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How to figure a home's fundamental value
6 v: G, L" f$ ?$ }. k3 _7 I4 ^+ PLeamer 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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- ]* n S7 q9 yLeamer 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. _% w' t# F6 Z8 N# b5 T( ]" v. ~- l
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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:1 [% @. Z6 Y; P$ w
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In Boston, the residential real estate market’s P/E recently topped 30 -- compared with just under 20 in 1988.* k4 u. z# t/ C8 p/ u) Q
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San Francisco’s previous peak of 25.6 in 1989 has been eclipsed, with the P/E currently at just over 27.0 l2 O- I/ O- S1 K8 F6 X
San Diego’s current P/E is nearly 30, compared with a 1989 high of 23.4.2 [7 y- \7 H3 U& X0 Q6 F0 _8 G8 Q
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.# }9 y6 R0 z# a+ D
You 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. K4 h0 E3 O, l6 `) d3 P- @
+ o( `) ^ _4 l3 ~; n2 bIf 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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{7 O( e# H! e2 F+ I: Q. D$ [2 x# W8 SIf home prices are rising while average rents are falling -- which is the situation in San Francisco -- the bubble is pretty much unmistakable.& l+ J0 c6 ?3 ?/ n: h) W$ ]
8 U$ m: j/ B/ `+ l, C Home P/E ratios for 9 metro areas - ?9 |% A' x' |1 h, U2 b
Avg. 1988-2000 2001
1 ?) x: m1 `( ]0 Z* s/ jBoston 20.5 30.2
$ A. |( Z, f2 c5 wSan Diego 22.8 29.7
# Y: f9 ]; o. J- d Q( O' P$ dSan Francisco 23.8 27.2
: m" H( c3 h2 J0 rLos Angeles 21.3 25.6 " I& Z& n3 w7 G' T( o7 j
Seattle 20.4 25 ' _) _, \5 ?$ }2 |" S
Denver 17.7 23.7 9 V8 x: N% {$ @7 O; x
New York 21.2 22.5 : Z+ f( F a! X5 g8 E' j
Chicago 17.2 20.8 ( o3 J9 W" i: a5 f* m
Washington, D.C. 17.1 20.4 8 g! h# a3 \$ ?# c+ [ `5 ~
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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.) z& G1 u, o/ O6 O
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& |9 ~/ ~+ }) u+ c E* p! F0 iFrom: http://moneycentral.msn.com/cont ... ingguide/P37631.asp |
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