Price-to-Rent RatioIs it better to rent or buy a home?

Renting or buying a home… which of the two is the better choice?

For those looking for a short or temporary stay, renting would probably be the better choice.

But what about those looking for a more permanent stay?

Would buying be the better choice?

Or is there an argument as to why renting would be the better financial decision?

These are questions that any new homeowner would probably ask themselves.

And they’re right to ask these questions.

After all, renting or buying a home is a big financial decision.

But how can one tell whether it’s better to rent or buy a home?

To help with this important decision, a new homeowner may want to take a look at the price-to-rent ratio.

Basically, the price-to-rent ratio compares the price of homes to their annualized rent in a given location.

In this article, we will be talking about the price-to-rent ratio.

What information does it tell us?

How can it help in deciding whether it’s better to rent or buy a home?

Aside from helping homebuyers in deciding whether to rent or buy, what else can the price-to-rent ratio do?

Let’s try to answer these questions as we go along with the article.

What is the Price-to-Rent Ratio?

The price-to-rent ratio is a metric that compares home prices to annualized rent in a given location.

It helps in identifying which is the better choice between buying or renting a home.

This allows buyers or renters of homes to evaluate the two choices with just a single equation.

Basically, the price-to-rent ratio suggests better and more affordable living arrangements.

Because of this, the price-to-rent ratio is one of the most common tools that new homeowners use to determine whether it’s better to buy or rent a home in a given location.

The price-to-rent ratio does more than just that though.

It is also an important metric in the world of real estate.

Investors in real estate use the price-to-rent ratio to identify the best places to buy rental properties.

They either use the ratio itself or derive the annualized rent from it.

From there, these investors will identify which places are likely to have a higher demand for rent.

Neighborhoods with relatively lower rent prices tend to have higher demand that their higher-priced counterparts.

Here’s a general guideline for interpreting the price-to-rent ratio:

• Is the price-to-rent ratio not more than 15? If the price-to-rent ratio shows a figure of 15 or less, it suggests that it’s cheaper to buy than rent a home.
• Is the price-to-rent ratio within 16 to 20? If the price-to-rent ratio shows a figure of 16 to 20, it suggests that it may be better to rent than to buy a home
• Is the price-to-rent ratio 21 or higher? If the price-to-rent ratio shows a figure of 21 or higher, it suggests that it’s definitely better to rent than to buy a home

All in all, the price-to-rent ratio is a great tool in determining whether it’s financially better to buy or rent a home.

The Price-to-Rent Ratio Formula

Calculating the price-to-rent ratio is pretty straightforward.

You only have to divide the median sales price of homes in a particular area by the median annual rent amount. Put into formula form, it should look like this:

Price-to-Rent Ratio = Median Home Price ÷ Median Annual Rent

You may also use the average home price and average annual rent instead of using their median counterparts.

Do note that the median refers to the middle value when you arrange all the values from lowest to highest.

Let’s have an example. Let’s say that the median home price for a particular neighborhood is $600,000.

The median annual rent for this neighborhood is $42,200. Let’s calculate the price-to-rent ratio:

Price-to-Rent Ratio = Median Home Price ÷ Median Annual Rent

= $600,000 ÷ $42,200

= 14.22

As per our calculation, the price-to-rent ratio is 14.22.

This suggests that buying a home in this particular neighborhood is a better financial choice rather than renting there.

Let’s have another example.

Only this time, we’ll be using the average figures rather than the median.

Let’s say that a particular neighborhood has an average home price of $780,917 and an average annual rent of $23,569.

Let’s calculate the price-to-rent ratio for this particular neighborhood:

Price-to-Rent Ratio = Average Home Price ÷ Average Annual Rent

= $780,917 ÷ $23,569

= 33.13

As per our calculation, the price-to-rent ratio for this particular neighborhood is 33.13.

This means that it’s better to rent than to buy a home in this neighborhood.

For investors of real estate, they might interpret it as a place that’s good for rental properties.

As you can see from our above example, calculating the price-to-rent ratio is simple.

The challenge lies in gathering the required variables.

Limitations of the Price-to-Rent Ratio

One of the advantages that the price-to-rent ratio has is that it’s simple to use.

To calculate it, we only need two figures. And depending on the resulting figure, we can have an idea of whether it’s better to buy or rent a home in a particular location.

However, this simplicity comes with a cost.

The price-to-rent ratio fails to consider certain factors in its calculation.

One of these factors is the prevailing interest rates in the area.

Depending on the interest rates, the cost of buying a home may be more affordable or more expensive.

This may not matter much if the buyer is planning to pay the whole amount in cash.

But for those who consider getting a loan to buy a home, the interest rate matters.

Another factor that the price-to-rent ratio ignores is the overall affordability of buying or renting in a particular market.

For example, two cities may show the same price-to-rent ratio but have widely different home prices and annual rent amounts. One city could be significantly cheaper than the other.

The price-to-rent ratio also fails to account for “the cost of living” in such locations.

The price of the home or its rent amount is only one aspect of owning or renting a home.

Once situated in such a home, you will be incurring costs, which aptly refer to as the cost of living.

An area’s cost of living can greatly affect the decision of to whether buy or rent a home in a particular.

Unfortunately, the price-to-rent ratio does not account for it.

To make up for all of these limitations, the buyer or renter must not solely rely on the price-to-rent ratio.

Use it alongside other metrics that make up for its lack of accounting for the above factors.