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July 15, 2002 -- A recent article focused on economist Edward Leamer's approach to determining whether home prices in an area are overvalued, and by extension, whether it makes more sense to buy or rent. Mr. Leamer's ideas sparked widespread interest among readers, with many seeking further explanation.
Mr. Leamer, who directs the Anderson Forecast, a quarterly economic outlook produced by the business school at the University of California at Los Angeles, says potential buyers should calculate the price/earnings ratio of a home -- with the earnings portion of the ratio being the home's potential rental income -- and compare it with historical levels to determine whether a home is overvalued.
Some readers expressed confusion about a graphic that accompanied the column: It gave a P/E index for homes in the Los Angeles area and one for homes in the San Francisco area, not the actual P/E ratios. "That index was simply a guide to indicate whether the P/E ratios in the regions were high compared to where they were historically," says Mr. Leamer.
Based on the indexes, "I wouldn't buy real estate in the San Francisco Bay area right now, because of the high P/E ratio and the weakness in the rental market," Mr. Leamer says. "People buying homes now in the Bay area are making an investment decision that no one else is making -- that tech investment will bounce back quickly," fueling demand for housing in the area.
Many readers asked for more details. Here are some of those questions and Mr. Leamer's responses:
Q: Why are rental rates a good way to evaluate home prices?
A: What often happens in markets where home prices are rising is that people "are not buying based on the intrinsic value" of the property, Mr. Leamer says. "They're buying because they think someone will pay more for it a year from now."
Rental rates are simply a way to help determine whether that expectation is realistic, by establishing an intrinsic value for each home -- the earnings that home could produce -- so that you can then see how the price of a home relates to that value and how that ratio compares with historical ratios for the region.
Q: Why does a P/E ratio make sense for evaluating a house that the owner has no intention of renting out or one that is in an area with few if any rentals?
A: Ultimately, the market "will value that house as if it had a rental value," Mr. Leamer says, because that is the intrinsic value of the house, and the intrinsic value will assert itself when emotional and psychological factors play themselves out. He draws a comparison to the stock market and the lessons the bubble and subsequent collapse of recent years taught investors: "A high P/E ratio suggests that there's not much room for a stock to keep growing. We've learned in the last year or two that the P/E ratio matters. There may be investors out there that have not gotten the message, but they're feeling a lot of pain."
Granted, determining the rental value for some properties, such as Bill Gates's home, or in areas lacking an active rental market, "is difficult," Mr. Leamer says. Still, "I think the number of homes in those categories are a lot fewer than people would imagine. Most of us do have a sense of what properties rent for."
Q: Are you using the P/E ratio to analyze home values for the purpose of a pure investment or a primary residence?
A: Both. Purchasing a home as a primary residence is "an investment, and one of the most important investments most people will make," Mr. Leamer says. "You may think you have the ideal house and are willing to pay for it, but why pay a premium on what the market would bear for that asset? If you're the CFO of Your Home Inc., you need to start thinking about investments in this way."
Q: How do the tax benefits of owning a home figure into this analysis?
A: "Tax benefits matter in deciding whether the P/E ratio makes sense" in an area, says Mr. Leamer. "First compute the P/E ratio, and then consider the tax implications," both property taxes and the tax write-offs on mortgage interest. But that doesn't alter the comparison of the P/E ratio of a home to the historical P/E ratios for the area. "The bottom line is, when prices are going up and rental rates are flat or going down," he says, "there's a disconnect and properties are overvalued."
Q: What's the predictive value of this viewpoint?
A: "My view is that it has good predictive value over long periods of time," from five to 10 years, says Mr. Leamer.
