## Friday, January 26, 2007

### Real Estate Price to Earnings Ratio

I have known for a long time now that the most important number to look at when considering an investment is the Price to Earnings ratio or P/E ratio. Essentially this ratio tells the the potential investor how long (in years) it will take for the current net annual earnings of the investment (assuming they stay the same) to pay for the price of the investment. The P/E ratio doesn't help us project growth in earnings or the prospects of the company but those are speculative affairs anyway.

Many economists and analysts have also used the P/E ratio to evaluate the suitability of a real estate transaction. In essence they are asking the question - how long will it take for me to earn my money back from the net income on this piece of real estate? This is an incredibly fair question and has significant merit as an evaluative technique because after all isn't an investment an investment. Wouldn't we want to compare an apartment to a company to evaluate their merits as an investment relative to each other?

Lets look at an example:
Lets say that a \$200,000 apartment rents for \$1200 per month or \$14,400 per year (gross earnings). The apartment also has annual expenses of \$2,400 for strata fees and \$1,200 for property taxes. The gross earnings minus the expenses gives us a net earnings of \$10,800 per year. What is the P/E ratio? \$200,000 divided by \$10,800 which equals a P/E of 18.5 and ignoring all leverage or other investment return factors this means that if the rent stays at this current level it will take 18.5 years for the investor to have the return of his or her money from the net income. This also ignores the possibility of an interruption of earnings or an increase in expenses or rents but all things considered this P/E number now allows us to compare this investment to an equity investment.

I have written a few posts on Value Investing and one of the stock picking guidelines is to never pick companies with a P/E greater than 10. The above example from real estate falls well outside of those value guidelines at a P/E of 18.5 and for a value investor would be completely unsuitable as an investment. In comparison, a simple stock screen produces a list of 402 securities in the Canadian market with a P/E of 10 or lower which provides us with a great starting point for selecting companies to invest in. The same stock screen for the US market produces a list of 263 secuities, which again would be a great starting point.

So for investment purposes the current real estate market shows no value and in fact a recent TD Economics study on the Vancouver housisng market found that this market is in record high territory for all ratios including P/E, Rent vs Own, and affordability. There are times when the stock market also behaves the same way and P/E ratios get exceptionally high and I can show with certainty what happens when P/E ratios get exceptionally high - they fall. I expect no different in the real estate market. Do you?

RentingSucks said...

I agree things are overpriced but I think a P/E ratio calculation as outlined in this post is too simplistic for real estate.

A net present value calculation takes into account the cash inflows better. Real estate is different than stocks in that you get money every month that can be invested elsewhere. Stocks go up and you might get dividends once a year but real estate is solid cash flow. Also your calculation neglects captital appreciation over time which is generally about 5 percent over the long haul. A NPV calculation would take both the cash inflow and captial appreciation into account.

When real estate investors look at a property they want something that can carry itself with 25 percent down. That means all expenses including mortgage from day one are paid for by the cash inflows. That would be a better metric than P/E ratio.

mohican said...

rentingsucks: All great points and suitable for another post someday. I can only cover so much in one post and I chose P/E ratios because, despite what you are saying, it is still fair to compare based on that metric. I am not saying it should be the only metric one bases a RE investment on but a very important one, especially when comparing to other investment opportunities.

For a more fair comparison, I may look at an example of a 75% leveraged income trust portfolio versus a 75% leveraged RE investment. This would take into account the factors that you are mentioning.

BTW - I hesitate using a NPV calculation because it requires a speculative assumption of growth, which I am reluctant to speculate on for stocks as well as real estate.

Freako said...

"I agree things are overpriced but I think a P/E ratio calculation as outlined in this post is too simplistic for real estate."

Straight P/E is as much an oversimplification in equities as in RE. For example, a low PE stock is not necessarily a better investment than a high PE stock. What matters is PE versus earnings growth potential.

"Real estate is different than stocks in that you get money every month that can be invested elsewhere."

Actually, that is irrelevant. There has been much work on finance on this topic. Many stocks have dividends, many do not. Miller-Modigliano proved (theoretically) that the dividend decision itself does not change the value of the underlying asset. As common sense would suggest.

