think twice about investing in that market.
If it’s cheaper to rent, does it mean rent is also low?
When the price-to-rent ratio is high, this means that it would be more affordable to rent than to buy. However, the ratio doesn’t imply that rental rates are low. It simply means that someone can save more by renting than buying.
Let’s take New York, for example. New York, New York has a price-to-rent ratio of 36.38. This means that it makes more financial sense to rent. It doesn’t, however, mean that renting is affordable at all. We are all aware that real estate in The Big Apple can be eye-wateringly expensive. Both renting and buying aren’t affordable, but it would still be cheaper to rent than to buy.
What does the price-to-rent ratio tell investors?
By calculating the price-to-rent ratio, you can use it to:
#1 Determine where the demand is
One of the most important things to consider when investing in real estate is the demand for rental properties. In cities with a low price-to-rent ratio, homeownership is more affordable. Hence, you shouldn’t invest in these areas. Instead, stick to housing markets where the price-to-rent ratio is high.
#2 Monitor the housing market
The historical data of price-to-rent ratios can be very valuable. For example, if you notice that the price-to-rent ratio in an area was previously low but is now steadily rising, this could indicate that home prices have increased. This means that renting is becoming a better option.
#3 Determine your real estate investment strategy
If you’re interested in flipping a home like adding few pieces of furniture or replacing countertops with Cambria, look at markets with a low price-to-rent ratio. There, you can find several cheap properties that you can renovate and profit from. On the other hand, if you’re interested in investing, you should stick to cities with a high price-to-rent ratio, as these will generate the highest returns.
As an investor, you shouldn’t always invest in properties with a high price-to-rent ratio. You could be able to profit off of them, but they could also be over-budget. For example, if a $250,000 home in San Francisco has a high price-to-rent ratio, you could buy it, but you’ll have a hard time turning a profit due to the high price.
You’re better off buying several cheaper homes that still have a high price-to-rent ratio, but you’ll get to expand your portfolio and reduce the risk at the same time.
Does this mean you should invest in areas with high price-to-rent ratios?
Not necessarily. It’s important to remember that the price-to-rent ratio is only one side of the story. People may prefer to rent, even if buying a home could save them more money. For instance, they may not be ready for the responsibilities of homeownership, or they have no plans on staying in one place for too long. In fact, some may neither rent nor buy. Many millennials are choosing to stay with their parents due to the pandemic.
Hence, aside from the price-to-rent ratio, you should also consider the following factors:
- Population growth
- Job market
- Employment growth
- Renter-to-homeowner ratio
- Employment sectors
- Household incomes
- School rankings
- …and much more
Although the price-to-rent ratio is a straightforward way of determining whether there is a demand for rental properties, it’s not the only metric to think about. To gain a deeper understanding of the market, you should enlist the property management services of a property manager.
The bottom line
To sum it up, properties with a high price-to-ratios are often smarter investments. However, you shouldn’t skip the other metrics as these can provide a clearer picture of the market. Take your time to decide — remember, real estate isn’t something you can return for an exchange. It’s one of the most important investments you’ll ever make, and it can also be one of the best if you do it right.
