A Simple Ratio to Analyze Real Estate Investments
There are many questions I often get asked from people that want to get into real estate investing. Two of the most commonly asked questions are, “how do you perform market analysis” and “what are the key metrics you look at that help you determine if a market is worth investing in?” At the moment, my husband and I own four rental properties in Jacksonville, Florida. Conducting fundamental market analysis brought us to our decision to invest in Jacksonville and helped us choose the neighborhoods as well. In this article I will discuss the rent-to-sales ratio, which provides an efficient method to determine whether a market is worth investing in.
What Is The Rent-To-Sales Ratio?
Our market research starts with comparing several fundamental market factors, one being the rent-to-sales ratio. The rent-to-sales ratio measures the relationship between a property’s annual rental income and the property’s purchase price. To calculate the ratio simply divide the property’s gross annual rent by the property’s purchase price. The higher the ratio, the better the market for rental properties. We use historical annual rental pricing and sales data from Zillow Data. We typically look for areas that can generate a rent-to-sales ratio between 12% and 14%. This should provide us with enough of a margin to still profit each month in the event the rental market turns south.
Putting The Rent-To-Sales Ratio To Use
A balance must be made when analyzing new rental markets. We look at each market’s upside potential and downside risk. The rent-to-sales ratio will provide a good insight into the amount of risk a market has. Here’s an example of how to use this ratio:
• Say we purchase a home for $100,000 and put 20% down
• We finance the property with a conventional 30 year loan with a 5% interest rate
• Monthly principal and interest payment will be $537
• Assuming an additional $300 per month for taxes, insurance, and maintenance expenses
• Our total monthly expenses add up to $837
• The monthly rent for this property is estimated at $1,200, which adds up to a gross annual rent of $14,400
Now lets calculate the rent-to-sales ratio for this property example:
A 14.4% rent-to-sales ratio is exactly what we would be looking for! There are some other metrics to look at here as well such as cash flow and rental margin:
• Cash flow is equal to the gross monthly rent minus all monthly expenses for the property. For our property the cash flow would be: $1200 - $837 = $363
• Rental margin is the percentage difference between your gross monthly rent and monthly expenses divided by the average of the gross monthly rent and monthly expenses. Going back to the property example, the rental margin would be:
Now assume we enter into a recession and rental prices in our area drop by 25%. This means if the property is vacant we now have to reduce the amount we charge for rent to $900 to make our rental property competitive with the current market. Given our monthly expenses are $837 we can still profit each month — albeit a much lower profit. The goal here is to not lose money. Eventually recessions end and rental prices should swing north again leading to a larger positive monthly cash flow.
What We Can Interpret From The Ratio
It’s our job as investors to determine how much risk we are willing to accept for the amount of reward we hope to gain. A market with a higher rent-to-sales ratio typically means that an investor will have more rental margin if they purchase in that area. By conducting some simple analysis prior to making an investment, one can easily determine how much rental margin one requires to take on an investment. Obviously, we want higher rental margins since higher rental margins equal more downside protection. But what if we are in an environment where we cannot find our desired rental margin? Should we wait until markets shift in our favor where prices go down or rents go up? Should we not invest at this moment? Or should we change our desired margin requirements? These are tough questions to answer and I cannot provide a one-size fits all answer here since each individuals’ investment goals are different. But what I can suggest is to:
1. Understand the market environment we are in by monitoring the rent-to-sales ratio. Sometimes prices are really high relative to historical prices, income, and rental rates so it may be a better time to build your cash stockpile and continue researching so that you will be ready for the right opportunity. I can say with confidence that prices will swing up and down and the investors who are patient will be the ones who are able to take advantage of the great opportunities when they arise.
2. Set investment constraints prior to making any investment and stick to them. Allow yourself some some wiggle room, but don’t accept less of a rental margin just because you really want to invest your money somewhere. When people do this they are chasing the price and foregoing all of their rational investment knowledge. Don’t do this! Stick to your plan. You definitely don’t want to end up losing your hard earned money.
Performing The Analysis
Zillow Data provides historical rent and sale prices for many metropolitan areas. Some data is even broken down into zip codes. I use this information to track trends of the rent and sales prices of areas that I want to invest in. Below is an example of the rent-to-sales ratio of the zip code 32205 from May 2017 through July 2019. This is a popular area within Jacksonville. Remember that the higher the rent-to-sales ratio, the better it is for rental property investing.
From the chart above we can see that the ratio has decreased and appears to have hit a floor of around 9% around late 2018 and early 2019. Since both rent prices and sale prices appreciated over this time span, we can conclude that the sale prices of homes in this area appreciated at a higher rate than rental prices, bringing the rent-to-sales ratio down. This could be driven by a shift of demand to own rather than rent in this area.
The chart above should be used to evaluate where the current market is at relative to historical data. Over the past two years the rent-to-sales ratio has been in a range of 9% to 10%. We would need to conduct much more analysis to come up with an outlook of this area and to forecast future rent and sale prices. But the analysis we have conducted thus far should give us a general idea of this area and if this is performed on other zip codes or metropolitan areas we can then compare and determine which areas we should further investigate. I view the rent-to-sales ratio as a first step when analyzing a new area.
The below chart compares the historical trends of the rent-to-sales ratios of Jacksonville, FL and Atlanta, GA.
As we can see from the chart above, the sale prices have appreciated much more in the Atlanta market relative to the Jacksonville market. This could be due to more of a demand to purchase properties in the Atlanta market. Again, more in depth analysis is required but we can clearly see that the Jacksonville market as a whole had prime investment opportunities from 2012 to early-2015. Anyone could have spotted this opportunity just by evaluating the area’s rent-to-sales ratio. This is not to say you cannot find pockets within Jacksonville, Atlanta, or any other market right now that has a rent-to-sales ratio above 12%. It will take some effort, but with your newly gained tool of the rent-to-sales ratio you will have a quick way to discover markets that have opportunities for investment. I’m Elenis. I’m writing about my journey toward greater happiness and financial independence for my family. You can connect with me here on BiggerPockers or on LinkedIn. Feel free to ask me any questions you have about rental property investing or real estate, I’ll try to answer as best as I can.
Originally published at www.medium.com on December 14, 2019.