Many of us are familiar with the idea of a P/E ratio for a stock. This is the ratio that shows us how much we are paying for each $1 of earnings of a company. As an example, GE is trading at $33.20 with a P/E ratio of 21.70. This means that you are paying $21.70 for every dollar in earnings that GE makes. The P/E ratio has been a traditional indicator for when to buy a stock. The lower the P/E the better is the logic here.
Many people who invest in real estate have a similar idea with a Real Estate P/E Ratio. An RE P/E ratio is determined by taking the price of your home and dividing it by what it would rent for. Now obviously you can’t just take the actual price of your home and divide it by the monthly rent. What you normally do is take the total monthly carrying cost of a property and come up with a monthly total of ownership. (20% down payment, 30 yr mortgage, taxes, and insurance) Then you can divide this number by what you can rent the property for monthly. A simple example would be a 1 bedroom condo that costs $100,000. You put 20% down. And the total monthly payment would be somewhere in the neighborhood of $1,000 per month. (Mortgage, Tax, Insurance around $750 and Condo fee of $250) (In 2000 I owned a condo and this was my approximate payment). This 1 bedroom would have rented for about $1200 per month at the time. So the P/E ratio would have been $1,000/$1,200 = 0.833. Let’s look at this same 1 bedroom in today’s market. The price now is $300,000. 20% down is $60,000. Finance $240,000 for 30 years at 5.75% = $1,400.57 per month, plus taxes, insurance, condo fees = $1,800 per month. (I’m being generous here. It would actually cost more then this.) This condo would rent for approximately $1,400 per month now (Check for 1 bedrooms in Glover Park, DC). So the P/E would be $1,800/$1,400 = 1.286. Notice that the lower the number the better. If the number is above 1 you are in the negative. If it is below 1 you will make some positive cash flow on the investment.
My next goal was to come up with a way to track the real estate P/E ratio for the DC metro area as a whole. This would give me an idea of when the market made sense to invest. That is how I came to this RE P/E DC Ratio. The price is the Office of Federal Housing Enterprise Oversight House Price Index. (http://www.ofheo.gov/media/pdf/hpimsa_05q3.xls). They have broken out housing prices by the metropolitan areas from the census. For DC they go back to Q3 1975. This number is an index number that started at 100 in Q1 1995. The earnings number comes from the CPI. (http://www.bls.gov/data/home.htm)
The Bureau of Labor Statistics keeps consumer price index information for metropolitan areas as well. One number they keep is called the “Owners' equivalent rent of primary residence”. They started this for DC in Dec 1997 at 100. The Owners’ equivalent rent of primary residence is a unit of the CPI (representing 20% of the total CPI) that tracks how much houses would cost to rent. It represents the best number that we have to give us a solid basis for how much rents are in an area.
So, take the Housing Price Index number (P) and divide it by the Owners’ equivalent rent (E). Since both these numbers are index numbers it works really well to show the relation between prices and rents. I must warn that these numbers do not actually give you the P/E number like in the example at the top. What they do tell us is the relationship between the two. So, in Q4 1997 the P/E Ratio stood at 1.0465. In Q3 2005 the P/E Ratio stood at 1.8988. This means that the P/E Ratio went up 81.44% during that time. From Q4 2000 until Q3 2005 it went from 1.1383 to 1.8988 which is an increase of 66.81%. The example I used above (which is based on my actual experience) went from .833 to 1.286. An increase of 54.38% which is not too far off from my actual experience.
We can use the DC RE P/E Ratio to give us an idea of how overall prices and rents are interacting within the DC metro area market. This dramatic increase in P/E means that housing prices have been increasing much faster then rents. It seems that now would be a very bad time to buy an investment property. We will have to wait until either condo prices drop or rents rise significantly in order to be able to get a better (or any) return on our investment.