Real estate investors want to know how to use price to rent ratio when making an investment decision.
Whether you’re a first-time investor or a seasoned one, you must have heard about the price to rent ratio. If not, here’s a quick definition – it is a metric that measures the relative affordability of renting vs. buying real estate property in a given housing market. Some real estate investors don’t pay much attention to this ratio as, when first reading the definition, it seems that it’s tailored to help residents (that is, homeowners and/or renters), not investors looking to buy rental properties.
Though the price to rent ratio is typically used by homeowners and renters to decide which makes more financial sense, that doesn’t make it useless in real estate investing! As a matter of fact, experts in the business advise investors to take this real estate metric into consideration before buying an investment property in a certain location. To understand how to use price to rent ratio, however, you need to know how price to rent ratio is calculated first. Keep reading as we explain how to calculate and then use the P/R ratio as a real estate investor.
Price to Rent Ratio Formula
So, how to calculate price to rent ratio? It’s actually really simple – all you have to do is find the average home price and the average annual rental income in the housing market where you’re thinking of investing in real estate and follow this formula:
Price to Rent Ratio = Average Home Price/ Average Annual Rental Income
For example, say you’re thinking of buying rental property in the Orlando real estate market. According to Mashvisor’s real estate data, the average price of homes for sale in Orlando is $339,654 and the monthly traditional rental income is $1,701 (meaning the annual average is $20,412). Therefore, the price to rent ratio for Orlando is 17.
Now, the price to rent ratio is generally divided into three categories. Each one will tell you something about the real estate market:
- 15 and below – Low: indicates that the average property price is relatively affordable compared to annual rent prices and that it’s better to buy a house than to rent one.
- From 16 to 20 – Moderate: indicates that the average property price is rather high compared to the annual rent price and that renting a house is typically a better option than buying one.
- 21 and above – High: indicates that the average property price is expensive compared to annual rents and that it’s definitely better to choose to rent a property over buying one in this real estate market.
You can find the home prices and rent prices of any housing market and get ready-to-use data using Mashvisor! To learn more about how we’ll help you make faster and smarter real estate investment decisions, click here.
How to Use Price to Rent Ratio When Buying an Investment Property
So that’s the answer to how is price to rent ratio calculated and what each ratio suggests to homeowners and/or renters in the housing market. Now you must be wondering how to use price to rent ratio as a real estate investor. While this real estate metric is simple, it’s also very telling. To make smarter real estate investment decisions, you can (and should) use the price to rent ratio to:
1- Find Out What the Demand for Rental Properties Is
One of the most important features of the best places to invest in real estate is the rental demand. As an investor, you should care about what the demand for rental properties is like because it’ll affect how much you can rent your investment property out for, your rental income, vacancy and occupancy rates – all of which affect your monthly cash flow. Of course, you want to own positive cash flow properties to get a good return on investment. Such properties, however, are only found in real estate markets with a high demand for rental properties.
How can real estate investors use the price to rent ratio here? As mentioned, the P/R ratio tells you if residents find renting or buying a house more affordable. Investors can use this information as an indicator of rental demand to see if they’re in a profitable location. For example, cities with the lowest price to rent ratio typically have fewer people looking to rent since a lower ratio tells residents that the market is affordable and a great place to buy a home. Therefore, a smart investment decision would be to find housing markets where renters can’t afford to buy. Demand for rental properties in these markets will be higher and so will your rental income.
2- Study the Housing Market Trends
Another way of how to use price to rent ratio when buying an investment property is to study market trends regarding property prices and rental rates. What you can do is try to find historical data for home prices and rental rates of the city or housing market where you plan to buy an investment property. Calculate the historical P/R ratio using this data and try to see if there are any trends worth looking further into.
Another thing to do is to compare the historical ratio with the current one and notice if there have been significant changes in the housing market. For example, the price to rent ratio in your location of choice may have been in the low category in previous years, but it’s slowly entering the moderate category. This could mean that the average home prices were relatively affordable compared to rental rates but are now increasing. If real estate market trends show that this increase in home prices has been happening for quite some time, this suggests they’ll probably keep rising – which makes renting a house a better choice for residents. As you can see, studying historical P/R ratio data and trends gives investors a better idea of whether it’s a good time to buy a rental property or not.
3- Narrow Down Your Investment Location
As every real estate investor knows, the location of an investment property plays a huge role in how much profit you can expect to make. Meaning, if you want to find a profitable real estate investment, you must first find a profitable location. There are several metrics that you can calculate on the market level to get an estimation of how profitable rental properties in a given housing market are. These include cap rate, cash on cash return and, of course, the price to rent ratio.
Here are some simple examples of how to use price to rent ratio for finding your investment location. Say that you had just decided to start making money from real estate investing, but your local market is not a good place to start a rental business. Now you’re trying to figure out where in the vast US housing market you should buy. To narrow down thousands of real estate markets to a handful, start by researching the price to rent ratio by city and selecting markets where the ratio is favorable for investors. Then, you can do more calculations and analyses to hone in on a single real estate market.
We’ve already done the first part for you and found The Best Real Estate Markets to Invest in the US for Price to Rent Ratio!
4- Choose the Best Real Estate Investment Strategy
You might be wondering “what is a good price to rent ratio for real estate investing?” While some might say to focus your investment property search on locations with a lower P/R ratio since it’s more affordable to buy, this is not always solid advice. The truth is, what makes a good price to rent ratio in real estate investing depends on a few factors, mainly your budget, property type of interest, and real estate investment strategy. Here’s how to use price to rent ratio when you’re trying to choose the best real estate investment strategy.
For example, if you’re interested in buying multi-family homes for investment and making rental income, then you shouldn’t be investing in cities with lowest price to rent ratio. As mentioned, these cities will have a lower demand for rental properties and, thus, won’t generate good rental income nor positive cash flow. Instead, this investment strategy would be profitable when investing in cities with highest price to rent ratio – if your budget allows it.
On the other hand, if you’re implementing a fix-and-flip investment strategy, then a low P/R ratio makes sense. This is because you can find cheap investment property for sale which you can renovate to increase its value. In addition, the fact that residents can afford to buy homes in such real estate markets means that you’ll have a large pool of potential buyers to choose from when the time comes to sell the investment property. Hence, you’ll maximize your profit from flipping homes when investing in cities with lowest price to rent ratio.
Final Notes for Real Estate Investors
As you can see, though the price to rent ratio formula is very simple, it can be very useful to a real estate investor. However, that doesn’t make it the ultimate metric to base your investment decisions on. While it’s a good starting point, there are limitations and problems with the price to rent ratio. For example, it doesn’t say if it’s a seller’s market or buyer’s market nor does it say anything about the market’s condition, economic growth, crime rates, rental expenses, and other factors that investors should look at. Remember, real estate investing is a numbers game. Successful investors are those who run all the important numbers before making any investment decisions.
So now that you know how to use price to rent ratio, the next step is to read more about how to do a real estate market analysis as well as investment property analysis to ensure investing in profitable properties in the best locations. You can learn all you need to know on our real estate investment blog and then use our tools to start analyzing cities and properties like a pro! To start your 14-day free trial with Mashvisor and subscribe to our services with a 20% discount after, click here.