Use Price-to-Rent Ratio for Home-Buying Decision

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It’s a tough decision in today’s market: continue renting or to make the leap and buy a home?

Home prices have fallen by 20% to 30% in many markets, making homes look like bargains compared to a few years ago. But what if you were to buy now only to see prices drop further?

Tools like BankingMyWay.com’s Rent vs. Buy Calculator can help one decide whether a specific home purchase is a better deal than a specific rental. But to get a more general idea of whether home prices have hit bottom requires a study of the local market.

One of the most useful ways to do that is with the price-to-rent ratio, which divides a home’s price by the annual rent one would pay for a comparable property. In the 1970s, ‘80s and ‘90s this ratio ranged from 10 to 14. A $200,000 home would have rented for between $14,285 and $20,000 a year, for example.

The ratio is not absolute. But the higher it is, the more likely it is that homes are priced too high.

Today, the ratio is around 20 in many parts of the country, so that a $200,000 home would rent for $10,000 a year. That suggests the home is overpriced by historical standards. To get back to the 10-14 range, the price would have to fall to the $100,000 to $140,000 range or rents would have to rise.

Housing markets can vary dramatically from one neighborhood to another, so a national, statewide or even town-wide price-to-rent ratio isn’t very useful. You’ll need to assess the neighborhood that interests you on your own.

In ideal circumstances, you would find an assortment of properties for sale and identical, or nearly identical, properties for rent. A perfect comparison would look at condos for sale and rent in the same building, for instance.

Often, the comparison is more like apples to oranges, such as single-family homes and apartments in a complex. The best you can do is compare properties of similar size, with the same number of bedrooms, bathrooms and parking or garage spaces. If enough are on the market, you should be able to calculate an average sales price per square foot for properties of a certain type. Then come up with an average rent for similar places, and divide the price by annual rent to get the ratio.

Zillow.com and JPMorgan Chase (Stock Quote: JPM) have lots of data on recent sales, and Apartments.com has one of the most extensive for-rent listings.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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