If a company chooses to keep the cash instead of handing it out as a dividend, the stock will rise as a result. The investor can then has the option to sell a small portion of his holdings to "extract"
money to invest elsewhere, just as an RE investor would have.

"Also your calculation neglects captital appreciation over time which is generally about 5 percent over the long haul."

Strongly disagree. You are putting the horse before the cart. Appreciation does not happen in a vacuum. From a fundamental perspective, it is the improvements in earnings (rent) which CAUSES the appreciation. In other words, there is no such thing as sustainable appreciation in the absence of improvements in the fundamentals. It really ticks off when guys like Pastrick use models which "assume" appreciation.

"When real estate investors look at a property they want something that can carry itself with 25 percent down."

That is another metric, rent versus carrying cost. Not totally unrelated to P/E. The main difference is that prevailing interest rates are factored into the equation.

patriotz said...

Well and simply put, mohican.

I often hear RE realists (or "bears") say that people shouldn't think of their personal residence as an investment. They have it backwards, actually.

People should think of their personal residence as an investment, and apply the same metrics to it as buying a stock or bond. By any investing metric, Vancouver RE is a screaming sell today.

And thanks Freako for the riposte to the first reply. Couldn't have said it better.

mohican said...

freako: good analysis, nice response, I especially like the reference to Miller-Modigliani .

patriotz: thanks for the compliment and I completely agree that real estate is an investment even if it is for personal use only. In fact, everything that a person spends time or money on is an investment of sorts.

We spend our time and money on things that we enjoy now, will enjoy in the future, or, altruistically, others may enjoy. The world is not only about financial investments but social, moral, ethical, and personal investments in things that may not have a monetary return but provide a return in a person's or society's enjoyment or satisfaction.

See the different definitions of investment and direct attention in particular to the economist's definition and this would fit well with what you and I are suggesting here. Here I go, getting all philisophical, but this is a paradigm shift in thinking for many people in our money hungry society. Introducing the concept of stewardship as a way to look at one's choices in life is a massive change.

Freako said...

I don't think there is any doubt that a home is an investment. It just is, since the home has a non-consumable portion that is exposed to market fluctuations.

The next question is whether it should be "thought of" as an investment. I presume that the answer depends on individual preference. Do you want to view reality as it is, warts and all, or do you want the rose tinted glasses perspective? I have no beef with either perspective, we all have our own ways of dealing with the hardships of life. However, don't use the latter as an argument for how others should act.

Another related thing to watch for (and I have seen many anecdotal examples) is assymetry in reasoning. When prices go up, real estate is an investment. When they go down, it is a home. Such mental tricks is a futile attempt at self-delusion. A related line of thought is that one can't lose since prices will eventually recover.

RentingSucks said...

Thanks a lot for your counterpoint. I'm still digesting it. Really interesting how you tightened up the comparision between stocks an housing by pointing out how you could get some cashflow just by selling some of your stock which is rent equivalent.

If your goal is to get into the market at some point its good to understand who your're competing with. I am pretty sure my numbers are a good match for Joe Average but I have no idea about investors. If they are using IRR and NPV and 25 percent down/rent covers carrying costs to see value where I don't using straight P/E
then I have to look seriously if this is a valid metric.

Also at this point in the market using 5 percent (which is really a 1982 trough to 2007 near peak number) is probably not wise but it was a not too bad a thing to do even 2 or 3 years ago. They were right in other words and a lot of people (like me) were wrong. I mean even if they lose the last 2 or 3 years and things go back to trend they will still probably do OK over the next 22 years or so.

I think I really underestimated the force of inflation on housing. Yeah greater than inflation appreciation really kicked my ass the last few years but it was slowly but surely kicking my ass and I didn't notice before.

Hopefully I will get a chance to correct that mistake.

Freako said...

"Really interesting how you tightened up the comparision between stocks an housing by pointing out how you could get some cashflow just by selling some of your stock which is rent equivalent."

