After rising at a quick pace for the last five years, housing prices are now at a plateau according to some. Housing bubble believers frequently point to the fact that housing prices have run up while rents have remained relatively flat, and claim that the disparity must be corrected by a decline in housing prices. Analyzing the purchase price of a given home against the price it fetches in rent though shows that housing still remains a great investment with much room to the upside. In fact, the P/E ratio of housing is currently below most stocks when it should be higher due to a decreased risk factor. Even in the most overpriced markets, the price of housing is backed up by solid fundamentals.
Price / Earnings Ratio
Stocks are traditionally valued based upon their earnings. The most common metric for evaluating stocks is the Price / Earnings ratio (P/E). P/E takes the current market price of a stock and divides it by the share of yearly earnings that single share represents. For example, MSFT (Microsoft) currently trades at 27 with earnings per share of $1.18. This computes to a P/E ratio of about 22.9. P/E ratios of established DOW companies are typically in the mid 20s.
Apples to Apples
We can use a similar metric for evaluating housing prices. A typical house in the Bay Area sells for $700,000 and can be rented for about $2,800 per month. Yearly, this sums to $33,600 collected in rent and a P/E of 20.8. The P/E ratio of houses in even the most expensive of markets is currently very close to 20. Many mid-priced markets have P/E ratios closer to 15.
Using P/E, it is clear that housing is not overvalued compared with stocks. A dollar invested in the housing market today returns more each year than a dollar invested in MSFT. Clearly if a bubble exists in the housing market then there must also exist a bubble in the stock market. Do those that advocate the existence of the housing bubble also claim that a stock market bubble currently exists?
Higher P/E for Housing
Housing trading at a discount to stocks represents a great opportunity for homebuyers because based on fundamentals, housing prices should command a higher P/E than stocks. Traditionally, solid established companies have commanded a higher P/E ratio because there is less earnings risk with those companies. Microsoft is much less likely to go bankrupt tomorrow or drop in price than the latest .com startup, so investors are willing to pay more for MSFT.
Housing is a more solid and less risky investment than even the least risky of stocks. Rent prices (earnings) fluctuate very little when compared with corporate earnings. In addition, housing prices fluctuate much less than stock prices. This remains true even in the wildest housing bubble dreams of bubbleheads. In the stock market, equity can drop 20% overnight when a company issues a poor earnings report or the market crashes. Housing will never drop 20%, not even in a single year, bubble or not. All of these facts mean that investors should value housing at a greater earnings multiple than stocks, meaning housing currently represents a great investment value.
Now let’s get back to the earnings side of housing – rent prices. Rents have been relatively flat in recent years, and doomsayers claim that this indicates housing prices must fall. I see it as just the opposite – rent prices will be forced upward, which will lead housing prices to rise even more.
In conclusion, housing is under priced and has much room to the upside when compared to stocks. Five years ago housing was ridiculously under priced, and today housing is still moderately under priced. Sitting around waiting for housing prices to return to bargain levels as they were in 2000 is like waiting for GOOG to drop back down to 20: It’s not going to happen, you will be waiting and renting forever.