How You'll Know When It's OK to Buy

David Leonhardt of The New York Times this week wrote a first-person account of his decision to purchase a home in Washington, D.C., despite his stance as “an evangelist for renting.” His story contains an effective, easy-to-remember formula for determining whether it’s better to buy or rent.calculator.jpg

Over the last several years, I’ve come to like a simple, back-of-the-envelope way to compare the costs of renting and owning. You find two similar houses, one for sale and the other for rent, and divide the sale price by the annual rent. You can call the result the rent ratio.

The concept will probably sound familiar to stock market investors. It’s the real estate market’s version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check.

Throughout the 1970s, ’80s and ’90s, the average rent ratio nationwide hovered between 10 and 14. In the last few years, though, it broke through that historical range and hit almost 19 by the time the housing market peaked, in 2006.

Leonhardt ran the numbers for condos and numbers in Washington and came up with rent ratios in the 15 to 16 range.  While that’s not as low as in past decades, the ratio was 20 a few years back.  And, he notes, prices near the coasts have always been higher than the national average.  So even though he knew prices hadn’t quite bottomed out yet, they were close enough, he reasoned, to make buying the right decision.

Leonhardt said that L.A.’s rent ratio has been as high as 25.  What is it now?  Here’s an example from my neighborhood:

Renting a two-bedroom house in my neighborhood would cost around $3,000, or an annual rent cost of $36,000.  Two-bedroom homes in my neighborhood have sold for around $900,000.  Dividing $900K by $36K, you get a rent ratio of 25.  In order for me to consider buying, that house would need to cost around $520,000 — or my rent would need to go up a lot.easel.jpg

Will prices in my neighborhood ever fall that far?  Probably not. This established neighborhood, where people have lived for a long time, didn’t see a ton of turnover during the run-up.  But people trying to sell right now are in for a rough ride. They will be forced to take much less if they really need to sell now.

What’s your rent ratio?  Are there any areas in greater L.A. where, according to this formula, buying is coming close to making sense?

Recent Redfin posts:
Downtown Open House
The Five Biggest Home-Buying Myths

  • http://www.thishikingtrail.com candice

    There is a house on the market in the west valley that is listed at $615K or for lease at $3250/mo. That’s a rent ratio of 15.7. Now, given that you could probably purchase for less than asking, the rent ratio isn’t so horrible. But I do have a feeling that house is going to drop in price, especially since it looks like it needs some TLC. So, why buy when I can wait a couple months and get it at a better price. The only thing is, of course, unless someone else snaps it up.

  • http://sfvrealestate.blogspot.com sfvrealestate

    Naturally, this story was all over LaLand this week. By all means, if you want to rent, rent. However, most buyers should — and do –have many compelling reasons to buy aside from this rent ratio.

  • http://losangeles.redfin.com/blog/author/cindy.allen Cindy Allen

    Absolutely true that there are reasons to buy a home other than price. In fact, price should definitely not be the first consideration. But there’s no reason to overpay for anything you buy, especially a home.

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  • Arash

    Renting in Los Angeles area makes much sense until about 2010, we will see the market then.

    There is no way the prices can sustain themselves. I know a lot of my coworkers that were laid off since Sept of 07 and still have not found a steady job and they are good capable people. I know a few that have left California for cheaper markets such as Austin and NC where salaries are about 15% less and housing costs are 1/5 or 80% less than LA. And some went to newer cities like Houston where the infrastucture is much better than LA since the city is newer with tremendous amount of freeways and new road construction and the houses average around 15 years old. Well, they are not in CA anymore but hey they have about an extra $3000 in the bank every month so essentially they can take a week off in the bahamas every month and still have the same money left over as they had in LA!

  • MIguel Rodas

    I m renting a house (6 month lease) in temple city for $1625/month. The house in not for sale, however I estimates that the average house price in that area is between 400K and 500K. Am I paying a fair rent? Can I negotiate to pay less next time (July) I renew the lease or should I look for a better deal.