# Risk Management: Key Ratios

### Objective

In the last post about general demographic information on a zip code level, we discussed different ways to screen for potential zip codes based on a breadth of factors. Another critical component of screening is to locate properties in locations where you avoid getting burned on the actual deal. Focusing on individual deals is time consuming; therefore, in order to drill down the total number of properties you need to look at, we need to examine where we are more likely to find better deals.

### Risk Management 101 – Ratio Analysis

There are many ratios out there for evaluating potential investment opportunities. One of the more common ones you may hear in the news is the Price-to-Earnings (P/E) ratio for stocks, which represents the current market value of the company relative to that company’s the net income. The benefit of these sorts of  ratios is that they allow us to understand an investment is expensive or cheap.

For example, lets say the long-run price-to-earnings ratio for the whole stock market is around 15.0x (meaning the price is about 15 times the net income of the company). If stock A has a P/E ratio of 16.0x and stock B has a P/E ratio of 14.0x, assuming all other factors are the same, an investor would more likely select stock B because it is “underpriced” relative to the stock market’s long-run P/E ratio of 15.0x. While there certainly many other factors you would need to analyze, the ratio helps give you a starting point so that you are not researching positions that are possibly overpriced to begin with.

In the same way we look at P/E ratios for stocks, we can adapt the same logic for residential real estate. Two of the key multiples we can look at include:

• Price-to-Income (P/I) ratio:  the ratio of the average home prices to the average personal income.
• Price-to-Rent (P/R) ratio: the ratio of the average home prices to the average rent.

Note: the averages may be replaced with the median as certain investors believe it is a better representation of centrality for a specific zip code. For the purpose of this analysis, I have utilized average numbers.

In order to acquire the data, we can acquire the average home price and household income data from the moving.com analysis per my previous post. The average rent figure is a bit more difficult to look at given the ever changing nature of local rent and aligning housing characteristics (such as the number of bedrooms or bathrooms). In order to acquire the information, I went to the MyApartmentMap website. Below, we can type in the zip code of the areas we are looking at:

After selecting the zip code, select the “rental data” link at the top of the page:

Finally, we can see the average rental rates for studio, 1 bedroom, 2 bedroom and 3 bedroom apartments.

Once this has been applied to all of the zip codes, we can compare the average P/I and P/R ratios. For the purpose of this analysis, I looked at both sales price relative to 3 br and 2 br rental prices. Using the same color scale as before, we can separate the good from the bad. Remember, we are looking for ratios below the median of all the ratios, which is an indicator for “underpriced” homes.

As you can see, this analysis will provide a conflicting analysis with the previous two posts. The reason for this is that growing jurisdictions (such as 30342) may be overpriced (an indication that the market has peaked and prices will soon start to fall). If, as an investor, you believe that the specific jurisdiction will keep growing, then the ratio analysis means less and less to you. However, to take a more conservative approach, picking from underpriced homes helps you find areas where prices still have room to move north.

However, be warned when selecting properties only based on the multiples, because they may also indicate that prices will keep falling in that respective zip code. From lessons learned in 2008, catching a falling knife can burn your investment portfolio. After the screening part of your investment due diligence, always remember to do a more detailed dive into the specific property (we will review this in later posts). The aim is to layer the initial analyses on top of the multiples research and find the best risk-to-reward ratio based on your investment profile.

Now, how else can we use this data? As the Great Recession has taught us, the economy moves in cycles. If we compare these multiples to historical data points, we can see when the market starts to become more overheated. Review this Investopedia article for more information on the P/I and P/R ratios.

### Conclusion

Being able to analyze the macro trends in the housing market allows individuals to smartly filter through different zip codes to find the best potential deals. Risk management is an essential component of any investment portfolio, real estate is certainly no exception. In the next lesson, we work on combining the research from the past couple of days and reducing the number of zip codes we are looking at from 27 to 3.