Price-earnings ratio – for investment homes?

Interest rates are down, rents are up and investors are snapping up foreclosures. If you buy it “right,” how do you gauge if an investment property will be worthwhile?

When analysts look at stocks, they often focus on the price-earnings ratio as a measure of whether the stock is overvalued or undervalued. The higher the number (especially relative to either the market as a whole or to historical averages), the more likely the stock is to decline in price over time.

UCLA Professor Edward Leamer proposed that real estate be considered in a similar light. In this case, though, the ratio is the price of the second home or investment property to the annual rent it will earn. This calculation will give you a standard by which you can judge the relative potential for appreciation of different properties in different neighborhoods and even in different cities. In other words, it helps to make sound investment decisions by giving you a tool to measure alternative investments against each other. Here’s how it works.

Suppose you’re looking at a $255,000 property that will rent for $1,500 per month, or $18,000 per year (We can assume no vacancy, but you can figure in whatever you deem to be reasonable.) You are also looking at a $120,000 property that will rent for $850 per month, or $10,200 per year. The price-earnings ratio for the first property is approximately 14 (255 divided by 18), and the second is approximately 12 (120 divided by 10.2).

The second property appears to be a better candidate for appreciation since it has the lower price-earnings ratio.

For a truly effective comparison of the two properties, you need to make a second calculation. You need to look at the price-earnings ratio average for both properties relative to those properties in the same neighborhood. If the ratio for the neighborhood of the first house is 20 while the ratio for the second house is 10, then the first property might be the better buy. It is underpriced relative to its surroundings, while the second property is overpriced.

Although all this might appear complex, it’s really quite simple. After all, you already know the prices being asked for the properties you are evaluating, and you should know what rent you can charge once you own them.

All that’s needed is to find out the averages for prices and rents in the immediate neighborhood, and you’re done. Check county records, or with a a local salesperson or a property manager to help you out with these two numbers. This is a helpful research process that could propel you to financial success.