Welcome to passive real estate investing, the show where busy people like you learn how to build substantial passive income while creating wealth for the long term. And now here’s your host Marco Santarelli.
Hello my friends and welcome to another episode of Ask Marco where I answer your investing related questions this week we have an interesting question, one that I get asked quite often and my team gets asked this question quite often and I think it’s a good one to address because it’s important, but I don’t want people to misunderstand it and it’s really the RV or rent to value ratio. And so the question this week comes from Pratik. I hope I’m pronouncing that correctly. Uh, product says hi, I just started listening to your podcast. I am really learning a lot of things about real estate investment. You mentioned the rent to value ratio in your podcast. You said start with 0.7 to 1% ideally, but I am living in Montreal and I don’t see the rent to value ratio anywhere around that. What I found realistically in Montreal is around 0.5% how does the people who invest in real estate in Montreal make a profit and monthly cashflow?
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Because all you will get from monthly rent is almost the same as your mortgage installment. I’m really sorry if this is a stupid question. I am new to this. Thanks in advance. First of all, let me just say that this is not a stupid question. It’s a great question and often there are no stupid questions because if you think you have a stupid question, chances are someone else has the same question as you and they’re wondering the same thing. And at one point in time we didn’t know the answer to all the questions that are out there. So we learn as we go. And if you don’t ask, you’re not going to get the answer. So ask. That’s why we do this. So let’s start off by defining it is the ratio of the monthly rent to the purchase price. That’s it. So let me give you an example so you can easily understand this.
I like to use the example of the hundred thousand dollar property and maybe in Montreal or coastal California or the northeast. There are many parts of the country where you don’t find a hundred thousand dollars properties, but let’s just say there are a lot of them throughout the country and it’s not atypical, but $100,000 property that rents for $1,000 per month has a 1% rent to value ratio or rent to price ratio, however you want to call it, and what that means is simply this, that you’ve taken that monthly rent of $1,000 divided it into the a hundred thousand dollars purchase price or that could be your acquisition price, whatever that number is because you may have not purchased it new. You may have a cost basis in a property of $100,000 and so your rent to value ratio is still going to be 1% but that’s all it is, is just dividing the monthly rent into the market value or purchase price.
Now let’s talk about the range in the target. Often. What you’re going to find is that number will range from the very low zero point x percent on up to as high as 2% or more. That’s not your target. Don’t get mesmerized or seduced by very high numbers and I’ll tell you why here in a second. Basically, most markets that make sense financially, fundamentally, economically are going to have rent to value ratios that range from roughly 0.7% on up to about 1.2 1.3% we find that a rent to value ratio of around 1% is typically the middle of the bell curve is the sweet spot. It’s what you’re going to find in good markets and good neighborhoods. Again, the 1% is a target. It’s what you would ideally like to have, but if you are looking at property that has an RV ratio of 0.7 0.8 0.9 those numbers can still work, especially if you’re in a growth area, a very desirable neighborhood or a neighborhood that’s above what I’ll call the middle of the bell curve.
Something like an a minus type of neighborhood. Something that is a little bit more premium, you’re going to find that RV ratio drops, but the given the take there is often if you’re in the path of progress or in a growth area or a growth market or growth neighborhood, you might be on the higher end of the mid point or median price of a particular area or market that will drop your RV ratio, but what you often get in lieu of that is stronger appreciation potential, so a range from 0.7% on up to one or 1.1 or 1.2 is going to be the sweet spot. It’s going to be where the numbers make sense. The cashflows there, you have a decent cap rate, you have a decent cash on cash return. Where you see extremes in this range are when you drop down into C class or even maybe D class neighborhoods, which I certainly don’t recommend you do, but if you’re in a n a c class neighborhood, typically you’re going to see that rent to value ratio go up.
In fact, often it’ll be above 1% it might be 1.1 1.2% or more. So the thing is is you don’t want to get trapped into a bad neighborhood just because it has a higher rent to value ratio. You have to consider the quality of the neighborhood, the demographic of the tenant crime, school system and all those things. Just because you have a higher RV ratio in a higher cash on cash return on the front end doesn’t make it a better investment. In fact, I would argue that you’re better off starting in a class neighborhoods that have lower initial rates of but stability, strength, desirability, less volatility and better appreciation potential and often you’re going to find those in the 0.8 0.9% RV ratios. Now keep in mind, I’m talking about traps that people fall into when they focus too much on the rent to value ratio, but this is just a simple test.
It’s a litmus test. It is one of the many metrics you’re going to look at. This is one of the first things I look at because I know that if it is out of whack with it’s RV ratio, I don’t spend any more of my time on it. I I know well enough that if it has a 0.5% rent to value ratio as you find in Montreal, southern California, Northern California, many of the coastal markets, some of the cyclical markets within the United States, uh, and this is true for Canada and other countries as well. This is certainly true for Vancouver and Toronto. When the rent to value ratio is out of whack, out of that normal range, in other words, is very low, 0.4 0.5%. I know that the numbers are probably not going to work and often that property is going to be in a very expensive neighborhood relative to that market.
So, so just keep that in mind. You have to look at all the metrics, not just the rent to value ratio. It’s just a simple litmus test. Anyway, that is a, the long and the short of it. I could go on about it, but I just want you to keep it simple and just understand that this is just one of many things. You’re looking at a shoot for 1% if it’s more great, as long as everything else still jives, you don’t want to be in a bad area, bad neighborhood, just to make that rent to value ratio go up or your cash on cash return go up. I still think that you’re better off getting a hundred thousand dollar home in a B class neighborhood, then getting a $50,000 home in a C class neighborhood even though initially those numbers look better on paper and your returns look larger initially. The fact is is that I’d rather have a good experience and just be in a stable neighborhood. All right. I hope that helps.
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