Who was it that said on here that PE ratios couldnt apply to housing recently?
Castles in hot air
From The Economist print edition What's it worth? Neither low interest rates nor population growth can justify recent house-price booms. Moreover, the thinking behind both arguments reflects a lack of understanding about how asset prices are determined. On any given day, a house is worth whatever somebody is prepared to pay. However, the lesson from the stockmarket bubble is that an asset's fundamental value must never be neglected. There are two ways to gauge whether house prices are sustainable: the p/e ratio and the house-price-to-income ratio.
• The p/e ratio. The price of any asset should reflect its future income stream. Just as the price of a share should equal the discounted present value of future dividends or profits, so the price of a house should reflect the future benefits of ownership—either the rental income earned by a landlord or the implicit rent saved by an owner-occupier. During the dotcom bubble, investors behaved as if profits no longer mattered. Likewise, people today are ignoring the link between house prices and rents.
In America, for example, a p/e ratio of sorts for housing can be calculated by dividing an index of average house prices by the index of rents which is included in the consumer-price index. In recent years, home prices in the United States have outpaced rents, pushing the p/e ratio to record levels, 16% above its 30-year average (see chart 8). San Francisco's p/e is almost 30% above trend. Estimates of p/e ratios for Britain, Australia and the Netherlands point to an even more pronounced bubble, suggesting that house prices in all three countries are at least 30% too high.
All this means that the return from investing in property has slumped. These p/e ratios are based on average rents, but over the past year or so rents on new lettings have fallen by 20-30% in New York, San Francisco and London. In London and Sydney gross rental yields (rents divided by price) have fallen to around 4%, from 7-8% a few years ago. In these cities it is now cheaper to rent than to buy.
The p/e ratio helps to expose the fallacy that house prices are rising because of growing populations and fixed supply, because these factors should affect the rental as well as the owner-occupier markets. The fact that prices are rising much faster than rents suggests that homes are being bought in the expectation of capital appreciation rather than underlying fundamentals. That is the definition of a bubble.
Some analysts argue that lower interest rates justify a higher p/e ratio. The same argument was made in the late 1990s for equities. But if rates are low because inflation is low, then future rents will also rise more slowly. Future rents should therefore be discounted using real interest rates, not nominal rates. As argued above, real interest rates in America or Britain are not particularly low.
The p/e ratio is probably the best measure by which to judge whether houses are overvalued, because it tries to value housing like other assets. But it is hard to get reliable, long-run series of rents for all countries. Moreover, in many continental European countries rents are still partially regulated by the government. If the p/e ratio proves difficult to obtain, another useful measure is available:
• The house-price-to-income ratio. The ratio of average house prices to average incomes, which tracks the long-term affordability of homes, is currently flashing red in America, Britain, Australia, Ireland, the Netherlands and Spain. In all these countries the ratio is close to or above previous peaks—ie, levels that preceded previous crashes (see chart 9).
All of the six countries where houses appear to be overvalued (America, Britain, Australia, Ireland, the Netherlands and Spain) also share another bubble-like symptom: an explosion in mortgage borrowing in recent years. Australian household debt has jumped from 55% to 130% of personal disposable income over the past decade. In the Netherlands the ratio has almost doubled to 180% of disposable income over the same period. The average new mortgage there is 110% of the value of a home, because lenders are happy to finance all the purchasing costs, including stamp duty and fees. In America, 21% of mortgages last year were for more than 90% of a home's purchase price, up from 7% at the peak of the boom in the late 1980s. This means that if prices were to drop, more households would be left with debts exceeding the value of their home than were a decade ago.
