April 20, 2008

Read house prices like the stock market for a different picture

Posted in Ireland · 25 comments ·
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On a price-to-earnings basis, how much is your house really worth?

The other day – when farmers were marching on the Dáil – a friend asked where the bottom of the Irish housing market might be. He was one of the lucky ones who never got involved in the house mania, but he was interested because he couldn’t reconcile the farmers’ poor mouth with the fact that agricultural land prices had been rising for years.

If the price of land was rising, the productivity of land must be rising exponentially to justify the rise in prices. If the productivity of land was rising, so too must a farmer’s profitability and income. As a result, he could not understand why they were complaining.

If things were as bad as the farmers’ leaders were claiming, surely Irish land prices should not have risen in the past few years? Presumably farmers were buying land, driving up prices. Either the farmers were lying about their incomes or they were irrational when it came to valuing land and were happy to pay over the odds for it.

Thinking about this took me back to my granny’s bar in Cork in the late 1970s. The hierarchy of the local village displayed itself in the supposedly democratic environment of the bar. Village status was based on the ownership of land. The men who had land drank and played cards in the tap-room, under the old photos of famous county hurlers.

In contrast, the labourers downed their Beamish and Murphys at the bar. On Sunday, the lads with land sat at the front of the church, while those without congregated at the back door smoking their Navy Cuts and scanning the Sunday World.

A system that covets agricultural land over agricultural productivity has resulted in a very rigid agricultural base in this country. This base was ideally suited to the ‘free-money’ days of the early Common Agricultural Policy, when money was linked to production, rather than productivity. Now, as the world opens up to agricultural products all over the world, the folly of paying high prices for land with low productivity is being questioned.

Now transfer this mentality to houses and their valuations. Are we displaying the same hopeless hierarchy based on that most over-valued attribute – ownership? During the boom, the price people put on houses was ‘hope value’. The game was to buy, watch prices rise and hope to sell on to someone else before the market dipped. There was no real value other than the price the last fella paid and the price the next fella was likely to cough up.

Now if we look a bit more scientifically at prices, using normal valuation techniques employed by the financial markets, what do we see? The smart boys in the stockbroking firms – the ones who last week were on the radio telling people to buy houses – have put a value on big Irish property companies. The beauty of the stock market is that it provides us with an approximate value of assets.

The stock market does not think that Irish land companies are worth much. Shares have fallen precipitously over the past year. If you would like exposure to Irish land and construction companies, you now have to pay on average five times’ annual earnings for household builder names and large property companies such as Grafton and Kingspan. This means that the stock market believes that, if a property company has earnings of, say, €100, the whole company today is worth €500.This gives us an approximation of value.

So if the whizz-kids in the financial market claim that companies with portfolios of Irish land are worth five times their profits, surely individual houses which are being used for investment purposes should be valued somewhat similarly?

After all, if you want exposure to the Irish housing markets without the hassle of tenants, estate agents, taxation and fees, surely you would buy a few shares, rather than a new shoebox in the commuter belt?

Now here’s where the story gets really interesting. The average price of a Dublin house is still circa €370,000.The average rent is about €14,000.Thismeans that, individually, Irish houses are trading at 26 times earnings!

Wait a second. If land companies with a collective portfolio of land and houses are trading at five times’ earnings, but individual houses are trading at 26 times’ earnings, either Irish houses are still dramatically overvalued or Irish stocks are deeply discounted or some combination of both. As it is more likely to be a combination of both, it implies that house prices have to fall and housing stocks have to rise.

Of course, people don’t buy houses with these types of valuations in mind. Most investors buy with a view to capital gain. There are obvious differences between shares and houses, but the general point is valid. If you are in the business of investing, you should have a valuation framework in your head that benchmarks different investments against each other. The bottom line is that the money you are spending has the same value whether you are putting it into stocks or houses.