There is always more than meets the eye. How many times have you not heard "RE is such a great investment because it can be levered". Truth is that ANY investment can be levered or unlevered to the individual investors heart content. Unlevered you say? Yes. It turns out that ANY company that has debt is already levered (for all practical purposes). If you buy the stock with cash, you are already implicitly "levered" for better or for worse. Of course, leverage do NOT affect risk adjusted returns on iota. To be frank, guys like Chipman may know a whole lot about the ins and outs of RE investing, but they still have a hell of a lot to learn.

"If they are using IRR and NPV and 25 percent down/rent covers carrying costs "

I certainly think that rent versus carrying cost is a useful metric, but I think specifics such as CF breakeven at 25% down is totally arbitrary (just as buying stocks below PE of 10). Each property class (high density vs low density) in different areas (high growth versus low growth) has different prospects, and thus should not be nailed down to a one size fits all rule.

Again, the anecdotal observation that so many RE investors blindly crank numbers tells me that they may have done well but for the wrong reasons.

Taken more loosely, which is a better metric? Price divided by rent or rent versus carrying cost?

I think if you use history as a guide, they both can be very predictive of future price movements. My simply Sauder analysis where I simply used the rent changes to price changes ratio over the past four years to predict return over the next four was very telling. I will e-mail the chart to Mohican once I beautifed it a bit. The co-efficient of correlation was -0.58 percent, meaning that it was a fairly strong predictor of future prices.

I am sure that carrying cost would arrive at similar correlation. I think the problem with carrying cost is that it is very sensitive to interest rate changes. If we believe that rates revert to the mean over time, then PE may be a better metric.

The problem I have with carrying cost is that we are altering the price of a perpetual rental stream based on short term interest rate changes. Would you pay more for the same car if the size of the payments dropped?

On that topic, I think the massive shift in long term interest environment over the last 35 years has overstate investment returns (both RE and equities). A good portion of capital appreciation was merely the shift to a lower discount rate. That is obviously not sustainable, and very reversible.

I think RE prices are up because they got hit with a triple storm:

1. The vast majority of market participants are non-investors who react emotionally to the fear of being priced out.

Investors break into two groups:

2. Speculators. Pure extrapolators who exacerbated the situation by competing with increasingly desperate owners.

3. Old school cash flow investors. These guys do know value. Which means that they are not buying. The problem is that they are not selling. Why? Dunno. Some type of assymetric logic. Chipman mentions something about not letting go of "good properties". Makes absolutely no sense to me. Once he also seriously argued that he would not sell even if he knew with certainty that prices would drop 35%. See for yourself here: http://tinyurl.com/yuuflf .

That would rarely happen in the stock market. Value investors would sell increasing amounts, and shortsellers add supply, balancing the market. Hence, RE has set itself up for the big one. Most of those involved are clueless.

patriotz said...

Chipman mentions something about not letting go of "good properties". Makes absolutely no sense to me.

Certainly some of it can be rationally explained by the high transaction costs and low liquidity of RE. If you could click your mouse and sell a house for \$9.99 at a known market price I think investors would let go of them a lot more quickly if they perceived a market top.

On the other hand what is a "good property" anyway? What makes one property "better" than another? History shows us that all market sectors in GVRD take similar hits in a downturn.

The only objective measure of how good a property is (barring increased future density) is yield, and the popular mindset seems to run counter to this more often than not.

Freako said...

"Certainly some of it can be rationally explained by the high transaction costs and low liquidity of RE."

Good point. It definitely keeps "daytraders" out. I still see some assymetry. RE flippers enter looking for 15%. Cash flow investors would rather suffer a 15% decline than sell. Of course, a decline is not certain, but at the margins one would expect increased propensity to sell as prices become increasingly distorted. Anecdotal observation, but I don't see that happening. I see more of, buy low, never sell.

"On the other hand what is a "good property" anyway? What makes one property "better" than another? History shows us that all market sectors in GVRD take similar hits in a downturn."

I have had endless debate with him on that topic. Tt sounds like something a race horse collector would say. To me, a "good" property is one I can sell for more than its worth. I don't care if it is a run down shack or a mansion. It is price relative to value that matters. And as you mention, virtually all properties are equally mispriced at this moment in time. Anyhow I don't think this line of thinking is quite common among CF investors. As is total ignorance of opportunity costs. As long as rents cover costs, all is "well".