People shopping for a home use the price to rent ratio to determine whether it makes more financial sense to rent or own.
Real estate investors can also use the price to rent ratio to identify the areas that could be good for owning rental property. By investing in areas where the demand for rental property is strong, investors may earn higher returns than in markets where people can afford to buy rather than rent.
What is Price to Rent Ratio in Real Estate?
The price to rent ratio is a calculation real estate investors use to forecast the potential demand for rental property in a given real estate market.
By dividing the median home price by the median annual rent in the market, a rental property investor can learn the affordability (i.e. does it make more financial sense for someone to rent a property or buy one).
Generally speaking, if the price to rent ratio is high, the market could be good for rental property. On the flip side, if the price to rent ratio is low, more people may choose to own rather than rent, assuming they can find the right property at the right price and have the down payment saved to qualify for a mortgage.
How to Calculate Price to Rent Ratio
Calculating the price to rent ratio is easy to do:
- Median Home Price / Median Annual Rent = Price to Rent Ratio
- $120,000 Median Home Price / $11,000 Median Annual Rent = 10.91 Price to Rent Ratio
In a market where it is cheaper to rent than own, the price to rent ratio would look something like this:
- $140,000 Median Home Price / $11,000 Median Annual Rent = 12.73 Price to Rent Ratio
Here’s what the price to rent ratio would look like in a market where it makes more financial sense to buy rather than rent:
- $100,000 Median Home Price / $11,000 Median Annual Rent = 9.09 Price to Rent Ratio
Real estate investors can also use the price to rent ratio formula to determine what the price of a home should be based on the ratio, and also what the annual rent should be:
Calculate home price using the price to rent ratio
- Price to Rent Ratio = Median Home Price / Median Annual Rent
- Median Home Price = Median Annual Rent x Price to Rent Ratio
- $11,000 Median Annual Rent x 10.91 Price to Rent Ratio = $120,010 Median Home Price
Calculate annual rent using the price to rent ratio
- Price to Rent Ratio = Median Home Price / Median Annual Rent
- Median Annual Rent = Median Home Price / Price to Rent Ratio
- $120,000 Median Home Price / 10.91 Price to Rent Ratio = $10,999 Median Annual Rent
What Price to Rent Ratio Tells Investors
The price to rent ratio is one indicator of how appealing a location might be for rental property investments.
In an area where the price to rent ratio is high – meaning that home prices are higher relative to the annual rent price – it makes more financial sense for someone to rent rather than own.
As home prices go up, the down payment amount needed to purchase a home also increases, making it more difficult for people to buy a home. For real estate investors, a high price to rent ratio could indicate there will be a strong demand for rental property.
On the other hand, markets where the price to rent ratio is low may indicate that there will be a lower demand for rental property, because home prices are lower relative to the annual rent price. However, the price to rent ratio only tells one side of the story. That’s because the ratio measures how economical it is to buy or rent, but not how affordable it is.
As the Federal Reserve reports, the median sales price of houses sold in the U.S. has increased by more than 53% over the last decade, and by 6% over the last year alone. As home prices rise, people need a larger down payment to qualify for a conventional mortgage. If home prices are out of reach for many people in a specific area, renting may be their only option.
Price to rent ratio also does not take into account other factors that cause people to choose to rent rather than own, or vice versa.
As a recent article from Fidelity explains, people may choose to rent because they plan on moving in a few years, don’t feel that they are up for the responsibilities of home ownership, or simply believe that renting offers a better value regardless of what the price to rent ratio might indicate.
Best Cities for Renters Based on Price to Rent Ratio
SmartAsset recently ranked the 50 largest cities in the U.S. according to price-to-rent ratio, with a price to rent ratio of 16 or higher indicating that renting is usually more favorable than buying.
According to the report, the top 10 cities with the highest price to rent ratio are:
City Median Home Value Median Annual Rent Price to Rent Ratio
|City||Median Home Value||Median Annual Rent||Price to Rent Ratio|
|New York City||$680,800||$17,796||38.26|
While these cities have very high price to rent ratios, median home values are high as well. Markets where housing prices and price to rent ratios are high don’t necessarily offer the best opportunities for investment.