The level of disparity between the valuations of property companies and property itself is enormous. Granted these valuations can be more than a bit hit and miss, but they do provide some basis, however flawed, for comparison. If you were to value individual houses on the same basis that the financial markets value the general property sector – on a price-to-earnings basis – house prices in Dublin could fall to levels that no one is countenancing.

Even if you meet the financial markets half way, the fall in house prices implicit in a price-to-earnings model is likely to be dramatic. Are we prepared for this? In such a case what would happen to employment, taxation and related factors such as law and order, immigration and the very social contract that underpins our society?

The best thing the state could do now is to ramp up infrastructural spending to put some floor under the general construction industry and to take advantage of tendering for work in a slack market. The last thing you should be listening to is stockbrokers on the radio telling you to buy houses now, when their own financial models are screaming sell!


  1. VincentH

    ‘Now here’s where the story gets really interesting. The average price of a Dublin house is still circa €370,000.The average rent is about €14,000.This means that, individually, Irish houses are trading at 26 times earnings!’. And that 14000 rent is 35% of the average earnings, a load on a body not seen since the Czar removed serfdom.

  2. John Q. Public

    Should there be a correlation between a property company’s share price and the price of a single house? This ‘price-to-earnings basis’ is only one way of looking at things. I think this article applies to investors only (who get the vat back anyway on new houses) and not first-time buyers who just want to live in a house. The thing is that most people are not in the business of investing anymore when it comes to houses so most people won’t benchmark different investments against each other as the house is the biggest and only asset they will acquire in their life. David, I think you are comparing the abstract to the concrete in a way here. Share prices and earnings are highly volitile while rent from houses can be more static due to contracts etc. Another point is that shares in companies have to be paid for today and appeal to investors only but houses can be paid off over 25 years and are a necessity for most of us unless you live outside.

  3. Johnny Dunne

    David, here is a comparison of European rental yields – we are at the end of the list only ‘tax havens’ have lower yields !?!

    http://www.globalpropertyguide.com/Europe/Ireland/rent-yields

    Moldova 14.36%
    Slovak Rep. 10.06%
    Ukraine 9.09%
    Netherlands 8.25%
    Romania 8.17%
    Hungary 8.09%
    Belgium 7.53%
    Macedonia 7.23%
    Czech Rep. 6.93%
    Slovenia 6.81%
    Turkey 6.47%
    Andorra 6.19%
    Estonia 6.13%
    Sweden 6.00%
    Poland 5.95%
    Bulgaria 5.87%
    Portugal 5.72%
    Germany 5.39%
    UK 5.36%
    Russia 5.23%
    Finland 5.00%
    Latvia 4.97%
    Switzerland 4.80%
    Denmark 4.61%
    Austria 4.40%
    Cyprus 4.38%
    Luxembourg 4.28%
    Italy 4.27%
    Norway 4.22%
    Lithuania 4.04%
    France 4.02%
    Ireland 4.00%
    Liechtenstein 3.29%
    Spain 2.87%
    Malta 2.85%
    Monaco 2.43%

  4. Johnny Dunne

    David, here is a comparison of European rental yields – we are at the end of the list only ‘tax havens’ have lower yields !?!

    Moldova 14.36%
    Slovak Rep. 10.06%
    Ukraine 9.09%
    Netherlands 8.25%
    Romania 8.17%
    Hungary 8.09%
    Belgium 7.53%
    Macedonia 7.23%
    Czech Rep. 6.93%
    Slovenia 6.81%
    Turkey 6.47%
    Andorra 6.19%
    Estonia 6.13%
    Sweden 6.00%
    Poland 5.95%
    Bulgaria 5.87%
    Portugal 5.72%
    Germany 5.39%
    UK 5.36%
    Russia 5.23%
    Finland 5.00%
    Latvia 4.97%
    Switzerland 4.80%
    Denmark 4.61%
    Austria 4.40%
    Cyprus 4.38%
    Luxembourg 4.28%
    Italy 4.27%
    Norway 4.22%
    Lithuania 4.04%
    France 4.02%
    Ireland 4.00%
    Liechtenstein 3.29%
    Spain 2.87%
    Malta 2.85%
    Monaco 2.43%

    http://www.globalpropertyguide.com/Europe/Ireland/rent-yields

  5. Vincent

    On Davids’ numbers, it is 3.75%.

