Tuesday, February 28, 2006

A Real Estate P/E Ratio for Washington DC

A special thanks to Eric in DC who wrote this article:

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.

20 comments:

  1. This is a very valuable exercise for anyone considering "investing" in DC real estate right now. The arithmetic demonstrates that it is a really bad idea.

    The only thing Eric has left out, that must be considered, is the opportunity cost of one's downpayment. In the current, low interest rate environment, downpayment funds will double, twice, over 30 years if invested in U.S. Treasury securities. That assumes no rise in interest rates over that timeframe. So, your $60,000 condo downpayment would grow to $240,000 if invested in T-Bills over the life of the condo mortgage.

    So it appears you will get killed both coming and going. Anyone want to buy a condo?

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  2. >> Now obviously you can’t just take the actual price of your home and divide it by the monthly rent.

    Actually you can. You'd want to use annual rent not monthly, and ideally substract maintenance and insurance out of the rent before dividing.

    Voila, there you have a P/E ratio, and it is on the same scale as your other investments.

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  3. Eric,

    A great piece of work - well done.

    I have one quick comment. In your first numerical example, it looked like you excluded the 20 percent and just calculated the housing cost from the loan on the 80 percent. I would respectfully suggest that you should include the foregone interest on the 20 percent.

    Having said that, using the HPI and the rental index seems to correct for this minor point.

    Again, congratulation on a very useful piece of analysis.

    returntodc

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  4. Wonderful work!! I am wondering about the following question.

    As you have defined the RE P/E ratio; at a RE P/E ratio of 1 there is no real economic distinction between renting and owning. For the RE P/E ratio significantly higher than 1, it obviously makes more sense to rent than to own. This implies a built in equilibrium tendency; as the cost of ownership becomes more uneconomical more people would rent bringing the ratio back towards 1.

    Why then has the ratio increased by almost a 100% and continued to increase for a good 6-7 years? If this is because the basic economic justification is forgotten in the hope of finding a bigger fool; then wouldn’t this be a “bubble” by definition?

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  5. " If this is because the basic economic justification is forgotten in the hope of finding a bigger fool"

    1) Speculative episode
    2) Lower interest rates
    3) Easy Credit

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  6. P/E ratios are about the best way to judge RE prices relative to fundamentals. The "earnings" or rent takes account income and demographics. If prices rise drastically above historic rents, then it will generally mean falling prices in the future.

    In all the bubble area, P/E ratios have risen dramatically. I think that easy credit (low rates and exotic mortgages/second mortages) are to blame. As the lending industry tightes up (on their own or on account of new regulation) we will see demand fall and P/E ratios come more in line with historic numbers.

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  7. Keep in mind, however, that the above formula is set on Condo rental rates (which also have a much lower rate of return on the open "for sale" market). And, not all real estate investors invest purely for the short-term monthly cash flow. Take, for instance, that a long term rate of return on your 20% down and approximately 2% out of pocket investment spread over the course of 12 months (the difference between your monthly rental income vs. what you owe), and historically spread that over the course of so many years, the rate of return superceeds that of a savings account, money market account, cd rates, or very conservative investing -- HOWEVER, with all but the investing, each of those options are GUARANTEED.

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  8. You are all correct that I left the deposit money out of the equation. I was really just trying to illustrate the metro area P/E ratio that we can keep an eye on for the future. Obviously each individual investment would require calculating the opportunity cost of the deposit money, but I think that the P/E ratio is presented pretty clearly and concisely without including the down payment. Most "investors" in the past few years would have benefited from seeing this even without the down payment included!

    Regarding the idea of a P/E ratio being > or < 1. I think you really would have to look at each individual investment to see if you are making money or not on the deal. Many real estate investors wouldn't step into a deal without at least an 8% total return. There was a good article in the Post a few weeks ago that went step by step through all the costs to consider when investing in real estate. I say good because they were basically saying there were no good investments in the DC area right now. I will attempt to find the article and maybe David will publish it.

    I think that the ratio I have created will give an indication of where prices and rents are going. The problem with it is that we don't know exactly where a positive or negative ratio really falls. What we do know is that either rents will have to rise and/or house prices fall to get it back to a level that would enable us to invest and make money.

    Thanks for all the positive comments. I will try to send more articles for David to publish on RE in DC.

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  9. Anonymous- My example used a condo to illustrate what a RE P/E ratio is. The actual DC RE P/E Ratio includes ALL forms of housing both on the P side and on the E side! On the Price side I used the Housing Price Index which includes Condos/Coops. On the E side I used owner's equivalent rent from CPI which again includes SFH and Condos/Coops. The situation for Condos is probably worse then the ratio suggests while the situation for SFH is probably not quite as bad as the ratio would suggest. That being said it still really shows how outrageous prices are when compared to rents. No matter is you are looking at houses or condos.

    Eric in DC

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  10. You are correct to say that not all real estate investors invest for the "short-term cash flow". Some real estate investors invest for the long term appreciation. Is this what you are saying?

    If so, have I got a deal for you! I'm ready to take some of my long term appreciation out of a couple rentals I've got!

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  11. Anybody interested in investing in Real Estate should read this article that was in the Washington Post:

    http://www.washingtonpost.com/wp-dyn/content/article/2006/01/27/AR2006012700728.html

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  12. Anon 10:17 - I think you've somehow inverted your arithmetic. In Eric's example, the assumptions result in a rate of return that is LESS than CD's, Money Market funds, bonds, etc. And you are right, those returns are virually guaranteed.

    Investment considers factors that are known, right now. If you are considering future price appreciation, or an increase in rents, you are speculating, and that is fine. As an investment, in the traditional sense, T-bills and CD's will, right now, outperform the real estate "investment" in Eric's example. Oh, it's also true that, historically, T-Bills have never called the landlord on Sunday morning to complain about an overflowed toilet. You choose.

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  13. If you save your graphs as .gif files they will compress more and not have those funny halos around the edges when you view them at 100%. JPG files are better for photographs or images with a variety of colour gradients.

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  14. anon 6:05,

    Thanks for the advice. I'll do as suggested

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  15. You might include depreciation of the property as well. If you believe properties are overvalued (which I do) and there will be a short term correction of 3-7% in the next year then 300K condo today might be worth 285K next year. So you are losing about $1100 a month on depreciation of a $300K condo. That would really mess with your P/E.

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  16. I'm glad I sold my house on 1st st nw when I did. Paid well over $200K for house where no quality of life exists. Now I'm in Montreal, paying $700 per month and have all the quality of life I could ever want.

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  17. I am a renter in a
    $2300/mo townhome near San Diego. I know that the landlord uses my rent toward the mortgage but I'm not sure if he's profiting. Given the "bubble" how can I find out if I'm being overcharged so he doesn't take a loss? He bought it just before leasing it to me for one year. When the lease is up in August, will I be able to negotiate new terms for future years since he may feel nervous about prices falling/me leaving?

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  18. Whether or not your landlord is porfiting really has nothing to do with you or the price. Prices should be set based on demand. Most landlords in areas like SF or SD are not recovering the cost of a new mortgage + HOA dues + upkeep + property taxes (on a new mortgage.) Of course if he bought the property 40 years ago and it's paid off then he's got no mortgage right? So if you want to know if you're paying too much go look at craigs list and see if you can do better.

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  19. The P/E ratio as illustrated here is incorrect. In the same way as used in any other investment calculation, the total outlay must be used not the "monthly cost of ownership". The above calculation lead to P/E ratios that are far lower than they actually are.

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