Somewhere just after the housing bubble burst in 2008 or so, I started hearing institutional investor types considering how they could use their cash to accumulate distressed real estate assets. Funds emerged Waypoint, Colony, BlackRock, heck even John Paulson – he of the Greatest Trade Ever – flipped from shorting sub-prime to going long real estate the old-fashioned way, buying houses. At first the trade looked insane. Who would buy homes in bulk in 2009? Surely there were better places to put your cash, right? But like all great trades, the skeptics are the ones who make it great. Now that prices have recovered so aggressively, the trades looks like a no-brainer.
How do we know when this investor opportunity is played out? When do prices rise to make it not a good deal any more?
Price to Rent Ratio
For understanding where to put your real estate dollars, we use a rule-of-thumb metric called Price to Rent ratio – Median Home Price divided by a year’s worth of rent. It looks like this:
(Median Home Price / (Median Rent * 12)) = Price to Rent Ratio
If the PtR is lower than 20 then, in a general sense, it’s a better deal to buy in a market than to rent it. (There are a lot of cases where this isn’t true, so use PtR as a tool for understanding a market, not for making investment decisions, got it?) For example a PtR of 15 means that after 15 years of paying rent, you’d have paid the whole price of the house.
In this way, Price to Rent ratio is a useful guide for investor market selection. For areas where rent is sufficiently high that the renter pays for the whole property in just 15 years, buy property and rent it! (Again, there are lots of other variables too, including price appreciation, which are not to be ignored.)
In US real estate markets, Phoenix has been the investor’s paradise. For several years, prices plummeted. Rents did not so much. So the PtR was a really strong buy signal. Furthermore, you still have massive migration into the city, so demand is real. And the investor gets the upside of a rising value of the underlying asset. Win-win.
However, as the market has recovered, home prices in Phoenix have climbed 30% off their lows. Investors are getting squeezed out by actual home buyers. All of a sudden, the PtR isn’t nearly as attractive as it was.
Median List Price to Median Rent Ratio for selected Arizona cities. Data as of April 12, 2013. Source: Altos Research
Phoenix, due to strong demographics and other factors, will still likely make investors good money in the coming years. But the real advantage is being arbitraged away each day.
Let’s look at other markets
Florida has climbed, but less compellingly than Phoenix.Median List Price to Median Rent Ratio for selected Florida cities. Data as of April 12, 2013. Source: Altos Research
The higher-cost California markets are not nearly as good a deal, as measured by Price to Rent RatioMedian List Price to Median Rent Ratio for selected California cities. Data as of April 12, 2013. Source: Altos Research
On the other hand, if we look at some Midwest markets, we see not only cheaper homes, but a weaker trend. Chicago has been the most lagging city in the housing market recovery in the past 18 months.Median List Price to Median Rent Ratio for selected midwest cities. Data as of April 12, 2013. Source: Altos Research
This set is just a high-level survey. For detailed rental market analytics, local and national, contact us.