Why I rent (even though I could buy) – Price-to-rent ratios

One rule of thumb in determining whether it’s better to buy or rent a home is the ratio of the price of the home to the cost of renting the home (actual or estimated.)  15 times annual rent  is one starting point.  (I’ve also read 150 – 200 times monthly rent, which equates to 12.5 – 16.7 times annual rent.)  For example, if a house was selling at $300,000 and it (or a very similar place) could be rented for $15,000 per year ($1250 per month), that house’s ratio would be 20, meaning it would be better to rent it than buy it.

I read an article on CNN Money that looked at 10 cities to either buy or rent in depending on the ’15 times annual rent’ rule for average home prices.  Seattle, my hometown, came in at 25 times rent, meaning it’s generally better to rent rather than buy (from a financial perspective.)  As the article shows, the general trend is that desirable coastal cities (Manhattan, San Francisco, Portland [Oregon]) tend to be overpriced using this metric, meaning it may be better to rent than buy in these cities.  Midwestern and Southern cities (Minneapolis, San Antonio) tend to be undervalued, meaning it may be better to buy than rent.  (There are other reasons why you might do one thing or the other, but I won’t get into them here.)

While useful, one problem with this simple ratio is that it doesn’t account for growth rates in real estate in these various markets.*  Presumably, home prices in markets with higher price-to-rent ratios like the coastal cities are likely to grow faster than sleepier midwestern cities.  Thus, some adjustment for growth should be made for a better evaluation.

Lastly, while knowing this average ratio for a whole city is a good starting point, one should always do the calculation for each property.  Even in a city where property is cheap relative to rents, it’s possible to overpay on an individual property.  Similarly, in a city where real estate is expensive compared to rents, you can still end up paying too much rent given the worth of the property.

Remember to account for homeowner’s dues if the property you’re considering is a condo or townhouse where such fees apply.  (As an arbitrary way to compare apples to apples, take the monthly dues and multiply by 60 and add that result to the purchase price of the condo.  Use that adjusted value as the ‘true’ cost of buying for the purposes of the above calculation.)

The graph below shows some housing data for various cities (circa April 2010.)  The skinnier bar at the bottom for each city corresponds to the price-to-annual rent scale at the bottom of the graph.  The fatter bar at the top for each city corresponds to the foreclosure rate scale at the top of the graph.

* For investing geeks, the Price-to-Rent ratio for homes is similar to Price-to-Earnings ratio for stocks.  The PE ratio also doesn’t account for the future growth of companies.  Hence, fairly valued high-growth technology stocks tend to have higher PE ratios than fairly valued, mature consumer goods companies.  Even so, the PE ratio is a useful starting place since the market often overvalues high-growth stocks under the false assumption that the steller growth rates will continue indefinitely, which they never can.  (Think of the tech boom when we saw PE ratios at astronomical levels of 100 – 200, suggesting that investors expected such companies to maintain absurd growth rates well into the future.)

The PE ratio can be adjusted to account for growth by dividing by historical/expected growth rates to get the PEG ratio.  Like all ratios, the PEG is fraught with its own problems as well.

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2 Responses to “Why I rent (even though I could buy) – Price-to-rent ratios”

  1. Greg Uratsu Says:

    Ward Ward Ward how you’re so wrong again. Yes you’re right, I did make the mistake of buying, but you sir are making a mistake in renting when you can just build a house out of garbage, mud, and sticks.

    -Greg

  2. Find out how your rent compares and then save on it! « Words of Ward: Ward's Guide to Personal Finance and Investing Says:

    […] save on it! December 22, 2010 — Ward Williams As you may know from reading my articles on home-buying, I’m not a huge fan of buying real estate.  Instead, I prefer (and counsel […]


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