Arnold Kling  

Housing P/E's

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Ed Leamer's analysis of home prices in the San Francisco Bay area is summarized.


His findings: In the Bay Area, the average P/E for a house shot up to 13. 8 in the first quarter of 2004, compared with 7.2 in 1999 and 2000. Today's ratio is more than a third higher than it was 1989, just before housing prices started a multi-year descent.

In Santa Clara County, the average P/E is 15.8 today, compared with 10.3 in 1989.

"We are in a situation that is more extreme than it was in 1989," says Leamer, director of the UCLA Anderson forecast.


Brad DeLong's reaction is exactly the same as mine.

Personally, I think we are in an interest rate bubble--and that high housing prices are (outside of New York, SF, and LA) probably a rational reaction to very low interest rates.

I'm on an email list where people have asked about how to speculate against high home prices. My response, like Brad's, is that home prices are too high if and only if long-term interest rates are too low. If long-term interest rates are too low, then the easiest speculative strategy is to short long-term Treasury securities in the futures market.

But if you don't want to bet on economic forecasting (and I would not blame you if you don't), then the easiest strategy is to put money into a combination of money market funds and a stock index fund that tracks the world market.

For Discussion. Real estate agents always say, "Now is a great time to buy a home." Could they be wrong this time?


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COMMENTS (8 to date)
Jim Glass writes:

The Economist's housing index has US home prices as only 10% above the long-term norm http://www.economist.com/printedition/displaystory.cfm?story_id=2736477

If true, that's hardly a bubble. It has housing bubbles in other parts of the world, like New Zealand.

Anecdotes about booming local housing prices -- e.g., up 100% in a year in the part of Manhattan where I am writing this -- do not translate into a bubble in the national market. Housing is not liquid or portable so local conditions can be far, far from the national average.

I doubt that Leamer's SF Bay is any more indicative of the national average than is my section of Manhattan.

Chris writes:

Sorry, but how do you calculate the P/E ratio of a house? The price part I understand but what are a house's "earnings"?

-- Economic Neophyte

Shannon writes:

This is explained in Lerner's piece thusly: "...In the stock market, you calculate P/E by dividing a company's share price by its annual earnings per share.

In the housing market, you divide the price of a house by the annual rent it could fetch."

Chris O'Donnell writes:

He is using apartment rent as a proxy for earnings. However, apartment and single family homes are generally substitute goods. Isn't that sort of like calculating the auto industry P/E using Harley Davidson earnings in the denominator? It might be an interesting number, but it doesn't necessarily tell you anything useful.

Lawrance George Lux writes:

Arnold,
It would be the wrong time to buy, because of the low interest rates generating high pricing, except for the largesse of the national debt which will eventually bring higher rates of inflation. lgl

Bruce Bartlett writes:

There is a mutual fund that shorts bonds. You can find it at www.profunds.com.

Robbie Renter writes:

I have a couple of questions for the group:
I rent a condo in Boston, in a fashionable neighborhood. The unit *directly* above me is on sale. I calculate the p/e ratio of the place I'm living in as:

450,000 asking price for a nearly identical place (the unit above).

21,000 annual rent (what I'm paying)
- 1,750 property tax
- 1,200 Condo Fees (approx)

18,000 (approx) net earnings per year

That's a p/e ratio of 25.
Now, my questions are:
- Isn't this a more accurate measure of local p/e ratio's if I assume that my rent and my neighbors asking price are typical for facilities and location? (btw: I obviously don't believe my rent is significantly different than current rents, and I've seen other similar units in the building sell for about the same price as my neighbor is asking).
- What's wrong with my calculations?
- Is this high or low, ignoring rates of growth for rents and purchases?

Yasser writes:

What about the fact that a large number of home buyers are shifting to adjustable-rate mortgages? As Stephen Roach has noted, "...the ARMs portion of the dollar value of new mortgage origination exceeded 50% in May 2004, well in excess of the 20% share prevailing in early 2003."

Given that ARMs aren't fully tethered to long-term treasury yields, I am not so sure about your assertion that high housing prices mean yields on long-term treasurys must be too low. Clearly that is only part of the story.

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