  6. I am currently renting a 3 bet semi-d in Ennis. Paying 700 a month. That’s 8400 /year. Similar houses in the same estate went up for sale recently at €265K that’s a P/E ratio of 31. I know that the house was purchased 9 years ago for 100K. So that’s a more realistic P/E ratio of 12. As far as investment properties go they have a long way to fall before they become realistic investments.

  7. Philip

    It is worrying the amount of working capital that has suddenly ground to a halt in the last 6 months. On my commute home, I’ll pass 3 half finished developments where not one house has shifted. “Houses ranged” from 500 to 1400K. About 200 units in all. Very nice developments all in very nice areas well within Dublin catchment area. The work stopped before Christmas 07. I can list a further 2 developments as you head out of town where the whole finished estates about have been boarded up at the entrances – . I am sure folks here can list similar examples.

    I say again, what is worrying is the suddenness. Who was it that said that “people don’t realize that they are just one, two or three paychecks away from poverty”? We just had 20000 folks join the dole last Feb.I certainly hope the Infra-spend accelerates or folks will be getting a taste of what social anarchy is about pretty soon.

  8. MK

    Hi David,

    Yes, it is interesting to contrast property valuations and property companies, but they have never been valued the same nor can they. In terms of shares in a property, people (or pension funds) dont need to have them, so they are optional. But in terms of homes, people have to live in them, in some shape or form.
    Also property companies that own property will have more risk, they may be more leveraged, etc. Its not an apples to apples.

    The rental yields are interesting to look at. Ireland’s (at 4.0%) is the same as that of the very large France, also a euro country. Spains figures show that rent is cheap there and property still over-valued perhaps, although I dont know their property details. In my area I think yields are approx 4.5%, but less ‘rentable’ properties are probably as low as 3.5%. We also have to consider that some property owners are not able to rent their places.

    Another way to measure property values is in terms of salaries/income. Not accounting for taxes, which should be done, a rough rule of thumb shows that with an average income in this county of approx 40k/42k/44k or something, the average home value at less than 300k is about 7 times income. A graph using the same figures from the 1960′s to now will show us how far ahead we are, and how much we could go down by. I would be surprised if we went below 5 times, or an average of 210k. That is about a yield of 6.6% (using a figure of 14,000 for rent), which is a P/E of 15. There is no way that the market will go down to 5 P/E. Essentially, earnings is not the rent income/yield but the affordability to pay for and live in a property which underpins the market as a whole.

    The farmer and agricultural use of land is a completely separate use of the land so it has to be looked at and analysed completely differently. In practice, farmer land owners over the last 10 years have been selling bits here and there for development no doubt to supplement their farming income, but the key is to distinguish between the land use which can dramatically convert its land value. eg: sites (4-8 per acre) can go for 200k to 300k. The same land area could not be agriculturally valued at the same level.

    The overall question though is an interesting one, where will the bottom actually be …

    MK

  9. hjjhjh

    The 100 time rent formula comes because that is the point at which housing makes sense as a leveraged investment, when credit conditions return to normal.

    Take a look at the following (click animate):

    http://stockcharts.com/charts/YieldCurve.html

    Basically Bank Lending is a carry trade between the short term left hand side of this curve (where banks get their money) and the higher rate at the right hand side of the curve (what the ordinary schmoe pays over the long term). The right hand is going to get much higher relative to the left hand. The stage is being set for the next phase of the credit crises. Basically the crisis is being postponed so that banks can be recapitalised by hiking up the cost of lending paid by the consumer, and reducing the costs paid by the bank to lend to the consumer. The bank keeps the difference.

