A lot of the information floating around out there on price to rent ratio is targeted towards homebuyers.
But, the price to rent ratio can be a powerful indicator of where to invest in real estate for rental properties. That’s why as the successful real estate investor you aim to be, you need to know how to use price to rent ratio.
Price to Rent Ratio Defined
The price to rent ratio is just that; it’s a ratio that compares the average property price of a real estate market to the average annual rental income. Of course, for the price to rent ratio to be of any use, this kind of real estate market data has to be accessible. With online platforms, like Mashvisor, a real estate investor can get access to data related to the property price and monthly rental income of any US housing market. Not only will this kind of real estate analytics help you find the price to rent ratio, but naturally it will drive your real estate investment decisions.
What Does It Indicate for Real Estate Investing?
What this value indicates is whether or not a real estate market is a good option for buying a property or renting one based on relative affordability of the two options. This is where it is important to differentiate the use of this real estate value for homebuyers and real estate investors.
When it’s a good real estate market for the average person to buy a home, it’s not a great real estate market for an investor to buy rental property in. Why? Because unless you’re implementing a fix and flip strategy or buying up investment property at below market value to sell soon after, you’ll want tenants to give you cash flow from rental income. The price to rent ratio is a simple indicator of what the demand for a rental property in a market will be like. If this value is telling everyone that the real estate market is a great place to buy a home, there will likely be fewer tenants looking to rent your investment property; demand will be lower and so will your rental income.
So, in a market where the price to rent ratio indicates it’s a great place for buying a home, steer clear. When the price to rent ratio indicates that it’s more affordable to rent a property, run to that real estate market and buy an investment property.
What the Price to Rent Ratio Is Not Telling Investors
Unfortunately, as powerful as an initial assessment the price to rent ratio may give us, it does fall short. That’s because it doesn’t indicate the following things:
- The details of the condition/state of a real estate market
- Is the market a buyer’s market or seller’s market?
- The affordability of an investment property in the real estate market
- The rental expenses
- The return on investment or cash flow
So, while the price to rent ratio can be a great way to help you hone in on a real estate market, it doesn’t provide the complete real estate investing picture you need to make a sound investment.
How to Calculate Price to Rent Ratio
Let’s take a look at the Los Angeles real estate market 2018 to see what a real price to rent ratio looks like this year. The price to rent ratio formula is as follows:
Price to Rent Ratio= Average Property Price/ Average Annual Rental Income
For the Los Angeles real estate market 2018:
Average Property Price: $969,000
Average Monthly Rental Income: $2,140
Price to Rent Ratio= $969,000/ ($2,140*12)
Price to Rent Ratio= 38
All values are provided by Mashvisor’s real estate investment calculator. To learn more about our product, click here.
What Is a Good Price to Rent Ratio?
So, if you’ve looked up “what is a good price to rent ratio”, these are the ranges and what they indicate that you’re likely to come across:
1-15: It is a better option to buy a property than to rent
16-20: It is a better option to rent than to buy a property in most cases here
21 or higher: It is a much better option to rent a property than to buy one
The problem with that? It’s tailored to homebuyers and not real estate investors. I have seen many beginner real estate investors follow that advice, thinking they were making the right move based on affordability. The truth is, when/if it’s a sound financial move, you should be investing in real estate in a market where the average person cannot buy a house. As mentioned, this drives the demand for your rental properties.
So, here is how the price to rent ratio should drive your investment decision:
1-15: This may not be the best real estate market to invest in real estate
16-20: This market will offer plenty of great opportunities to invest in real estate rental property
21 or higher: Here is the best real estate market to invest in rental property, according to this ratio
The Los Angeles real estate market 2018 then would make for one of the best places to invest in real estate if you can afford it.
Want to invest in Florida this year? Read “Buying an Investment Property 2018: The Highest Price to Rent Ratio Markets in Florida” to choose from the best cities to invest in real estate.
Price to Rent Ratio vs. Cash on Cash Return vs. Cap Rate
Because you won’t be using the price to rent ratio alone in your investment property search, it’s key to understand how it differs from other important metrics.
Price to Rent Ratio vs. Cash on Cash Return
There are two major differences between the price to rent ratio and the cash on cash return. Let’s take a look at the cash on cash return formula:
Cash on Cash Return= Net Operating Income/Total Cash Investment
The first difference comes in the net operating income (NOI). This is essentially the cash flow that a real estate investor would receive from a rental property. It is the total annual rental income- rental expenses. Remember, the price to rent ratio does not take into consideration any expenses accumulated by an investment property.
The second difference is the total cash invested. This isn’t the same as the price of the investment property unless you forgo traditional investment property financing with a mortgage and pay in all cash. For the cash on cash return, the total cash invested is the down payment, closing costs, rehab costs, and any other fees paid to obtain the investment property.
The average cash on cash return can also be found for a real estate market. However, while the cash on cash return will help real estate investors determine the return on investment, the price to rent ratio will not.
Learn More: What Is a Good Cash on Cash Return?
Price to Rent Ratio vs. Cap Rate
These two metrics are more closely related. Here is the cap rate formula:
Cap Rate= NOI/Property Price
Again, because the NOI includes rental expenses, this makes the average cap rate a different kind of evaluation of a real estate market than the price to rent ratio. Where they are similar is the element of the property price/value.
Just like with the cash on cash return, the average cap rate can give a good idea of the kind of return on investment received in a real estate market while the price to rent ratio will not.
The Ultimate Metric in Real Estate Investing?
No such thing. If you want true success with a real estate investment, make sure you look at all of the numbers for an investment property. The price to rent ratio can help you narrow down thousands of real estate markets to a handful. From there the cap rate and cash on cash return will help you choose the best place to invest in real estate and the best investment property as well.
Looking for the best way to choose a location for real estate investing? Mashvisor has pre-calculated metrics for the US real estate market neighborhoods to help you make the best choice. Sign up today for a 14-day free trial and avoid the hassle of manual data gathering and calculations.