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Two of those questions are:
What’s a good price to pay for this real estate investment?
Once you’ve purchased your investment, you may wonder what’s a good rental price?
Both of these common questions can be answered with one formula: the price to rent ratio.
But what is the price to rent ratio?
More importantly, how can it help you as a real estate investor?
In this article, we will discuss:
- How to calculate the price to rent ratio
- Where you can find price to rent ratio information
- Additional real estate formulas
- And more
Let’s begin by defining the price to rent ratio.
What is Price to Rent Ratio?
When calculated, the price to rent ratio will give you a number that indicates whether it’s cheaper to buy or rent a property in a specific market, which can help you, as a real estate investor, determine if it’s the right market for you to invest in.
If the price to rent ratio is high, this means that renting is more feasible than purchasing a home in that market.
That means for an investor it could be beneficial to own a rental property.
The inverse is true: if the price to rent ratio is low, this means that it’s cheaper for someone to own a home in that market than to rent, leading to a smaller pool of potential renters.
In this case, it may be difficult to find consistent tenants.
Next, we’ll look at how to calculate the price to rent ratio.
How to Calculate the Price to Rent Ratio
To calculate the price to rent ratio, simply take the median home price for a specific market and divide that number by the median yearly rent for that same market.
The formula is as follows:
Price to Rent Ratio = Average Property Price/Average Annual Rent
How Real Estate Investors Use Price to Rent Ratio
The price to rent ratio can be an extremely useful tool for a real estate investor to have in their back pocket.
Let’s cover what exactly the price to rent ratio indicates.
The price to rent ratio is divided into three different categories:
- 15 or below
We’ll look at each category next.
Price to Rent Ratio: Score of 15 or Below
A score of 15 or below typically means to investors that home values are low, which makes the cost of homeownership significantly lower than in other areas.
This means that renters will be harder to find. It also means the average rent will be on the lower end.
Now, this isn’t to say this whole market is a wash.
Price to Rent Ratio: Score of 16-20
A score of 16-20 typically means to a real estate investor that this market is optimal for a rental.
This range typically indicates that home prices are high enough to sway people away from buying, leading to more renters.
This can be a great market to invest in.
Price to Rent Ratio: Score of 21+
A score of 21+ means that the average home price in this market is too expensive for someone to buy in, making it much more feasible to rent.
This also comes with higher risk because you’re putting more money on the line. It can make turning a profit much more difficult as well.
Other Uses for Price to Rent Ratio
The price to rent ratio also has other uses. Investors can use the formula to calculate how much they should pay for a home or how much they should charge for annual rent.
We’ll look at both next.
Calculating the Best Price for a Property
To calculate the best price to pay for a property, you can rearrange the price to rent ratio by doing the following:
Average Home Price = Average Annual Rent / Price to Rent Ratio
Calculating Rental Market Rate
To calculate the market rental rate for a specific property, you can rearrange the price to rent ratio by doing the following:
Average Annual Rent = Average Home Price / Price to Rent Ratio
Where to Find Price to Rent Ratio Data
You don’t have to determine the price to rent ratio on every property you look at. The information is readily available — if you know where to look.
The MLS has this information, and you can access it for free on Trulia and Zillow.
Other Important Real Estate Investing Tools To Consider
The price to rent ratio is just one of many tools that real estate investors use when looking at potential investments.
Here are a few other formulas to keep in mind.
Gross Rent Multiplier
Gross rent multiplier will help a real estate investor determine how long it will take a real estate investment to be paid off by the rent collected.
You can learn more about the formula here.
Cash-on-Cash return is used by real estate investors to calculate the cash flow generated by a property compared to the total amount of cash invested.
You can learn more about the formula here.
Price to Rent Ratio: The Bottom Line
Price to rent ratio can help you determine whether or not a specific property is worth investing in.
Keep in mind that when using the formula, mid-range price to rent ratios can be the sweet spot when it comes to real estate investing.
These sweet spots are typically much stronger rental markets than markets with low price to rent ratios.
Plus, they can be an easier and a less risky acquisition strategy than those markets with higher price rent ratios.
Whether or not you decide to invest in a particular property, ensure that you are continuing your real estate education, which is the best way to make your next deal your most profitable one yet.