OT - SF Bay Area RE Bubble...
Home buyers can learn from burst of stock bubble
Sunday, July 21, 2002
©2002 San Francisco Chronicle.
URL: sfgate.com
Stock investors got in trouble in the late 1990s by ignoring price earnings ratios.
Economist Ed Leamer is afraid that home buyers, especially in the Bay Area, may be making the same mistake.
A P/E ratio reflects how much an investor is willing to pay today for an expected stream of income.
The P/E ratio for a company is its current share price divided by its annual earnings per share. It helps you judge how cheap or expensive a
stock is compared with other stocks and with its own historical valuation.
For a house, the P/E ratio is the current market price divided by how much rent the house could fetch in one year, minus expenses.
Emotion and misunderstanding can take P/Es to extreme highs and lows.
Leamer, director of the UCLA Anderson Forecast, sees the same kind of mania that swept over the stock market bubbling up in the housing
market.
The P/E ratio for the Standard & Poor's 500 index, based on actual reported earnings, has averaged 14.5 over the
long run. But in 2001, it reached 55. Tech stocks commanded even more ludicrous valuations. In March 2000, Cisco was trading at 192 times
earnings, Intel at 60 times, Microsoft at 70 and JDS Uniphase at 713.
The theory was that earnings would grow at something approaching the speed of light. In retrospect, that was obviously laughable. But a lot of
people believed it at the time.
When the recession hit and earnings started to slow, people realized stock values were based on foolish expectations and to some extent
overstated earnings. Prices crashed and P/Es shrank to more realistic levels.
Today, Cisco's P/E ratio is 55, Intel's is 39 and Microsoft's is 27. JDSU has no P/E ratio because it has no earnings.
Investors have become much more realistic about stock valuations but seem to be ignoring house P/Es. Of course, you can't look them up like
you can a stock's P/E, and many people think of a home as more than just an investment. But Leamer says home buyers "should go through the
same mental calculation in purchasing a home as in purchasing a stock."
Divide the asking price by how much the home could be rented for on an annual basis. If a $500,000 house could generate $25,000 in rent
after subtracting maintenance and management fees, the P/E ratio is 20.
You can't directly compare a home's P/E to a stock's P/E, but you can compare it to other homes in the area and historical valuations.
Using aggregate numbers, Leamer calculated housing P/Es for various metropolitan areas from 1988 through 2001.
He divided the median sales price for existing single-family homes in each region by the average rent for a two-bedroom unit.
What he found: In the Bay Area, house P/Es are higher than they were in 1989, just before the last housing bubble burst.
The P/E for Bay Area houses averaged 27.2 in 2001, down slightly from 2000 but still higher than 1989, when it averaged 25.6. In 1993
through 1995, it hovered around 21.
Leamer finds that home values in Boston and San Diego are even more inflated.
Granted, this is a crude estimate. Houses differ by type and location. The exercise ignores tax benefits and maintenance costs. And comparing
homes against a two-bedroom apartment is hardly apples to apples.
HOME P/ES OVERVALUED
But the basic finding is undeniable: Home prices in many regions are outstripping rental rates.
Leamer's data ends in 2001, but according to other sources, home prices in the Bay Area have continued to go up this year and rents are
coming down.
Rents for all size units in large apartment complexes averaged $1,388 in the first quarter of this year, according to RealFacts. That's down 3
percent from the fourth quarter of last year and down 17.4 percent from the first quarter of 2001.
Meanwhile, the median price for all homes and condos in the Bay Area for the first five months of this year averaged $390,000, up 2.6 percent
from the first five months of last year, says Dataquick.
"Rents are soft or negative while prices are going up," Leamer says. "That's the same kind of disconnect we saw in the stock market."
BAY AREA PRICES KEEP RISING
Leamer says rental rates are the best measure of demand for housing. Demand is falling because people who lost their jobs are moving out or
doubling up.
The Bay Area population actually fell an estimated 1 percent between 2000 and 2001.
So why do Bay Area home prices continue to rise, despite the tech meltdown and virtual disappearance of stock option income, which
accelerated the 1990s home-buying binge?
The big reason is falling interest rates. They make houses more affordable and encourage banks to lend more because the difference between
their deposit and lending rates grows.
EASIER LOAN TERMS
Today, many buyers can borrow up to 100 percent of a home's purchase price, compared with 80 or 90 percent historically. Banks will let
buyers devote 40 to 50 percent of their income to debt payments, compared with 33 percent or less in the past.
If interest rates begin rising and incomes don't, people likely will pay less for housing. If rates rise far and fast enough, maxed-out borrowers,
including those with home-equity loans, could be forced to sell at distressed prices.
Many people also borrowed money to buy stocks, although they could not borrow more than 50 percent of the stock's value. When stocks
imploded, some had to sell stocks to repay their loans, which exacerbated the decline.
Of course, people will hold onto their houses longer than stocks, unless they have no choice.
Another reason home prices keep rising is pent-up demand. Many people who lost out in multiple-bidding situations kept on bidding, even as
the economy went south.
SUCCESS AT LAST
Richard Surosky and his partner, Mae Lum, searched for a house in the East Bay for two years. They visited more than 300 open houses and
bid on 15. They were outbid on all but one, which they didn't buy because the seller wouldn't let them inspect it first.
A month ago, the couple placed a winning bid -- $470,000 for a nice two- bedroom, one-bath home near Oakland's Rockridge district. They
faced only two other bidders, compared with a dozen or more in years past.
Their agent, Monica Rohrer of La Maison Real Estate, wonders if their success signals a market top. "That was maybe an indicator to me," she
says, half joking.
Surosky says he finally got the house because he was willing to pay more and accept a smaller house than originally planned.
Some people wonder what will happen when people like Surosky finally have houses.
EXPENSIVE NO MATTER WHAT
"People who are desperately jumping in now may be making an error because they may be buying an asset that's overpriced," Leamer says.
He says home buyers can justify high P/Es because of the tax advantages homes afford. Likewise, low yields on other investments such as
bonds can justify a higher home P/E. And homes in regions expected to experience high growth and rapid appreciation in rents may deserve
higher P/E, just like a tech stock can have a higher P/E than a carmaker.
"But you are completely deluding yourself if you think there can be a long- run disconnect between a house price and its potential rental
stream," Leamer writes in his report (available on the Web at uclaforecast.com).
Steve Cochrane, a senior economist with Economy.com, says, "There's a real disconnect between the single-family and multifamily markets.
Over the long term, the two should balance out."
But that doesn't mean house prices must come down. Instead, Cochrane says housing prices will stabilize and rents will come up.
"I think we'll see a more orderly transition to equilibrium prices," he says.
Cochrane admits that consumer debt levels are high but points out that mortgage defaults are low, especially in California.
INTERESTING TRANSITION
"If interest rates go up in conjunction with an improving economy, there will be a shift in demand drivers. We'd have improved household
income taking over" for low mortgage rates.
He says the timing of such things "is never always right, but it could be a smooth transition."
Cochrane says the limited supply of homes, especially in the Bay Area, should prevent home prices from slipping too much.
But Leamer says that theory is all wet. Whether you're talking about oceanfront property or Victorians in San Francisco, everyone knows
supply is limited. It's already built into the price.
"Once it's in the price, it can go up or down. You have downside risk like you have in any other asset," he says.
Home PEs soar
Price-earnings ratios for homes in metro areas where valuations are high and rising. PE is calculated for each region by dividing the median
sales price for homes by the average rent for a two-bedroom apartment.
Source: Ed Leamer, UCLA Anderson Forecast |
