Rent or buy? A simple test

This guest post comes from Len Penzo at Len Penzo dot Com.

My friend and I recently got into a discussion at work regarding the housing market.

The big super unknown for my colleague, of course, was whether or not prices had dropped far enough to make it worth buying a house again.

"It's a good question," I told him, "We could ask my Magic 8-Ball, but it's in the car and I don't feel like making the long walk to the parking lot."

I know what you're thinking. As luck would have it, the portable GPS system I was using in my car had gone on the fritz, and so I tried using the 8-Ball as a stand-in. I quickly ended that experiment after beta-testing it over the previous weekend; it failed miserably.

Oh, it was fairly accurate when asked questions like, "Should I take the 405 northbound to Santa Monica?" But there is nothing more frustrating than trying to shake a Magic 8-Ball and read an answer while driving a stick shift in rush-hour traffic. Especially when it tells you to "concentrate and ask again." Believe me.

OK, maybe not; you got me. I digress.

The price-to-rent ratio

In my inland neighborhood, home prices have stabilized after dropping by as much as 40% since the bottom fell out of the housing market several years back.

Then again, home prices where I work in Orange County, Calif., still seem to be a bit overpriced. The mixed conditions are understandable because there are naturally going to be market variations from region to region. That's just the way it is, folks.

So what's a guy or gal to do if they are trying to gauge where a particular housing market is still overinflated and they don't want to rely on a Magic 8-Ball?

Perhaps one of the better indicators is something called the price-to-rent ratio or P/R, which is simply the median home price in a given region divided by the annual rent you can get for a similar home. Post continues after video.

A low P/R can be a signal that regional home prices are cheap compared with renting. On the other hand, a high P/R can indicate that you'd be better off renting.

The P/R is not perfect because the varied mix of homes affects the median price. It also can't tell you if a particular house is appropriately priced.

Still, I think it is a terrific way to get a back-of-the-envelope​ estimate as to whether it's better to rent or buy.

Calculating the P/R ratio

Just for fun, let's use the P/R ratio to see whether it would be better to buy or rent houses in my neighborhood.

Right now, there are three homes in my housing development that are offering monthly rents of between $2,300 and $2,350. The median home price for similar homes in my local area is currently $450,000.

P/R = (Median home price)/(12 x monthly rent), or

P/R = ($450,000)/(12 x $2,300), so

P/R = 16.

OK, Len, so what does that mean? Is 16 high or low?

Well, The New York Times notes that, nationally, the average P/R through the 1970s, '80s and '90s stayed between 10 and 14 before peaking at 19 at the top of the housing market in 2006.

In 2009, the regions with some of the highest P/Rs included Oakland, Calif., (36.3), Honolulu (34.8), San Jose, Calif., (32.3), San Francisco (28.4), Seattle (28.1) and -- surprise! -- Orange County (26.8).

Markets with some of the lowest P/Rs included Pittsburgh (11.7), Detroit (12.1), Cleveland (12.6), Phoenix (13.3), Riverside/San Bernardino, Calif., (13.5), and Las Vegas (13.9).

Generally, a P/R of about 15 is considered by many folks to be low enough to take the plunge and buy a house. On the other hand, many people typically consider renting to be the better choice when the P/R reaches 20 or so.

In my example, with a P/R of 16, if someone were looking for a home in my neighborhood, they might feel fairly comfortable buying.

Folks who want to dig deeper can also try comparing the current P/R to the historical average for a given region. You can often get that data from a local real estate agent. For a more complete list of recent P/Rs by region from The New York Times, including some limited regional trend data, click here.

In conclusion

Keep in mind that the P/R ratio is really meant to guide you on the timing of your purchase. When it comes time for deciding whether buying a home is right for you, you'll need to evaluate other criteria. 

For example, it is important to consider the length of time you plan to live in the home, and your willingness to tackle typical homeowner duties like mowing the lawn, shoveling snow, and other general home maintenance activities. You'll also want to make sure you have saved enough money -- not only to cover the required down payment, but also additional savings to cover surprises that will inevitably pop up from time to time.

• Bing:How much house can you afford?

That being said, when it comes time to try and figure out whether now is the right time to rent or buy a house, you can always count on the price-to-rent ratio to get a rough answer.

It may not be foolproof, but it will certainly be a whole lot more reliable than a Magic 8-Ball.

More from Len Penzo dot Com:

• 12 good reasons why you should and should not pay off your mortgage early
• 21 reasons why corner lots are for suckers
• Use a ledger to teach kids money-management skills