To determine if a house is overvalued, many home buyers use the price-to-rent ratio (P/R) method which is much like a P/E ratio when buying a stock. The price to rent ratio is simply the value of the home divided by the annual rent. As illustrated below, any ratio greater than 20 is considered to be severely overvalued. A price to rent ratio of 16-18 would be ideal and I think this is the sweet spot for a desirable location in the Bay Area. The bottom line is that you should not have to pay more than 20 times the annual rent for a home. Let's take an example of a typical single family home in a desirable location in San Jose, CA:
Home Description: 1800 sq. ft, 3 Bedroom, 2.5 Bath
Home Price: $800,000
Rent: $2,800
Annual Rent: $33,600
Price to Rent Ratio: 800,000 / 33,600 = 24
Fair Value of Home (P/R=18) = $605,000.
As you can clearly see, a desirable home in San Jose has a price to rent ratio of 24 which is considered to be severely overvalued. To figure out what is the fair value of this particular home, let's step down the P/R several notches to 18 which is modestly overvalued but still reasonable. Based on this simple calculation, the fair value of this home should be $605,000! So unless the rent goes up extraordinarily fast, it's almost a certainty that this home will fall 25% in value within the next several years.
What do you think about this analysis? What are the price to rent ratios in your area?
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5 comments:
I'm not sure how much rent is at the moment around the Bay Area for a single family home. I suppose you have to take into account whether someone is paying rent for an apartment (at the same time, saving money) and trying to buy a single family home. Does the price to rent ratio work for them in this case. I still think one should consider how much house they can actually afford (based on traditional 30 yr mortgage). Actually, I think they should figure out how much house they actually need and not buy the biggest house they can get just because they can afford it. Anyhow, my 2 cents. If you have an idea how much average rent for a single family home is around the bay area, let me know so I can figure out what the fair value I should be paying.
Thanks for your comments A Dub! Not sure what is the average rent in the Bay Area. It really depends on the location. But my thinking is that most people probably don't want to pay more than $2,800 for rent whether it's a house or a apartment because they really want to save up for a house of their own.
As for the P/R, the only way this method would work is if you are comparing rent to price of the same single family home. Hope this helps!
What is the typical P/R down in the LA area?
I agree that another good tool to use in conjunction with hotpads would be a way to tell what the avg rent in the relative area is. Otherwise, if you happen to have low rent, the results may be skewed. Google brought this:
http://mullinslab2.ucsf.edu/SFrentstats/
which basically maps out the rent prices that people are listing on craigslist. Too bad it's only good for SF.
Nice tool! Maybe the tool will expand to other parts of the Bay Area in the future. Thanks for the info!
Just saw your entry. Here in my neck of the woods in expensive Oakland/Piedmont, price to annual rent is typically 25-40. It is beyond belief. You'd need a few percent home price increase per year to offset your cash flow loss vis a vis renting. But this is a pipe dream, since such huge price/rent ratios suggest housing is overpriced and will not even stay with inflation.
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