The Price to Rent Ratio Says “Never Buy a House!”

It may not be Wednesday, but I find waffles a worthy breakfast treat ANY day of the week. Today’s post is brought to us by blogging friends from way out west: Waffles on Wednesday! Fetch yourself some of Canada’s finest organic maple syrup, tighten that bathrobe belt, slip on those reading glasses, and enjoy reading about the price-to-rent ratio. It’ll have you convinced why you should never buy a house!

——————–

We’ve discussed real estate a couple of times on our blog, and we’ve even gotten a bit of a reputation for being against owning real estate. Given that we live in one of the most bloated real estate markets in the country, it’s hard not to have it come up in discussion almost every time we’re talking with friends.

We constantly get asked if we are ever going to buy a house. Then we constantly have to reply “no.” We live in such a cost-inflated area, it just doesn’t make sense. I always reference that the “Price-to-Rent Ratio” is more than 15 where we live, meaning, we’re better off renting.

What is the Price to Rent Ratio?

The price-to-rent ratio is a way to determine how inflated housing prices are in a given area. It’s calculated by taking the price of a property and then dividing it by the annualized rent of the property.

Let’s say we can rent a 1 bedroom apartment for $1,000 a month. Take that amount and multiply it by 12 to get the annualized rent, or $1,000 * 12 = $12,000.

Say an equivalent place in the same area is up for sale @ $120,000. Then, the Price to Rent Ratio would be 10 ($120K/$12K).

You can see more about the recent price-to-rent ratios in different areas of the country at Smart Asset.

So, now that we understand all that heady math, is the Price to Rent ratio useful? Or, as Sean Connery would ask on Celebrity Jeopardy, “Does it work??”

What is the “Rule of 15”?

Historically, the Price to Rent Ratio has hovered right around 15. That means houses have historically been valued at about 15 years’ worth of rent. But recently, things have gotten a bit out of balance. From smartasset.com:

“National and city price to rent ratios have risen and fallen over the years depending on the state of the housing market. In the years before the housing crisis, as the housing market heated up, the national ratio rose from 22.73 (in 2005) to 24.50 (in 2007).

After the real estate market turned, as home prices fell and rentals grew more expensive, the ratio began to fall, dipping below 20 in 2011, down to the current ratio of 19.21.

Before the housing bubble and subsequent crisis, the average hovered somewhere around 15. That indicates that we are still in a period that is more favorable to renters than buyers from a historical perspective.”

Now, I had heard of the rule of 15 before. I’ve even mentioned it on our site: Crazy Real Estate in LA. This isn’t to say that if the Price-to -Rent Ratio is lower than 15, that housing is affordable. It’s just a comparison of renting to buying. Both can still be absurdly expensive.

I never really understood how it worked or why. I just kind of took it with a grain of salt. But I was curious… So, I sat down one Saturday morning and put together a quick model to see how it works and why. Now, we’re going to walk through it…

Assumptions When You Buy a House

This model isn’t super robust, but it was enough for me to understand what goes into the calculations.

Here are some of the assumptions I made:

1. This is for a primary residence home, not rentals or investment properties.
2. I included monthly tax and repairs on a house. I also amortized mortgage payments.
3. Based on historical averages, I used the rate of inflation for the rate of equity growth on the house and the rent increase.
4. I took everything that was not spent on the house, and invested it in the market, at the average market returns. So the down payment was invested at the beginning, and then any monthly house-related payments exceeding rent (principal, interest, HOA, Repairs, Taxes) were also invested.
5. I didn’t include the costs of acquiring or selling the home, or the cost of exchanging equities (i.e., no commissions).
6. For the Buyer, I used Interest, HOA, Repairs, and Taxes as the cost. For the Renter, I simply used rent.
7. I used a 30-year fixed-rate mortgage and figured an assumed rent amount over the same period. I didn’t bother including PMI if the down payment was > 20%.
8. I didn’t include mortgage interest deductions, because most people don’t itemize anyway. And with new tax laws, even less will. (Though Cubert would advise you to run this by your accountant, or at least TurboTax to ensure you’re getting the best tax break.)

You can see how I laid out the back-end data here:

Then, I rolled it all up and gave myself a nice little dashboard that you can see here:

Shockingly, it comes out very close to the Rule of 15. I’m quite impressed by myself!

What Did I Learn From Using the Price to Rent Ratio?

There are a couple of things that were reinforced throughout pulling this analysis together:

1. Housing is Expensive – Whether it’s better to rent or buy, you’re still looking at shelling out hundreds of thousands of dollars over 30 years. Even when buying a house, you are probably going to pay almost 2X the purchase price in interest, taxes, and repairs… OOF-duh! (Cubert added the “-duh” for MN folk benefit.) It’s kind of nuts to see it laid out like this.
2. Market Returns have a large impact on whether or not it makes sense to rent or buy. – By adjusting the market returns from 8% to 5% the break-even point on the Price to Rent Ratio moves from ~17 to almost 24. That’s a huge shift.

1. Much of the growth that comes from renting, is from compounding on the investment of the down payment. – Through a bunch of the different scenarios that I ran, the mortgage payment was equal to or less than the rent, but the renter still came out ahead. –Because the down payment was invested over the long haul and the growth on that lump sum out-paced the smaller gains on the house. (Notice the shape of the curve in the upper left corner of the dashboard!)
2. Leverage works if you put less down on the house. – I honestly think this is because of my rudimentary model. I didn’t include PMI. When you lower the mortgage payment by investing enough to avoid PMI, you don’t have as much to invest up-front. (This is why Cubert always goes for the lowest down payment possible on rentals.)

What Does This Mean For Us?

I put this together because I was curious about what happened near the inflection point. I wanted to know, “Why 15?” What I found is that, through a variety of scenarios, the inflection point (i.e., where buying or renting offers the same benefit) happened to be right around 15 every time.

Put another way, this is where the leverage on the house is roughly equivalent to the ratio of the market returns to the inflation rate. So, you are gaining equity at the same rate by either buying or renting. Lower the ratio and the leverage of owning a house works in your favor. Increase the ratio, and you’re losing out on better returns from the market.

Fluctuations abound. But I think 15 is a good benchmark/rule of thumb.

Even simpler? Take the monthly rent and multiply it by 200 to get a comparable home purchase price. If you rent for $1,500 a month, then you better limit your home purchase price to $300,000 or less. Good luck trying that action in D.C., San Francisco, or the City of Angels.

This is all a moot point for us waffles, given the fact that our Price to Rent ratio is somewhere around 35. So, yeah, it makes a ton more sense for us to rent. I put our numbers into this handy calculator, and it laughed at me. “Don’t you ever buy, knucklehead!”

People tend to take our stance on real estate as “anti.” That’s not the case. It just makes no sense for us to buy a house in the current market conditions where we live (L.A.). There are many things I’d rather do with $1 million, rather than buy a crappy little 1,000 sq. foot house.

If you’re curious and want to play with the model, download a copy of it from Google Drive.