Is Your Home Overvalued?

Housing has had a great run in the United States for more than 50 years. Is it likely to continue? This question can be answered in three parts: (1) Determine a price to earnings ratio (P/E) of your home, (2) estimate a fair P/E for a home, and (3) salt to taste (adjust for local market dynamics).

What Is the P/E of Your Home?

A first step is to determine the "fair" value of a property. As with stocks and bonds this is impossible to do precisely, but easy to approximate. The calculation of fair value relies upon calculating a price to earnings (P/E) ratio.

A stock's P/E is calculated by dividing the price of the stock by the earnings for the stock. In the stocks chapter, for example, we looked at Microsoft. The current price of Microsoft (July 2004) is $28, and the pre­ dicted earnings for 2004 are $1.27 per share. Thus, Microsoft's P/E is 22.

To calculate the P/E of a house or other piece of property, we divide the price of the property by the income it produces. This is easy for a rental property (as long as we are careful to adjust for taxes). For a prop­erty that is occupied by the owner, however, there is no rent. In this case, the "earnings" are the estimated rental payments if someone else occu­ pied the property.

For example, I live with my wife and our new baby in a condominium near Harvard University and Harvard Square . As our place has filled up with cribs and baby toys it has become obvious that we will need to move. Accordingly, I have been getting some estimates for the value of Bonds, Stocks, and Real Estate our place. The market price for our condominium is something like $650,000.

What is the value of our property? Because I don't assume the market price will stay constant, and I'm not sure when we will sell, I estimate the value independent of the current price. The key is the going rental price for the property. Even though we aren't currently earning anything on our property, I will use the market rental rate as the "earnings" for my P/E calculation.

The going rental rate for our apartment is about $2,800 a month. To calculate the P/E we need to factor in all costs including taxes. After our costs, we could generate about $2,000 a month in rental income from our property. So we could earn $24,000 a year in rent, after expenses. So the P/E for our condominium is the price ($650,000) divided by the earnings ($24,000). The P/E for our apartment is 27.

What Is a Fair P/E for a Home?

What is the fair P/E for a home? One way to answer this is to compare the P/E of a house to that of stocks and bonds. Table 9.1 makes this compar­ ison and summarizes some key attributes of the different investments.

The U.S. stock market as measured by the S&P 500 has a P/E of about 18; this calculation uses the estimates for 2004 earnings ($61.50) and the current figure of the S&P 500 (1101). 7 The 10-year Treasury bond cur­rently yields 4.4%. This converts to a P/E of 23.

TABLE 9.1 Key Investments Characteristics of Stocks, Bonds, and Real Estate

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How does a house compare with these two major alternatives? Table 9.1 lists four important investment characteristics and then analyzes the trade-offs between stocks investing, bonds, and real estate. When comparing two investments, the more favorable the investment attributes, the higher the fair value and the higher the P/E that can be justified. For example, if two investments are identical except for tax treatment, then the investment with the lower tax rate deserves a higher P/E.

Attribute #1, Risk: An investor in U.S. Treasury bonds is sure to get the original investment returned. Those who own stocks or houses risk losing their investment.

Attribute #2, Potential for Gain: The U.S. Treasury bond investor can make modest capital gains (if interest rates fall). Both the stock mar­ ket investor and the home buyer have the potential for substantial gains. Because houses can be bought with very modest down payments, how­ever, they have the highest potential for gain.

For example, Fatima 's $5,000 investment in real estate became more than $250,000 in just a few years. An investor who bought the Dow Jones Industrial Average in 1927 would have achieved the same 50-fold increase if she or he had held the stocks until 2004. 8 So a few years' investment in housing can provide a lifetime's worth of gains in the stock market.

Attribute #3, Tax Treatment: Stocks are treated more favorably than bonds. Both dividends and long-term capital gains have lower tax rates than interest payments on bonds. Houses have the most favorable tax treatment. This ranges from the tax-deductibility of interest payments to the exemption of taxes on substantial capital gains from sales.

Attribute #4, Inflation Protection: Normal U.S. Treasury bonds are not protected against inflation (though some bonds do have such protec­ tion). Both stocks and housing are protected against inflation.

How, then, do housing investments compare with stocks and bonds?

202 Applying Science and Art to Bonds, Stocks, and Real Estate

The answer is that houses share many characteristics with stocks. Houses offer more potential for gain and better tax treatment than stocks. While the higher potential gain in houses should come with more risk, this has not been the case over the last decades.

So what is the right P/E for housing? Based on the characteristics of risk, return, taxes, and inflation protection, housing investments look similar or better than stocks. In addition, the finite supply of land might argue for a bit of a premium. Based on this analysis, housing could command a fair P/E as high as 30. Housing P/E's are categorized in Table 9.2.

Salt to Taste

As we all learned in elementary school, the three keys to real estate are location, location, location. While there is a single market for IBM stock, there are many, many different markets for real estate. While we have just made some general conclusions about "fair value" for a house, those P/E categories should obviously be adjusted for local circumstances.

When people look at real estate at a local level they tend to analyze by city and region. We can read that housing prices have gone up by 15% in Phoenix , but declined in Buffalo . In reality, however, "location" is a much more fined-grained notion than an entire city.

My friend Jon, who lives in Charlotte , North Carolina , learned the

TABLE 9.2 Is Your Home Overvalued?

House Price to Earnings Ratio Value Category

More than 30 Expensive

Between 20 and 30 Premium

Between 10 and 20 Solid Value

Less than 10 Cheap

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importance of location (and timing) over the last several decades. He sent me an e-mail summarizing his real estate experiences. The e-mail enti­tled, "financial frustration" said:

I bought a condo in 1985, when I was single, two blocks from my office [in downtown Charlotte ] for convenience for $60,000. The property lost value for years while houses two miles away gained in value. I sold the condo in 1993 after getting married in 1992 for $84,000 and bought a home for $180,000. Seven years and two children later, I sold this home for a small loss after significant improvements. Finally, I bought my current house for $360,000 just as the economy was slowing (June 2001). My original condo is now worth more than $200,000!

Jon has owned real estate since 1985 in a booming market. Nevertheless, due to family changes he has almost magically missed out on making money; his timing and movements missed the micro trends within his area. So there is much more to location than a city or region. In my own building, for example, the properties on different floors and on different sides of the building have performed differently.

Accordingly, our valuation ranges should be combined with knowl­ edge of local conditions. Just as an above-average P/E may be appropri­ ate for the stock of a super rapidly growing company, a property in the right location can justify high valuations.

Is There a Housing Bubble?

A glance through a bookstore can produce some serious fears about housing prices. Titles such as The Coming Crash in the Housing Market and How to Profit from the Coming Real Estate Bust are likely to get any homeowner's pulse racing. Are we experiencing a housing bubble and, if so, will the bubble crash? to Bonds, Stocks, and Real Estate

There are some compelling clues that allow us to make a judgment as to the existence of a housing bubble.

Clue #1: Housing Prices Have Risen Far Faster Than Rents

There is no nationwide housing P/E. While we don't know the absolute value of the P/E we know that it has risen by 43% since 1982. Figure 9.2 graphs the rate of increase in housing prices divided by the rate of increase in rents.

Since 1982, housing prices have risen 43% more than rents. My wife and I have had a similar experience with our property. The market price of our condominium has almost doubled in just the last 5 years. In the same period, rents in our building have increased by about 20%.