Rent vs. Buy

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.

And while home prices — and rent ratios — have always been higher on the coasts, they reached whole new levels recently. In the Washington area, the ratio went above 20. In Boston, New York, Los Angeles and south Florida, it topped 25. In Northern California, it approached 35, higher than it had been in any city, at any point on record.

In concrete terms, a rent ratio above 20 means that the monthly costs of ownership well exceed the cost of renting. At current mortgage rates, for example, a $500,000 house would typically bring monthly expenses of about $3,000 (taking into account taxes, repairs, a typical down payment and, yes, the mortgage deduction). When the rent ratio is 20, that same house could be rented for only about $2,000 a month.

There are two problems with buying a house in this situation. The first, plainly, is the extra $1,000 you’re paying each month for the privilege of owning, on top of the thousands of dollars you spent on closing costs. The second problem is that a rent ratio above 20 is a good indication of a bubble. When the prices of houses get out of line with the competition’s prices — that is, those in the rental market — a correction is coming.