    People often talk about how much the price of a house would earn in a bank account being more than the property earns in rent. The point of property as an invetsment is that somebody else pays the investment for you. Your cash deposit, plus time, buys the house free and clear. When all the financial distortions play thesmeselves out, the only sustainable value will be the classic and now long forgotten-in-ireland 100 times monthly rent. Anything else fails in the long run.

  10. dave

    hj,

    Congrats. That is the most succint and brilliant post on the entire matter I have read ever. I dont say that lightly. I have a masters in economics from a good NAmer uni and have struggled to ‘hit the nail on the head’ like you just did. (The other day I told someone that property was like a bond where you put down a small amount and someone else pays off the rest for you, while you get the full amount of the bond later). Will have to think a bit about the math of the x100 formula though! cheers.

  11. Kevin Keane

    If you want to compare the P/E of a house with that of a company that’s carrying debt on its balance sheet, then for the house:

    P = down-payment and E = income net of mortgage interest.

  12. Frank Keane

    to comment on this article and what Kevin just said.

    The best way to do a side by side comparison of the P/E of house ownership versus the stock market is to ignore leverage (gearing). A cornerstone financial theory called the “Miller-Modigliani Theory” suggests that leverage (gearing) should not matter to the value of an asset, be it house, company shares or whatever. They won a Nobel prize for this piece of simple logic.

    Now I’ll grant that due to taxes and other matters, that in the real world that theory is not exactly right. But it’s close enough.

    So, I agree with David McWiliams analysis and I’ve thought this was true for a long long time.

    Renting a house is a close (imperfect but close) economic substitute for buying one. So buying a house where the P/E (purchase price divided by imputed rent ignoring debt cost) is at some level way beyond the stock market tells you that you are in bubble-land.

    Nice article Mr. McWilliams.

  13. Kevin Keane

    Mon frere, my point is that you shouldn’t compare leveraged with unleveraged returns. I’m well aware that M-M theory says that leverage does not affect value, but that’s beside the point.

    Let me add that even when you get the basis of comparison right, and consider the myriad other factors influencing the investment decision, you are unlikely to find that current home prices are good value.

  14. MK

    > The 100 time rent formula comes because that is the point at which housing makes sense as a leveraged investment, when credit conditions return to normal.

    Well, first, the vast bulk of residential properties in Ireland are not bought as an investment. Secondly, credit conditions are never ‘normal’. They change and residential property tends to be over-valued (usually) or under-valued at any point in time, rather than bang on. When the over-valuation becomes extended (it is a bubble) and when it falls back significantly (20%) with knock-on consequences (it is a bubble bursting)

    In terms of the ’100x rule’, I presume you mean 100x monthly rent so using David’s example that’s 100×14000/12 = 116k. That is the same as saying a yield of 12%. I dont think there is a 100x rule, do you?

    > Basically Bank Lending is a carry trade between the short term left hand side of this curve (where banks get their money) and the higher rate at the right hand side of the curve

    No, banks loan to customers over the same duration as they get paid, they take a margin. It is not a difference in terms. eg: customer gets a 5-year fixed, bank takes out a 5-year fixed. Banks have a licence to get the funds, customers cant go direct. Banks are in a no-lose situation (normally).

    > Basically the crisis is being postponed so that banks can be recapitalised by hiking up the cost of lending paid by the consumer, and reducing the costs paid by the bank to lend to the consumer. The bank keeps the difference.

    Yes, I agree with you there. The Central Banks are facilitating the banks to avoid worse repurcussions. They are trying to draw it out so that the pain of poor decisions and systemic problems are spread out over many people. Joe Blogs (us) pays for the problems created by others. But Joe Blogs also benefits if confidence is retained, because at the end of the day, money is all about confidence. The day we all start withdrawing all our cash, stashing it under matresses (or futons) is the day the system crumbles.

