When purchasing an investment property, the price-to-rent (PTR) ratio is one of the metrics that you should look into. It indicates whether or not a property would make a profitable investment, and if people would actually prefer to rent in the first place.
In this article, we explain the purpose of the price-to-rent ratio and its importance to property investors.
What is the price-to-rent ratio?
In real estate, the price-to-rent ratio is used to determine whether it would be more affordable to own or rent a home in a specific area. Simply put, the price-to-rent ratio answers the question, “Would it make more financial sense for someone to rent rather than own a single-family home?”. It compares the annual rent of the property to similar properties for sale.
Calculating the price-to-rent ratio is pretty straightforward. Simply take the median sales price (i.e. the average price of homes for sale) and divide it by the median annual rent. For example, if the median sales price is $400,000 and the median rent is $2,000 per month, then the price-to-rent ratio would be 16.6 ($400,000 / $24,000).
What does the price-to-rent ratio tell property investors?
Property investors such as yourself can use the price-to-rent ratio to your advantage. It indicates whether a prospective property would be appealing to potential renters, or if renters would be better off buying a home.
Generally, if the price-to-rent ratio is high, that means that the median sales price is higher than the annual rent price. Hence, it would be more economical for someone to rent rather than own. If you’re planning on purchasing a property to rent it out, you should ideally invest in one that has a high price-to-rent ratio.
On the other hand, if the price-to-rent ratio is low, this indicates that homes in the area are relatively affordable. This means that it would be more economical for someone to own instead of rent.
Price-to-Rent Ratio Cheat Sheet
The price-to-rent ratio is dependent on the median sales price and median rent price of the area. Here’s how to interpret the results:
- If the price-to-rent ratio is below 15, this means that it’s better to buy than rent.
- If the price-to-rent ratio is between 16 to 20, this means that it might be better to rent than buy.
- If the price-to-rent ratio is above 21, this means that it’s better to rent than buy.
If you’re unsure about your calculations, you should consider enlisting the services of an investment adviser from a property management firm.
Does a high price-to-rent ratio mean low rent prices?
Since a high price-to-rent ratio indicates that it would make more financial sense to rent, does this also mean that rental prices are low? The short answer is no.
It’s important to remember that the price-to-rent ratio only contemplates whether it is “better” to buy or rent a home in a specific area. It does not imply that rental rates are either high or low.
San Francisco, for example, has a high price-to-rent ratio. This means that it’s more affordable to rent than own. But, as you might be aware, the rental rates in San Fran are extremely high. The price-to-rent ratio simply indicates that renting a home (even in an expensive area like San Fran) makes more financial sense. It does not imply that rental rates are low.
Where can you find price-to-rent ratios?
Price-to-rent ratios aren’t static, so an accurate compilation of price-to-rent ratios in the U.S. doesn’t exist. Hence, it would be better to calculate the current price-to-rent ratio yourself.
You can check websites such as Zillow and Opendoor for up-to-date information on median home values and median rent prices. Or, if you’ve hired a property management company, they can calculate the price-to-rent ratio for you.
Should investors always invest in properties with high price-to-rent ratios?
Currently, cities such as Oakland, New York, and San Jose have some of the highest price-to-rent ratios, but that doesn’t mean that properties in these areas are automatically “ideal” investments.
For example, if you were to buy a rental property in New York, you would have to spend a significant amount of money on a single property. Although the price-to-rent ratio is high, you may miss out on the opportunity to diversify your portfolio. As a property investor, you shouldn’t put all of your eggs in a single basket.
That’s why it is smart to work with a property manager or investment adviser. Enlisting their services means that you can invest in several properties across different markets. By conducting a comprehensive investment property analysis, they can help you find cheap properties for sale that still offer high price-to-rent ratios.
Remember, just because the price-to-rent ratio is high doesn’t mean it’s the right investment. You can still invest in properties with high price-to-rent ratios that are for sale for a lot less.
What other factors should you consider?
The price-to-rent ratio is one of many metrics to consider when it comes to property investments. Before buying a single-family rental property, you should also look into the following:
- Cash Flow. This contemplates how much money you’ll have after deducting all of the expenses, eg. mortgage and utilities.
- Cap Rate. Also known as the capitalization rate, this measures the profitability of a property.
- Gross Rent Multiplier. The GRM determines the potential profitability of an investment property.
- Return on Investment. The ROI measures the amount of profit you may make on an investment.
These calculations can be complicated, so consider asking a real estate professional such as a property manager in South Florida for help.
As you can see, you shouldn’t invest in a property with a high price-to-rent ratio right away. Ask any property manager and they’ll tell you that, most of the time, the best investments are the ones that have average price-to-rent ratios. This is because a low ratio indicates weak demand, while a high ratio indicates a high purchase price.
Luxury Property Care can help you with all of the necessary calculations. As a full-service property management firm, we’re committed to providing our clients with information on the current rent, sales price, etc., so that they can make informed decisions when it comes to their investments.