Applying stock market fundamentals to real estate
Here is a concept that could prove very useful to investors in evaluating whether or not a property is appropriately priced.
The concept of rent ratios is based on the most basic method of evaluating a stock, price-to-earnings ratio. This ratio measures a company’s share price with its annual profit and can be a good indicator of value with a stock.
This same concept can be applied to the housing market utilizing rent ratios which are created by dividing the price a house would sell for by the annual rent that the property would generate. For example, a house selling for $200,000 that rents for $1800/month would have a rent ratio of 9.3 ($200,000/($1800 x 12) ).
The rent ratio is just one of the factors that investors should consider when evaluating a property. Rents are a great reality check for housing prices but can be greatly affected by other issues including demographic make-up of a community such as a university town or a resort community with high seasonal rental rates. The aggressive rate of condo conversions in some markets can also have an impact of this ratio with rental stock shortages driving up rental rates in some markets.
Nation-wide the average rent ratio is approximately 17, which interestingly is below the current Standard and Poor’s 500 stock index price-to-earnings ratio of 20. During the dot-com boom in 1999, the S&P 500 PE ratios hit 35.
“>Is Your House Overvalued? [New York Times]