    MK

  15. Malcolm McClure

    Excellent article David. “the folly of paying high prices for land with low productivity is being questioned.” Not before time.
    1.4 acres of “development land” 4 miles from the nearest village and 6 miles from the ocean in a scenic western county is offered for sale at “Region of €100,000″. This development land is at 550 feet on the side of a mountain, served by a third class country road with a view of bog and pine forest. Yet it is probably a better investment than CDOs these days.

  16. shtove

    Price should be about (100-120) x monthly rent – so house value is 108,000 to 129,600.

    Or 3.5 x annual earnings (average is 40,000?) = 140,000.

    The latter figure is obviously bubbly!

  17. Garry

    Cant comment on what house prices should be but….

    If valuers had to work within some kind of framework like this where they had to stand over their house valuations (e.g. realistically could be sued by people in negative equity or the banks) , things would be interesting.

    Does anyone know how does a valuer put a euro value on any house, is it according to some formula or is it like feng shui….. mutter a few phrases, move the sofa, trouser their fee and tell everyone what they want to hear?

  18. g;gg;

    Thanks, but perhaps my point was a bit too succinct! My point was that as the cost of borrowing will increase, and the investor must cover those costs from rent, that when the Bond Curve distortions play out and return to the pre bubble era shape, that a price of more than 100 times rent will be impossible to cover on a property by renting it alone. Thus the bottom of the market will be 100 times the rent achievable at that time. However, young people waiting to snap up bargain properties had better not be planning to do so with a lot of borrowed money, If like me your savings are in six digits, great, otherwise you better have a rock solid risk rating and a substantial deposit.

  19. Malcolm McClure

    A house is Real estate. Real because it is already there. To value it, take the value of the plot, based on size and location. Add the insurance full replacement building cost, based on usable floor space and quality of finish. Anything more than this is just a twinkle in the Estate Agent’s eye.

  20. MK

    > To value it, take the value of the plot, based on size and location. (etc)

    But its the changing value of plot which is the biggest factor driving ‘house’ prices.

    A 3-bed semi-d to build it from scratch out of materials costs 100-150k, depending on exactly what you put in it. Lets take 125k as a resonable cost for a certain spec. And that cost (125k) is the same whether it is built in Foxrock or in the middle of nowhere. What people have been paying for is the land, the location in terms of the usefulness (commercially) of the said property. For example, its easier to rent out a place in Foxrock than in the middle of nowhere, and its easier in Dublin City or Cork City, etc. Those factors drive ‘house’ prices, not the materials, and that is what has been changing.

    Valuations have and always will be what people are willing to pay for a property. And the change up, as well as down.

    MK

  21. Malcolm McClure

    MK: A pretty ordinary semi-det in Ballsbridge sold the other day for €2.6 Million according to the Irish Times. From your estimate of building costs this makes land in Ballsbridge worth about €10 million an acre. To achieve 10% pa ROR from rental implies an income of €1 million per acre just to cover land costs. Lets say alternatively that we can build 12 X 2-bed apartments per floor per acre at a net rent for each of €30,000 pa. That gives an annual return of €360,000 per floor. Build, say five floors high and you cover the 10% ROR on both land and construction costs.
    (If you can find 60 tenants willing to pay €3000 a month to rent a 2-bed apartment.)
    Get planning permission to go higher and you’re Quids (Punts or Euros) in. Makes sense?

  22. Great article. Obviously a lot has changed since it was written with the global markets being as they are. Whilst the press continue on about how poorly property is performing they do have a point, but seem to have missed others.

    The stock markets as a whole are riding quite high at the moment, but so is gold (often regarded traditionally as having a negative correlation). Given this, when one compares gold against property prices, arguably gold is far more over valued and at risk of a crash. See: http://www.ipinglobal.com/ipin-live/blog/331743/property-versus-gold

    Comparing P/E of houses with that of stocks whilst it does give you an idea of performance, one has to remember that although stocks have the liquidity over property, this can also present them with a far more rapid decline because of that very fact.

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