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How to figure a home's fundamental value
$ Q( s8 f3 k) E @ b' Y9 |' W5 l) S6 JLeamer 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.
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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 & Poor’s 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.
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Leamer didn’t invent the concept of P/Es for homes. But his willingness to proclaim bubbles in several of the nation’s hottest markets has brought him lots of attention recently.
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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. Here’s what he found:/ i; b p# g! p* f/ e0 C- P/ C
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In Boston, the residential real estate market’s P/E recently topped 30 -- compared with just under 20 in 1988.
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! U' J$ x1 O5 C$ g XSan Francisco’s previous peak of 25.6 in 1989 has been eclipsed, with the P/E currently at just over 27. N& w' K# S8 _) l( G0 V
San Diego’s current P/E is nearly 30, compared with a 1989 high of 23.4.3 F; \5 b4 c3 W
New York, by contrast, is actually well below previous peaks. The area’s current 22.5 P/E is above its recent nadir of 17.6 in 1993, but down from 28.6 in 1988.
% A# x+ G( L& @" G7 T8 _' _# XYou don’t have to know exact P/Es, however, to spot signs of trouble, Leamer says. Any time there’s a disconnect between prices and the underlying value of homes, as measured by their market rents, there’s the potential for a bubble.
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4 ?+ s3 R( c6 ~6 Y0 [8 KIf home prices are rising much faster than rents, as is true in Los Angeles, that’s a strong indication a bubble is forming.
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If home prices are rising while average rents are falling -- which is the situation in San Francisco -- the bubble is pretty much unmistakable.
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5 H9 O! A: _9 B: @ Home P/E ratios for 9 metro areas
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Boston 20.5 30.2 ' U( P& u/ [" I3 L& l
San Diego 22.8 29.7 ( U( ~, @) T7 e- M# V' ~
San Francisco 23.8 27.2 : \% b' z$ {0 z' |4 W1 J
Los Angeles 21.3 25.6 6 M9 g6 z0 C1 [) A
Seattle 20.4 25
% ?) S5 n( g/ h& [. v# jDenver 17.7 23.7
1 q7 h% d6 l JNew York 21.2 22.5 4 \& K2 v0 K' ?& \ g! ?% m" X
Chicago 17.2 20.8 " n/ K) F a" S+ S$ M: S
Washington, D.C. 17.1 20.4 # w: ?( ?' I- Z r% w' J
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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.
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% T6 U0 i2 D7 pFrom: http://moneycentral.msn.com/cont ... ingguide/P37631.asp |
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