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| The Basics | Don't get trapped in a housing bubble
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Your house has a price-to-earnings ratio, just like a stock, and homebuyers who ignore that P/E could be overpaying. Here's how you can reduce your risk.
By Liz Pulliam Weston
Andy and his wife want to buy a home in the Atlanta area. But theyre worried they might be plunking down money just as housing prices peak.
How do I recognize signs of a housing bubble? Andy recently asked MSNs Your Money message board.
Thats 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 markets spectacular downfall.
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 Diego.
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 becoming overvalued.
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 & Poors 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 didnt invent the concept of P/Es for homes. But his willingness to proclaim bubbles in several of the nations 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. Heres what he found:
- In Boston, the residential real estate markets P/E recently topped 30 -- compared with just under 20 in 1988.
- San Franciscos previous peak of 25.6 in 1989 has been eclipsed, with the P/E currently at just over 27.
- San Diegos current P/E is nearly 30, compared with a 1989 high of 23.4.
- New York, by contrast, is actually well below previous peaks. The areas current 22.5 P/E is above its recent nadir of 17.6 in 1993, but down from 28.6 in 1988.
You dont have to know exact P/Es, however, to spot signs of trouble, Leamer says. Any time theres a disconnect between prices and the underlying value of homes, as measured by their market rents, theres the potential for a bubble.
If home prices are rising much faster than rents, as is true in Los Angeles, thats 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 |
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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 cant 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 assets 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 nations 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
So what should you do if youre thinking of buying a home in a market that seems overvalued? Personally, I dont believe the possibility of a bubble alone should keep you from becoming a homeowner. After all, prices could continue to rise for many years, or values could plateau rather than falling. Even if they do drop, whos to say you would be willing to buy then? Falling markets often scare buyers even more than rising ones, and the fear could keep you from buying for years.
If youre financially ready to buy a home and willing to stay put for awhile, you can reduce your risk from a real estate bubble in the following ways:
- Look for undervalued properties. Even in the wildest markets, there are ugly ducklings -- flawed homes that others overlook. If the defects are fixable, you might be able to get a relative bargain and be in better shape than your neighbors should prices fall.
- Buy defensively. Homes in good neighborhoods with good schools tend to hold their values better, real estate agents say. Single-family homes usually fare better than condominiums, which often are the first to lose value in a real estate recession and the last to regain it during a recovery.
- Stay put. Find a home you can live with for awhile. The people who get hurt the most during real estate recessions are those who are forced to sell, usually because of a job change or because they couldnt really afford the home in the first place. If you can hang on to a home for five to 10 years or more, you improve your chances of being able to ride out a downturn and at least break even when you sell.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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