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.
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.
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?