Bubble, bubble, P/E and trouble - Viewing housing prices like stocks brews concern

The Star-Ledger, June 26th, 2005


1690 words

English (c) 2005 The Star-Ledger. All rights reserved.

Back when the dot-com economy was soaring and Wall Street was riding El Toro Grande, the P/E ratio was the fat elephant on the rickety corral fence everyone was trying to ignore.

Bad idea, in hindsight.

Love it or hate it, the P/E ratio - meaning, the price of a stock divided by its earnings per share - foretold the last stock market meltdown.

Now, with housing red hot, some economists suggest a variation of the P/E ratio foreshadows a bubble that's about to pop.

Home values have doubled during the past five years in some states and the median price of an existing home nationwide just topped $200,000 for the first time. But the price of a home is not some abstract number plucked from the sky, said Mark Zandi, chief economist at Economy.com, a forecasting firm in West Chester, Pa.

Homes, just like stocks, have P/E-like metrics that can help buyers determine their fundamental value - the "P" being a home's current market value, the "E" what it could rent for, he said. And after crunching the data, he said the P/E ratio for the U.S. housing market, as well as some regional pockets in New Jersey, is way out of whack.

If Zandi and other economists are right, the ramifications for consumers and the broader economy are huge, because millions of Americans now derive much of their wealth from the equity in their homes.

The concept is simple: If it becomes cheaper to rent, home prices will fall and the nest eggs people were counting on will start to shrivel.

"Many people think of their homes as an investment and you need to judge if it's a good investment and whether the price you are paying is appropriate," he said. "It's like when you evaluate a stock. You look at its price and you compare that to the earnings of the business that supports that price."

In a well-functioning market, the relationship between market rents and home sale prices should be stable, real estate experts said. Any time there's a disconnect between these two numbers, there's the potential for bubble trouble.

Typically, the "earnings" part of the ratio consists of the annual rent a house could command. And the "price" part of the ratio consists of the home's current market value.

By comparing these numbers with historical levels, home buyers can get some idea of whether houses in their area are overvalued.

To calculate his ratios, Zandi divided home prices in a number of metropolitan areas by the annual market rents for those same regions - and calculated the ratios for each year since 2000. A PATTERN Here's what he found:

Nationally, the residential real estate market's P/E is 17, well above the historic norm of 11.

In the Newark metropolitan region - a five-county span that includes Essex, Union, Morris, Warren and Sussex - the residential real estate market's P/E topped 18.4 - compared with just less than 11 five years ago.

During this same time frame, home prices have risen 13.3 percent, while rental rates have only increased 1.4 percent, according to Zandi.

In the Middlesex-Somerset-Hunterdon area, the P/E is 19.1, compared with 11.6 five years ago. Here, home prices have climbed 15.2 percent during the past five years, while rental rates have only inched up 2.3 percent.

At the peak of the stock market bubble in the late '90s, the combined core P/E of the Standard & Poor's 500 index - 500 of the largest publicly traded companies in the United States - rose above 30, more than twice as high as its historic average of 15.

That means for every dollar of earnings for the S&P 500 back during the bubble years, investors were willing to pay more than $30.

"They were so far out of line historically, and it indicated that people's expectations were distorted," Zandi said. TRAPPED Robert Dunne, who has been renting a one-bedroom apartment in Madison above a dentist's office for $900 a month, has been trapped in this distorted universe for the past three years.

The 35-year-old volunteer fireman has lived in Madison all his life and is determined to stay there. His father, Jack, was the mayor and his brother is a full-time firefighter.

But in this town where builders routinely snap up $800,000 homes just so they can tear them down and erect $2 million homes, Dunne is being priced out.

"I recently saw a house on the street I grew up on, a run-of-the-mill, three-bedroom Cape Cod, selling for $630,000 and you look at it and you laugh," Dunne said. "It has the original shingles on the house and it was built in the early 1950s."

Still, he's determined to buy a home.

"I haven't seen prices decline in the three years I've been looking," he said. "Sure, they say the bubble could burst, but when? It doesn't look like it, and every day I look, the next house is more expensive than the other."

Despite the frenzy, local brokers tend to dismiss speculation about a "housing bubble."

"Our resale market is still very strong," Carol Tangorra, a Realtor at Schweppe Burgdorff Realtors in Montclair, said.

In Montclair, houses still sell in hours or days rather than weeks or months, Tangorra said, with a typical seller fielding 15-18 offers in one weekend.

"Houses are commodities and buyers establish the price," she said. "It doesn't matter what the price is. It's the perception of value. And if the perception of value is there, that house will sell very quickly." SETTING RECORDS On a broader scale, the government reported Friday that nationally, sales of new homes reached the second- highest level ever, for a seasonally adjusted annual rate of 1.3 million homes. But the median sales price dropped 6.5 percent, to $217,000, meaning half the homes sold for more and half for less. It was the second decrease in four months after hitting a record $237,000 in February.

Some economists say the surge in home prices that began in the late '90s is unusual in its strength and duration. Dean Baker, co-director of the Center for Economic and Policy Research, estimates $5.2 trillion in "bubble wealth" has been created since the real estate boom began in 1996.

John Krainer, an economist at the Federal Reserve Bank of San Francisco, recently crunched 23 years' worth of housing and rental data and found that nationally, housing prices have been growing faster than implied rental values for quite some time.

To calculate P/Es for metropolitan areas around the country, Krainer divided the existing home sales index, published by the Office of Federal Housing Enterprise Oversight, by the owner's equivalent rent index, published by the Bureau of Labor Statistics, and looked at quarterly P/Es for each year since 1982.

He found the value of the U.S. price/rent ratio is 30 percent higher than its long-run average.

That doesn't necessarily mean a bubble, but it does "imply that, at this point in time, home prices have grown faster, for far longer than rents have and that is implicitly saying that the market valuations right now are pretty high," he said.

Economists acknowledge the link between home prices and rental data often causes a bit of head- scratching on the part of consumers.

Few homeowners plan to rent out their homes, so why are rental values part of the calculation, anyway?

The reasoning: the market tends to value homes as if they could be rented, whether or not they will be, Zandi said.

''The value of a home is directly tied to the services the house ultimately provides," he said. "And those services are equal to the rent you would pay yourself to live in that house."

Michael Lattimer of Lattimer Realty in Fairfield thinks if interest rates continue rising, the number of people who can't afford a home - like Robert Dunne in Madison - will rise. That would surely kick the rental market into high gear and deflate the demand for housing, and by extension, prices.

"Once prices get too far out of hand and interest rates bump up, you will see the rental market take off," he said.