Price to Rent Ratio
The price-to-rent ratio is the ratio of residential real estate prices to the annual rents that can be earned from that real estate.
Price-to-Rent Ratio = Real Estate Price / Annual Rent
The price-to-rent ratio measures the value of a home compared to the income that it could earn in the same way that the price-to-earnings ratio measures value for stocks — it indicates the potential earnings for a given investment. It can also be useful in comparing different properties.
Market prices can fluctuate depending on the local economy, but when prices deviate significantly from the income that it can earn, then over time, prices will move in such a way that the price-to-rent ratio will tend to revert to the average. Therefore, if the price-to-rent ratio is higher than the historical average for the locality, there is a higher probability that the price will decline or not rise as much as for a property where the price-to-rent ratio was near the historical average at the time of the purchase. Likewise, if the price-to-rent ratio is low, then there is a greater probability that its purchase would be a good investment.
The price-to-rent ratio can also indicate whether owning or renting makes better financial sense. The average ratio for 1987-2007 has been about 15 (source: Home Prices Seem Far From Bottom), meaning that home prices were 15 times the annual rent that could be earned from the homes. During the real estate bubble of 2005 - 2007, the price-to-rent ratio increased to more than 20 times in some areas. A general guide is that renting is preferable if the price-to-rent ratio is greater than 20, whereas buying is better if the ratio is less than 15. If the ratio is between 15 - 20, then buying makes more sense if the buyer intends to live in the house for a long time.
Example—Calculating the Price-to-Rent Ratio
If a residential home cost $200,000 and rents for $1,000 per month, what is its price-to-rent ratio?
Annual Rent = $1,000 x 12 = $12,000
Price-to-Rent Ratio = $200,000 / $12,000 = 16.67
According to Run-up in the House Price-Rent Ratio: How Much Can Be Explained by Fundamentals?, published May, 2011, lower lending standards and interest rates from 1995 to 2005 increased house prices and allowed more people to buy a house, which, in turn, kept rents down, causing the price-to-rent ratio to increase dramatically.