|Don't get trapped in a housing bubble
Your house has a price-to-earnings ratio, just like a stock, and homebuyers
who ignore that P/E could be overpaying. Here's what you should look for and
how you can reduce your risk.
By Liz Pulliam Weston
Andy and his wife want to buy a home in the Atlanta area. But they're
worried they might be plunking down money just as housing prices peak.
"How do I recognize signs of a housing bubble?" Andy recently asked MSN's
Your Money message board.
That's the question many prospective homebuyers -- and current homeowners --
are asking themselves these days. As home prices rise at 20% annual rates in
some areas, many wonder if residential real estate is falling prey to the
same kind of wild speculation that led to the stock market's spectacular
The answer, says UCLA economist Edward Leamer, is yes -- at least in many
high-octane markets around the country such as San Francisco, Boston and San
How to figure a home's fundamental value
Leamer says he can tell because homes, just like stocks, have a
price-to-earnings ratio (P/E) that he believes determines their fundamental
value. The "earnings" part of the ratio consists of the annual rent the
house could command. Homebuyers can compare current P/Es with historical
levels, Leamer says, to get some idea of whether houses in their cities are
[this is similar to Dean Baker's analysis.]
Not everyone buys the idea that P/Es dictate value. But investors who
completely ignore P/Es do so at their peril, as many have learned in recent
years. Leamer, who heads the prestigious Anderson Forecast at the University
of California in Los Angeles, points out that the P/E for the Standard &
Poor's 500, a key stock benchmark, was nearly double its previous historical
high when the stock market bubble burst in 2000. When home P/Es peaked in
California, Boston, Dallas and other markets in the mid-1980s, devastating
real estate recessions followed.
Leamer didn't invent the concept of P/Es for homes. But his willingness to
proclaim bubbles in several of the nation's hottest markets has brought him
lots of attention recently.
To calculate P/Es for entire cities, Leamer divided the median home price in
each by the annual rent for a two-bedroom unit in each city -- and looked at
P/Es each year since 1988. Here's what he found:
* In Boston, the residential real estate market's P/E recently topped 30
-- compared with just under 20 in 1988.
* San Francisco's previous peak of 25.6 in 1989 has been eclipsed, with
the P/E currently at just over 27.
* San Diego's current P/E is nearly 30, compared with a 1989 high of
* New York, by contrast, is actually well below previous peaks. The
area's current 22.5 P/E is above its recent nadir of 17.6 in 1993, but down
from 28.6 in 1988.
You don't have to know exact P/Es, however, to spot signs of trouble, Leamer
says. Any time there's a disconnect between prices and the underlying value
of homes, as measured by their market rents, there's the potential for a
If home prices are rising much faster than rents, as is true in Los Angeles,
that's a strong indication a bubble is forming.
If home prices are rising while average rents are falling -- which is the
situation in San Francisco -- the bubble is pretty much unmistakable.
Home P/E ratios for 9 metro areas
Avg. 1988-2000 2001
Boston 20.5 30.2
San Diego 22.8 29.7
San Francisco 23.8 27.2
Los Angeles 21.3 25.6
Seattle 20.4 25
Denver 17.7 23.7
New York 21.2 22.5
Chicago 17.2 20.8
Washington, D.C. 17.1 20.4
It's difficult to compare P/Es from one city with those from another. P/Es
in Atlantic City, N.J., have wavered between 17.3 and 11.6 since 1988; in
San Diego, P/Es have not dropped below 20. But you can look on the P/E as a
measure of risk -- that is, the higher the P/E is above its average level,
the greater the risk, no matter where you live.
What could trigger a collapse?
Identifying a bubble and actually predicting when it will burst are two very
different matters, of course. Leamer acknowledges he can't forecast when
home prices will peak in any given market. The nature of a bubble is to feed
on itself, with rising prices convincing more and more investors that prices
can only continue to rise.
Such disconnects between an asset's fundamental value and what people are
willing to pay for it can persist for years. Leamer notes that Federal
Reserve Chairman Alan Greenspan started talking about a bubble in December
1996, when he made his famous speech about "irrational exuberance" in the
stock market. The Dow Jones Industrial Average back then was around 6,500.
The Dow, as you know, nearly doubled in the three years that followed before
the stock market bubble finally burst, sending prices skidding.
Leamer believes higher interest rates could be enough to knock many of the
nation's real estate markets off their perches. Other economists say hard
shocks to local economies -- such as the drop in oil prices that devastated
Dallas and Houston in the 1980s or the collapse of the defense industry in
Southern California in the early 1990s -- will be the trigger. Still others
dismiss any talk of a bubble, noting that a relatively strong economy could
keep prices on the rise for years.
How to reduce your risk...