Before buying a home, analyse your 'Price-to-Rent' ratio price.

Australia's property market has increased with an average 100 per cent growth over a seven year period. And whilst it seems good, and many people are frantically gearing themselves to the most extreme degrees to buy, there is a mathematical formula you can implement to analyse if renting is a smarter move than actually buying.

The 'Price-to-Rent' ratio is a ratio that compares the annual rental expenses compared to buying. Forbes contributor John Wasik contends that you can simply calculate this by doing the following:

Annual Rental costs: $460 per week (for two people) = $23,920 per year

What the prospective Purchase price would be = $400,000 

+ Mortgage registration fee = $111

+ Transfer Fee = $1,120

+ Stamp Duty = $8,185

Total = $10,839 

Purchase Price = $420,255

Price to Rent Ratio = 17.56

In this case, Wasik content that it is worth buying. If a home is well below this return then there are serious issues. One economist has mentioned price/rent ratio is similar to employing a price/earnings ratio for stocks.

'When a stock price is high, and its earnings per share relatively low, the P/E is high. A high P/E often indicates that the stock is too expensive, and the share price is headed for a drop' - Therefore in property, if your asset is too expensive and the return is so incredibly low, it may not be a good idea.

A lot of people bank on the idea of capital appreciation to counteract the loss that they incur, and they negatively gear the asset to write off the expense from their taxable income. But when you get dangerously low in your percentage, and it is clearly more economical to rent than buy, it may be better to look at investing your money elsewhere and getting a return from it that way, rather than sinking it in to property. 

It has been suggested that if people are willing to only pay 2-4% rent or (your return on investment), you may have overvalued it and could be over anticipating its long term value. As for renters, that should be strongly looking to secure a property where the rental ratio is as low as possible in regards to the purchase price. A smart person will be trying to find a property that someone has banked on the capital gain more than the rental return who is willing to negatively gear the home. Whilst some people rent in apartments like the one above, where they are paying $23,920 a year, if they went and leased a three bedroom home, where the home was valued at $750,000 look how it works out. 

Annual Rental costs: $750 per week (for three people) = $39,000 per year

What the prospective Purchase price would be = $750,000 

+ Mortgage registration fee = $111

+ Transfer Fee = $1,366

+ Stamp Duty = $40,070 

Total = $41,547

Purchase Price = $791,547

Price-to-rent Ratio = 20.29

Price-to-rent ratio of 1 to 15 = much better to buy than rent

Price-to-rent ratio of 16 to 20 = typically better the rent than buy

Price-to-rent ratio of 21 or more = much better to rent than buy

In this circumstance, both seem like better rental options because they aren't deriving a huge return. The one factor you need to remember is capital growth, so making sure you buy something with the best long term capital growth is essential. Whatever you do, make sure you have done your research on your Price-to-Rent ratio before making a decision and don't buy way too out of your comfort zone with too much banking on the capital appreciation. Once you are looking at a Price-to-Rent ratio of 25+ etc it is extremely dangerous. 

You can find out more about your 'Rent-to-Buy' ratio here.

If you're considering taking the leap here's our guide to negotiating as a first home buyer.

Happy house hunting!

From the Homely Team

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