Understanding the price-to-rent ratio can help you make informed decisions about real estate investments.
Here’s how it works, why it matters for real estate investing, and how to calculate it.
What Is a Price-To-Rent Ratio?
The price-to-rent ratio is a financial metric real estate investors use when evaluating investment properties, such as single family rentals. It is calculated by dividing the house price by the annual gross rental income it can potentially generate.
The ratio is an essential indicator for real estate investors because it provides insight into a given property’s potential return on investment (ROI). A lower ratio indicates that the property has good potential to generate long-term returns, while a higher ratio suggests that the property may not provide adequate returns over time.
The ratio can also be used to identify affordability and trends in the housing market and demand for rental property. Generally speaking, a low ratio indicates that people may prefer to buy rather than rent. On the other hand, a high ratio suggests that rents are relatively affordable compared to prices, making renting more attractive than buying.
Why Price-To-Rent-Ratio Is Important for Investors
By understanding the local market’s price-to-rent ratio, investors can gauge whether buying into that market will generate positive cash flow. The higher the ratio, the less likely an investor can achieve positive cash flow from renting the property out after deducting for operating expenses.
Another benefit of considering price-to-rent ratios is that they can indicate potential appreciation or depreciation of property values. While rental prices may remain relatively steady in a given area, the cost of purchasing property could increase due to supply and demand. This means markets with lower ratios could be good long-term growth areas.
How To Calculate Price-To-Rent Ratio
The calculation is easier than you may think since the equation is very straightforward. To determine the ratio, you will need to know the median home price in the area you are looking for and the average dollar amount of renting a comparable home in the same neighborhood for one year.
Once you have that information, divide the median home value by the annual rental rate to obtain the price-to-rent ratio. The formula looks like this:
- Median home value/Median annual rent = Price-to-rent ratio
For example, if a home is selling for $200,000 and the gross annual rental income is $20,000, the ratio would be 10:
- $200,000 home value/$20,000 gross rental income = 10.0
Note that a price-to-rent ratio that is good for a real estate investor may not be so good for a home buyer, and vice versa. Generally, a low ratio is good for investors because it means that the property generates more rental income relative to its purchase price. On the other hand, a low ratio could be bad for a renter because it is more cost-effective for homeownership, assuming they can afford to do so. The opposite is true for a high price-to-rent ratio.
Other Uses for the Price-To-Rent Ratio Formula
Provided that two of the three variables are known, real estate investors can also use the formula to calculate the property price and annual rental income. By doing so, they can avoid purchasing a property that may not provide the desired return on investment.
Calculating Home Price
Assume that an investor is considering purchasing a 3-bedroom single-family home as a rental. After establishing that the annual going rent in the market is $20,000 per year and the price-to-rent ratio is 12.5, the investor can rearrange the formula to determine an acceptable sales price:
- Median home value/Median annual rent = Price-to-rent ratio
- Home value = Annual rent x Price-to-rent ratio
- $20,000 annual rent x 12.5 = $250,000
Calculating Annual Rent
The formula can also be used to determine how much gross annual rental income a home should generate based on the home value and the price-to-rent ratio:
- Annual rent = Home value/Price-to-rent ratio
- $250,000 home value/12.5 price-to-rent ratio = $20,000 gross annual rent
Using the Historical Price-to-Rent Ratio
Price-to-rent ratios can significantly affect whether people choose to purchase a home versus rent one.
However, national price-to-rent ratios can change quickly and frequently. When home prices increase, more people turn to renting rather than buying. This increase in demand for rental property allows landlords to increase rents as leases come up for renewal.
According to research from Trading Economics, the price-to-rent ratio averaged 1.03 nationwide from 1970 to 2022. In the second quarter of 2022, the ratio reached an all-time high of 42.55. As of January 2023, it was 36.05.
The market has been experiencing an increase in rental rates and home values for the past ten years.
Price-To-Rent Ratio in Major Markets
Finding out the ratio of price to rent in major markets can provide a starting point of where to look for investment real estate. Here are the current ratios in some major U.S. cities. Home price data is from Zillow, and median annual rent data is from Zumper for 3-bedroom homes as of March 2023.
New York
- Median home value: $629,516
- Annual rent: $47,628
- Price-to-rent ratio: 13.22
San Francisco
- Median home value: $1,287,792
- Annual rent: $61,176
- Price-to-rent ratio: 21.05
Seattle
- Median home value: $831,102
- Annual rent: $40,200
- Price-to-rent ratio: 20.67
Oakland
- Median home value: $797,927
- Annual rent: $41,700
- Price-to-rent ratio: 19.13
Baltimore
- Median home value: $173,751
- Annual rent: $19,500
- Price-to-rent ratio: 8.91
Detroit
- Median home value: $71,285
- Annual rent: $14,400
- Price-to-rent ratio: 4.95
Other Real Estate Metrics for Investors To Know
Besides calculating the price-to-rent ratio before purchasing an investment, there are other metrics that real estate investors should keep on hand. Some of these metrics include:
Net Operating Income
Net operating income (NOI) lets you know how much money you make from a specific investment property, like a high-level income statement. To find the NOI, subtract your total income from operating expenses, including any money you generate from parking spots, pet or roommate rent, and appliance rental. You should not include your mortgage payments in the calculation as they are not considered operating expenses.
Capitalization Rate
The cap rate is the ratio between a property's income and the original amount of capital invested into the property. The cap rate provides the percentage of profit that the investment accrued. You can find the cape rate by dividing your NOI by the property value: Cap Rate = NOI/Property Value.
Internal Rate of Return
Internal rate of return (IRR) estimates the return you will receive from your rental property over its holding period. When calculating the IRR, you will want to set the property’s net present value to zero and use projected cash flows for every year you hold the property.
Cash Flow
Cash flow indicates how successful or not your investment is. Determining your cash flow shows you how much money you have left at the end of the month once you’ve collected rent and paid all of your expenses, including the mortgage payment if the property is financed. A property has positive cash flow when income is higher than expenses and negative cash flow if expenses are greater than income.
Cash-on-Cash Return
The cash-on-cash return calculation shows the total return you will receive on your investment property. This metric is important as it includes both your mortgage and debt service. To calculate your existing return, divide your net cash flow (after operating expenses and debt service) by the total amount of cash you invested into the property or portfolio: Cash-on-Cash Yield = Annual Net Cash Flow/Invested Equity
Closing Thoughts
The price-to-rent ratio is a crucial financial metric for real estate investors when analyzing investment properties. It helps determine whether a property is overpriced or undervalued in relation to its rental income potential.
By comparing the price-to-rent ratios of different properties and markets, investors can make informed decisions about where to invest their money for the best returns. This ratio should not be the only factor considered when evaluating an investment property, but it is important to keep it in mind.
Discovering the ideal real estate investment for your needs can be complicated if you are attempting to navigate it alone. Numerous opportunities are available, but each carries its own set of potential risks.
Are you not yet ready to buy a property outright, but are you interested in the cash flow real estate offers? Arrived can help. Through our platform, you can purchase shares of rental properties and start building a portfolio today.
