Key Market Indicators

The market consists of properties that are for sale, under contract or have recently sold. Whether you’re a homebuyer, seller or an owner, you probably have one central question about this market: where are prices headed from here?

When beginning to assess the value of a property you must consider how official appraisals are measured. Official bank appraisals are based on sales from the last six months in the surrounding area., this is generally the measurement you should use in determining your current property value.

To help you gain some insight into the pricing puzzle we’ll look at a few key performance indicators.

• – Price-to-rent ratio
• – Price per square foot
• – Absorption rate
• – Average Day on Market
• – Capitalization Rate

The indicators give a data driven picture of a current real estate market. Please keep in mind that each property is unique. The location, condition, amenities and macro-economic factors all affect the price.

Let’s take a look at each of these key market indicators:

Price-to-Rent Ratio

The price-to-rent ratio is a valuation of how affordable a property would be for renters in the local housing market. Fair value can be calculated based on the Price-to-rent ratio on a home.

Current Sale Value ÷ (12 x Current Monthly Rental Value) = Price to Rent Ratio

This indicator is used to determine if the current value of a property is a fair value. Generally it measures whether a property would be cheaper to rent or cheaper to own after paying a mortgage.

For example, if the average local home is worth $300,000 and the average rents are $1,200 a month:

$300,000 ÷ (12 x $1,200) = 20.83

The higher that number climbs, the more affordable the market is for potential buyers and worse for renters. This is important to understand whether the total monthly rental revenue would cover a property’s mortgage and fees.

The lower the price-to-rent ratio is, the more affordable it is to rent the property. This is not good for a potential buyer and likely means that at the current price, the market rents would not cover the total of the property expenses.

As you can see, the numbers will vary depending upon both the average home valuation and the average of what the renters market can carry for monthly rent expenditures. What this reveals to buyers is it might be better to rent a home rather than purchase it.

The use of a price-to-rent ratio is comparable to the price-to-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.

What someone is willing to pay to rent a place is that home’s “earnings.” Just as in the stock market, a high home price related to the rental earnings mean homes values will probably drop.

Cities with a high price-to-rent ratio are the least buyer friendly. If your current market has a high ratio, you should consider selling. 

Price Per Square Foot

As you might be able to determine from the name, price per square foot is the valuation of each square foot of the livable area of a property.

This metric is primarily used to compare and contrast similar properties. Since it is unlikely that each comparable will be the exact same size, this allows two or more properties to have a comparable value.

Price per square foot answers the question, “Am I getting more or less house for my money?” Though it is a commonly used metric, there can be several issues with focusing only on the price per square foot.

Other factors, such as property condition and location (i.e. the direction the home faces or the surrounding neighborhood) may push the price per square foot up or down.

Also, property improvements won’t necessarily increase your price per square foot. You may have excellent upgrades in the home, a brand new kitchen or remodeled bathrooms but if your home is not in a desirable part of the city, you won’t necessarily garner more price per square footage.

Therefore, although price per square foot is a commonly used tool for home valuation, there are other important factors, which need to be taken into consideration for determining home price.

Absorption Rate

Real estate is a unique market. Unlike stocks and options, real estate requires a time-consuming process to transact.

While stocks and options can be traded for a profit within seconds, real estate transactions can take weeks and sometimes years. This extended length of time has a dramatic effect on the overall marketplace and slows down the rate of change.

The rate at which homes sell in a localized market during a given time period is called the absorption rate. The absorption rate is a calculation based on dividing the number of homes sales in a month by the number of available homes for sale.

For example, if there is a neighborhood that has 10 homes listed for sale and 2 households in that same area sold last month, the absorption rate would be 2/10 = 20%.

A high absorption rate, generally over 20% or more, means that homes are selling quickly and it would be considered a seller’s market. A lower absorption rate means that homes are sitting on the market and there is more supply than demand, favoring buyers and generally lowering prices due to demand.

The absorption rate is considered one of the most important market indicators and should dictate pricing and demand trends of the current market.

Average Days on Market

The average days a property sits on the market before going into escrow is one part of the absorption rate. This indicator tells you how hot the market is at the current moment.

The shorter the amount of time a property sits on the market, the better for a homeowner. A short period means high buyer demand in the market.

A buyer’s market, when there’s more supply than demand, the homes take an average of 90 days or longer to sell. This happens when more homeowners are looking to sell their properties than there are qualified buyers willing to pay their price.

In a buyer’s market, sellers will likely have to accept a lower price than they ideally want. This hyper-competitive market is all about property condition and price. These two factors directly control a buyer’s decision and perceived value.

Investing in your property to improve the design and condition will make your home stand out compared to similar choices. After all, a buyer is searching for the best deal in the market.

From a real estate buyer’s perspective, this is the best time to buy. It allows buyers to find deals that could easily appreciate in value. 

A seller’s market is just the opposite. Demand is greater than the supply. The market conditions are ripe and price is a hot commodity.

In a seller’s market, it should take less than 60 days to sell a house. In fact, in a seller’s market with the right price, condition and marketing, properties should receive multiple offers.

The third type of market is when the average time on the market is between 60-90 days. This market would be considered neutral and has benefits for both buyers and sellers. This type of market will likely see more negotiations between the two parties since a buyer has slightly more leverage than during a hot sellers market.

Capitalization Rate

The capitalization rate, often just called the cap rate, is the ratio of net operating income to property asset value. This is the basic rate of return an investment will receive for a property at the purchase price.

Capitalization Rate = Yearly Net Income/Purchase Price

If a building is purchased for $1,000,000 and it generates $100,000 in net operating income, the amount left after fixed costs and variable costs, then:

$100,000 / $1,000,000 = 10%

The properties capitalization rate is ten percent; one-tenth of the building’s cost is paid by the year’s net proceeds. This indicates that it would likely take ten years to recover the cost of the building.

The cap rate is more commonly used in commercial real estate listings but can also be seen with residential listings.

I recommend including the financial calculations, including the cap rate, with residential transactions as well to help showcase the potential of a property. In addition, unique revenue generating aspects such as AirBnB and short-term rentals are allowing residential properties to legally generate additional revenue streams.

Depending on the laws and ethics, these scenarios can be highlighted as a selling feature. Be sure to check your local laws before advertising a property with a controversial analysis.