Buy or rent? Real estate agents deal with the answer to this question on a daily basis. Homebuyers will often come to their agents ready to buy, having made up their mind already that buying is preferable to renting. But proactive and successful agents don’t sit around waiting for buyers to reach out — they go door-to-door, send out mass marketing materials and carefully cultivate their FARM.
One way to convince renters that homeownership is attainable and preferred is to show them how owning their home is less costly than renting over the long run. This can be done by calculating the actual costs of renting versus buying a comparable home with a Buy-Versus-Rent After-Tax Analysis. [See RPI Form 320-4]
Economists compare buying versus renting through the price-to-rent ratio.
This ratio is calculated by taking a home’s value (say, $500,000) and dividing this by 12 times the monthly rent of a comparable property (say, $3,000 x 12). In this case, the price-to-rent ratio is 13.88.
On its own, this ratio doesn’t say much. But when viewed over several years, economists can identify trends that impact buyers, renters and the broader housing market. When the price-to rent ratio consistently rises, homebuyers’ costs are rising more quickly than renters’ costs for equivalent homes, making buying less desirable. In contrast, when the price-to-rent ratio falls, homeowners are getting the better deal and buying looks more desirable.
The price-to-rent ratio does not account for the other benefits and disadvantages of owning. For instance, every time a homeowner pays their mortgage, a portion of the payment goes toward paying off their principal balance. At the end of their mortgage term, they will be living basically rent-free, responsible only for taxes and upkeep. Likewise, when they sell, they will recoup some of their investment when their home equity has increased since purchasing.
On the other hand, homeowners are also financially responsible for maintaining the property and fixing it when disasters occur. Renters don’t suffer the same responsibility and don’t need to set aside savings for things like broken appliances or leaky roofs (though they do need to contend with potential rent increases). Homebuyers also need to invest a significant chunk of cash into their down payment, an opportunity cost that will not be able to be used for other investments. However, filling out a Buy-Versus-Rent After-Tax Analysis will give renters a better idea of the actual costs and savings of homeownership.
Price-to-rent ratio trends
The price-to-rent ratio is highly volatile, much more so than can be explained by normal market factors, according to a recent study by the Federal Reserve Bank of Atlanta. In the study, researchers pick apart the “price-to-rent puzzle” to identify why these large fluctuations occur.
The researchers explain that home prices rely generally on two factors:
- the available credit supply; and
- homebuyer incomes.
Whereas, rents rely on renter incomes — they are not directly reliant on the supply of available credit. However, rents are still indirectly reliant on the credit supply as landlords do need access to credit to purchase rental properties, and when credit is tight and interest rates are increasing, renters tend to pay higher rents to make up the difference.
Still, home prices are more prone to change than rents, resulting in a more divergent ratio. For example, during economic booms the credit supply increases, allowing prices to rise rapidly. When the credit supply tightens, as before and during a recession, home prices fall more quickly than do rents.
The researchers measure credit supply by the number of mortgage loans relative to home prices, along with the spread between the 10-year Treasury Note rate and 30-year fixed rate mortgage (FRM) rate. When the spread is low, it indicates lenders are willing to accept a lower return on their investment. When the spread is high, lenders are padding their risk premiums in anticipation of a market slowdown.
In 2019, this spread is significantly higher than historical standards, at 2.0 percentage points in October 2019 compared to around 1.55 points historically. Mortgage lenders are preparing for the housing slowdown that began in 2018 to continue in 2020 with the arrival of the next recession.
What can real estate agents do with this information?
Price-to-rent ratio trends can shed some light on when it’s a good time to switch from renting to buying. But it’s also a good indicator of market stability. When price-to-rent ratios are rising consistently, home prices can reach shaky heights. Renters rightfully sense they are priced out of the market, and when demand falls, prices fall too.
As we look ahead to 2020, home prices have crested their peak and are on a downward path. Lenders are tightening credit in expectation that the housing market and broader economy will continue to slow. Real estate agents can also prepare for the coming recession by overproducing, cutting spending and expanding their marketing efforts today.
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