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Five Strong Rent-to-Value Markets

Editor's note: As a special feature for April, Ratings offers a 20-part series on virtually everything about real estate. This installment, which originally ran as Top 1%, is Part 18.

How do you evaluate a real estate investment?

For most of us -- and readers of The Millionaire Zone -- it's about long-term gains. Buy low, sell high.

But that might take a while, especially in today's environment of oversupply and soft prices. So what now?

I believe it's back-to-basics time -- time to bring the whole return-on-investment equation back into play. That means a closer look at current cash flow, or rental income, against the cost of your investment. That income keeps you in the game for the long term. In some markets, it may enable you to go positive right off the bat.

That's a smarter way to play today.

Really, we're talking about judging real estate investments more like a stock or any business investment -- through short-term earnings and cash flow, not just long-term growth.

Many real estate professionals look at something called rent-to-value, that is, the ratio of rental income to the price of the property. Suppose the annual rent is $7,200 ($600 a month) on a $144,000 property. The RTV is 5% -- not a bad return compared with other investments, and certainly enough to keep you in the appreciation game.

Maybe because I invest in stocks, I actually prefer the inverse of the RTV ratio -- the VTR ratio, if you will. It works like a P/E ratio for stocks. In the above example, the VTR ratio is 20, comparable to a stock with a P/E of 20.

OK, enough explanation. How do we use these ratios to make an investing decision? And do different U.S. markets really vary that much?

You bet. With the help of 2006 median rent and home price data from Sperling's Best Places for 375 U.S. metropolitan areas, I was stunned at how much markets vary.

In fact, the VTR ratio (P/E equivalent) runs from a low of 10 in depressed markets such as Danville, Ill., and Flint and Saginaw, Mich., to a screaming 56 in the Salinas-Monterey Bay area of California. In fact, most California locations are over 40, confirming the inflated home values you've read about. To say the least, that's a challenging market for new investments.

So what about the good market opportunities? Here's how I found them.

I'm looking for VTR ratios under 20. Fifteen to 17 is the sweet spot. Reversing the ratio implies a 6% annual return on your total investment. And since you're probably using a mortgage, your real ROI could be much higher.

Click here for the video version of this story from Jennifer Openshaw.
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