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?