What is Price to Rent Ratio?
Price to Rent Ratio is a metric calculated as the price of a property to its annualized rent and which helps in determining whether it makes sense to buy the property or rent it considering various factors involved in making each scenario lucrative at the same time pointing out the drawback of each, therefore it helps the home-seeker in making an informed decision.
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For eg:
Source: Price to Rent Ratio (wallstreetmojo.com)
Price to Rent Ratio Formula
The formula to calculate the price to rent ratio is represented as below:
- However, as the figures vary quite a lot when we move from suburbs to metros within a country, using an average is not highly advisable statistically as the average metric can be affected by the effect of the outliers.
- So, at times we replace average figures with median figures; however, due to lack of data availability, this switch is not always possible, so usage of average is still quite prevalent.
Example of Price to Rent Ratio Calculation
According to a study published by the name of, “The state of the Nation’s Housing 2018” by the Joint Center for Housing Studies (JCHS) of Harvard University, The median sales price of a newly constructed house in the US was $323,100, and the average price was $248,800, and according to the same study, the average monthly rent varied between $1500 and $2000 depending upon the areas surveyed. Therefore an annual rent would be somewhere near $24,000.
Solution
Calculation of Price to Rent Ratio
- = 248000/24000
- Price to Rent Ratio = 10.33
If we use the average monthly rent of 1800, then the ratio would be calculated as:
- = 248000/18000
- Price to Rent Ratio =13.78
It is a convention that when this figure is below 15, it is better to buy the house while if it is above 15, then we should rent the house.
Even the outcome of the above-mentioned study, which analyzed the current trends in the Housing market, conveyed that the population was edging towards homeownership and that there was a bump in the home renting trend.
This result was arrived at after surveys and data collected by the US Census Bureau, and analyzing the actual numbers instead of calculating the above ratio; therefore, we can say that the study in a way verifies what the ratio implies.
It is a known fact that right before the crash of the housing market in 2007, the Price to rent ratio had become very high and had crossed the mark of 20. This was due to the bubble that was created around the housing market that over-inflated the market prices of the houses.
Advantages and Disadvantages of Home Ownership
Although some of the countries have different benefits and costs for home-ownership, in general, they are more or less similar.
- Stability: Once people are at a certain stage of life, where they can see a future in a certain city, they plan on making long term living arrangements and therefore prefer buying a home to avoid the renewal of the rent agreement and the possibility of having to move to another home in case of nonrenewal.
- Tax Deductions: In the US, the interest on mortgage and the property tax are exempt from taxation in case of homeownership; therefore, that helps in reducing the tax liability of the owners.
- Capital Appreciation: The prices of homes increase, so, in general, the homeowner benefits from selling it at the appreciated price. It helps a lot if the purchase price is very low because then the return is high.
- Old-Age Benefits: Once the entire mortgage is paid off, the homeowner doesn’t need to worry about a regular expense in his old age, however, in the case of rented homes. They still have to pay the rent when the income is low as most old age people live on pensions or fixed incomes.
- Expensive: Mortgage payments are higher than rent payments, in general; therefore, the expense is higher, and defaulting on payments may cause a bigger loss because the previous payments become a sunk cost in case of default leading to foreclosureForeclosureForeclosure refers to the legal action taken by the lender when the borrower fails to repay the amount due against the mortgage loan. The lender can take the possession of mortgaged asset or property or resale it to a third party for recovering the default loan amount.read more.
- Repair and Maintenance: Owning a home makes the owner responsible for the repairs and maintenance of the home, and that is a big expense if such repairs are frequent. Therefore due diligence should be done before buying a home.
- Mortgage: Home loans are long term liabilitiesLong Term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). read more, and therefore, one needs to be sure of having a long term inflow stream that enables the owner to pay off the mortgage.
Advantages and Disadvantages of Renting
- Flexibility: At the start of their careers, people need the flexibility to be able to switch cities easily; therefore, they prefer renting. Also, as income increases and life requirements change, people need to move on to bigger and more appropriate places, renting enables them to do it quickly
- Cost-Effective: Maintenance, repairs, property taxes, etc. are the responsibilities of the owner, while the renter only needs to worry about the rent, so initially, renting is a cheaper option when people are starting a career.
- Amenities: Generally, apartment complexes have sporting and fitness amenities, among others, which give the renters the convenience of having such facilities in close vicinity and paying only a limited amount for using them as compared to getting membership of a club that provides such facilities.
- Lack of privacy: Rented places are available in a community format, and people who desire privacy and quiet are not able to get it.
- No tax benefits: Owning a home brings tax benefits and reduces tax liabilities, and therefore renter may lose out on the same
Conclusion
A good way to decide whether to buy or rent a home could be comparing the present value of all the mortgage payments and other costs of ownership and the benefits of the same and arriving at net present value. Next, doing the same for renting the home, by finding the PV of the future rent payments after incorporating the expected inflation. Doing so will give us which option is better suitable.
In a way, the Price to Rent Ratio does the same. Although the ratio will always be higher than 1 because the rent would never be higher than the cost of owning the place, however, factoring the advantage of owning should justify the owning decision; otherwise, renting is more appropriate. If the former is the case, then the ratio would be higher; otherwise, it would be lower.
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