NEW YORK (Money Magazine) - As investors, we've become all too familiar with the price/earnings ratio, that simplest of measures for gauging the value of a stock.
After all, if we'd paid P/E ratios more heed a few years ago, we might have recognized the stock market bubble well before it popped.
These days it's real estate everyone's worried about, and Edward Leamer, an economist and director of UCLA Anderson Forecast, is suggesting that we apply a P/E-like metric to our homes -- the "P" being a home's current market value, the "E" what it could rent for.
If the P/E is up dramatically, Leamer says, you may be living in a bubble.
Sound intriguing? Here, in question-and-answer format, is what you need to know to understand and use this method for valuing real estate.
Why do you want a P/E for a home?
The price we pay for a stock theoretically reflects the company's current earnings and reasonable expectations about its future earnings. But it can also reflect irrational, and ephemeral, market sentiments like optimism or "irrational exuberance."
P/Es tell us how highly the market values each dollar of earnings -- a valuation we can then compare with other stocks (or the same stock at other times) to gauge how much is based on ephemeral factors.
Leamer's aim was to create a similar measuring device for our homes. With U.S. median home prices up 54 percent over the past decade -- and dramatically more in many regional pockets -- we'd all like to know what our homes might be worth in the future, especially should current market sentiment turn.
What's rent got to do with it?
Few of us plan to rent out our homes, so why are rental values part of the calculation? Leamer's reasoning rests on the premise that the market values homes as if they could be rented, whether or not they will be.
|Metro area†||Home P/E†|
|New York City†||32%†|
|San Francisco Bay†||30%†|
|†Source:††Edward Leamer, UCLA, based on National Association of Realtors and Bureau of Labor Statistics data.|
If it suddenly becomes much cheaper to rent, say, a $500,000 home than to own one (maintenance, property taxes and tax breaks included), some of us would consider selling our homes and renting instead, and some potential buyers would drop out of the market. Over the long run, Leamer figures, rent and sales prices should basically move in sync.
In the short run, however, they can get out of whack. Last year, Leamer crunched 19 years' worth of his P/Es on California housing and found that P/Es in the San Francisco Bay Area had expanded far more than those in the Los Angeles metro area since the end of the 1991 recession. Leamer sees this as "evidence of a bubble in San Francisco compared to L.A."
What's the P/E danger zone?
There isn't one. What matters is not the P/E itself but its change over time.
The fact is, as long as economic growth is high in a region, spurring new jobs and increased demand for housing, rental rates will likely rise and asset prices will increase even more, expanding the P/E for housing.
"A high P/E ratio can be justified in those markets where you would expect to see strong demand for housing in the future," Leamer explains. Low interest rates will also buoy P/Es. But if assumptions about economic growth or mortgage rates don't pan out, housing P/Es will have to compress.
So how much has my P/E changed?
The first step: Divide your home's market value by how much it would rent for on an annual basis. Then repeat the calculation using older data. Finally, compute the change.
You may have no idea what your house would rent for because the rental market in your area is limited. Local real estate agents may be able to give you an estimate.
But because reliable data can be hard to get, we asked Leamer to calculate metro-area P/E changes for us. He uses local versions of the shelter component of the consumer price index as a proxy for rental data.
Should I worry if my P/E is way up?
Housing bubbles typically don't pop like stock bubbles. Instead, home prices usually deflate slowly.
Transactions dry up before prices drop because homeowners tend to hang on rather than sell at a loss -- as long as they can make their mortgage payments.
For this reason, some real estate experts think the critical relationship is not between home prices and rental costs, but between the housing market and income levels.
That said, if prices and P/Es have gone up a lot, it's likely that they'll eventually come back down. "The equity markets taught us rather rudely that P/Es matter," Leamer says. "The same is true for the housing market."