For example, an investor living in San Jose with $250,000 in capital to work with could buy one rental property as a local investor, assuming a conservative 25% down payment. Although the property purchased might have a high price to rent ratio, by putting all of his eggs in one basket the investor misses out on the opportunity to potentially reduce risk through diversification.
Alternatively, the same buyer could utilize the Roofstock Marketplace to invest in real estate remotely. Instead of buying only one house in San Jose, he could own multiple rental properties in different markets across the country where prices are more affordable and the price to rent ratios are still attractive.
Where to Find Price to Rent Ratio Information
City-level price to rent ratio data provides a valuable, high level view of potential rental property investment opportunities. Once a market is selected for further analysis, the next step is to drill down and analyze price to rent ratios at a zip code or neighborhood level.
Let’s look at an example of how to find price to rent ratio information using Zillow Research Data for home prices and market rent data. To use this method, all an investor needs is a very basic understanding of how to use an Excel, Google Sheets, or OpenOffice spreadsheet:
- Home prices: On the Zillow Research Data page (https://www.zillow.com/research/data/) go to the Home Value section, select ZIP Code from the Geography drop-down menu, and download the spreadsheet using a name such as ZHVI for Zillow Home Value Index.
- Rent prices: On the same page (https://www.zillow.com/research/data/) go to the Rental section, select ZIP Code from the Geography drop-down menu, and download the spreadsheet using a name such as ZORI for Zillow Observed Rent Index.
- Open both spreadsheets and save each one using a different name, such as ZHVI PRI for home values and ZORI PRI for rent data. These will be your working spreadsheets for your price to rent ratio research, and you will still have the original spreadsheets if you need to access the data again.
- Using the ZORI PRI spreadsheet for rent data, go all the way to the right of the spreadsheet and insert a column next to the most recent rent data.
- Using the ZHVI PRI spreadsheet for home prices, go all the way to the right of the spreadsheet, copy the most recent home value data for every zip code, then paste that data into the new column on your ZORI PRI spreadsheet.
- Create a new column on your ZORI PRI spreadsheet next to the data you just pasted, and enter the calculation to divide ZHVI home values by ZORI rents.
- Your ZORI PRI spreadsheet now has the price rent ratios for each zip code.
How Investors Use the Price to Rent Ratio
By having the price to rent ratio information for every zip code in the U.S., an investor can quickly and easily identify which zip codes may be best for rental property investments.
For example, let’s say the median price of a home in a target area is $160,000 and the median annual rent is $19,200 ($1,600 per month) for a price rent ratio in your target market of 8.3:
- $160,000 Median Home Value / $19,200 Median Annual Rent = 8.3
By comparing the price to rent ratio in the target market to the price to rent ratios in each zip code in the target market, an investor can zoom in on areas that might be good for owning rental property.
Zip codes within the target market that have a price to rent ratio above 8.3 may be good for rental property investment because the higher the price to rent ratio is, the more attractive an area can be for renting. On the other hand, if a zip code has a price to rent ratio lower than the target market, the area could be more attractive for home ownership versus renting.
Looking Beyond the Price to Rent Ratio
Calculating the price to rent ratio is just one of the many factors and financial metrics investors should consider before purchasing rental property:
- Job and population growth greater than the state and national average.
- Diverse economy with a good variety of different employment sectors and household incomes.
- Good neighborhood and school rankings, and low crime rates.
- Growing proportion of renter-occupied households compared to homeowners.
- Gross Rent Multiplier = Property Price / Gross Annual Rental Income
- Net Operating Income (NOI) = Rental Income – Operating Expenses (except mortgage payment)
- Cap Rate = NOI / Property Value
- Cash Flow = Money remaining after all operating expenses, including the mortgage, have been paid
- Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
- ROI = Annual Return / Total Investment
The price to rent ratio is a quick and easy calculation that compares the median home price to the median annual rent. Using the price to rent ratio metric, real estate investors can select areas that may be good for rental property investments.
Cities and neighborhoods where the price to rent ratio is high may make good areas to buy rental property in, because generally speaking it makes more financial sense for people to rent rather than own. In areas where the price to rent ratio is low, people may find it more attractive to buy instead of rent, which can make the demand for rental property low.