Home Price to Rent Ratio

A PROPERTY’S PRICE to rent ratio establishes its lowest market value. This month’s issue of Forbes (unavailable online) has an excellent article on this vital real estate fundamental. Both Realtors, buyers, and sellers want to know “how low can the market go?” McMurdie’s Real Estate Rule No. 78: the lowest value for any property is determined by what income it produces. Tract homes produce shelter, rent. Income value establishes the lowest price. Comparable sale value is the highest price.

How low can the residential market go? Down to the rental value.

If the list price of a home is $650,000, and its rental value is $2100, you don’t need a calculator to know rents will not cover expenses and mortgage payments.

Historically investors buy homes when cash flow from a rental, after tax deductions, is zero. No net after tax cash loss. This is simply because rental rates go up after a couple of years producing first tax benefits, and then actual cash income.

Traditional fix and hold investors have been out of the market for several years. The price/rental ratio has been to low.

Fix and flip has never traditionally worked. Fix and flip depends on double digit appreciation.

Fix and Hold investors improve on rental income returns by buying fixers, fixing to increase rents right away; getting tax benefits from repair deductions, and then obtaining net after tax income from the purchase the first year! Price appreciation is a secondary benefit.

Investors are in the market now, including Silicon Valley, but the price to rent ratio will need to go up before investors jump into buying rentals. Rental rates are going up. This will help. But here in Silicon Valley prices will need to decrease by 20% or more before knowledgable investors buy rentals.

My guess is that by Fall 2008 prices will be 20% lower, provided mortgage interest rates remain low, investors will then buy and flatten out the current Bear Market.

Remember McMurdie’s Real Estate Rule No. 126: Bears always come out and clean up the income bargains in the market.