Price to Rent Ratios

One thing about stocks that’s confusing for many people are the new valuation metrics that always seem to be springing up. Whether it’s PEG, beta, EBITDA, or whatever. Some magic combination of all the right metrics will tell you the secrets of the universe and which stock will be the next Coca Cola/Wal-Mart/Microsoft/Google. Things are a bit simpler in real estate. Generally, in fact, real estate investors don’t seem to use any fancy metrics at all. That’s not to say real estate investors don’t analyze their investments. They do, they project fair value for the property and generally do a cash flow analysis. One metric that economists and some investors have used to compare real estate values is price to rent ratio.

Price to rent ratio is basically the real estate equivalent to the stock measure known as price to earnings ratio (p/e ratio), the older brother of PEG (price to earnings divided by the projected growth rate). To figure the price to rent ratio for a particular property, first conservatively estimate what you think the property would rent for on the open market. If the property is currently rented, it’s a safe bet to say you can just use whatever the property is currently renting for (assuming all the units are filled). You then compare that number to the purchase price of the property.

For the sake of simplicity, let’s say the property is a single family home that will cost you 100k, and you believe that you’ll be able to rent the property for no less than $1000. The property would therefore produce $12,000 (12 months x 1k) worth of income before expenses (taxes, insurance, maintenance, repairs, etc.). The price to rent ratio, then, would be 8.33 (100k/12k). Do we know if this is a good investment property? I would say that we don’t (although that sounds like a pretty attractive ratio to me). There are other factors to consider before we can judge how good of a ratio that actually is – namely the opportunity costs. What else could we do with the money to receive a similar return? What is the price to rent ratio on other available properties? How much leverage is involved, and at what rate? What can we expect the cash flow situation to be like?

The answers to these questions, will, of course, for the most part depend on the particular market and situation. If the average price to rent ratio in an area is 30 (like a San Francisco), then this is obviously a better deal than if it were 15 (though it still looks like a good deal).

If you have potential cash flow issues, this is something to consider as well. As a rule of thumb, you should count on between 35-45% of the income to be eaten up in expenses (I know that sounds high). In our case, 45% (following a rule of conservatism) of 12k is $5400. Assuming 20% down, a 30 year term and a 5.5% annual rate, we’re looking at about another $5500 per year in mortgage payments. The sum of those numbers is $10,900. That number, subtracted from our original 12k, leaves us a net of just $1100. That assumes full occupancy, too. Of course, those mortgage payments are slowly building you equity in a potentially valuable asset, but even with a price to rent ratio of just 8.33, potential cash flow problems immediately arise.

Opportunity cost is an immediate issue. If you can get a 5% return on highly rated (safe) corporate bonds, you could invest your 100k for a low risk return of 5k. That obliterates our $1100, and we’re taking on considerably less risk (in theory, at least – companies can fail, too, of course). This of course ignores the benefits we receive from leverage (which any real estate loyalist will immediately cite). Our investment in this scenario was really only 20k (our down payment), which makes our $1100 net return actually at about a 5.5% return. Of course, we should probably add the $5500 in mortgage payments to this investment, knocking our $1100 net down to about 4.3%.

If you bought the property outright (all 100k) and subtracted just the $5400, you’d be left with $6600 for a tidy 6.6% – probably outperforming what you could generate from a AAA rated corporate bond.

Of course, all of these numbers ignore the fact that the property has the ability to appreciate. While this is a real possibility, you should not invest in a property counting on general widespread market appreciation as part of your return. If you can buy a property at a discount price, obviously, you’ll have equity already built in. This is another way to earn returns in real estate and is one of the ways real estate has the potential to outperform safer investments.

Price to rent ratios, are not, of course, a perfect metric for the health of the overall market. You’ll have to consider inventory levels (read – supply) and issues in the credit markets – both currently important drivers of price in the wrong (or right, if you’re a buyer) direction. Anyway, I hope you found something useful in this post. Weigh in on price to rent ratio by email or in the comments. Thanks for reading.

PS – In other news, The PFP was recently included in a blog carnival. Check that out here.