Do you know the price of everything but the value of nothing? Determining Real Estate property values.

In my first series of blog posts I want to start by discussing real estate, as the decision on where we live is a fundamental part of our personal finance journey. In a later series of posts I’ll switch to investing for retirement and other goals in life.

My message is simple: Understand the fundamentals of real estate and you will make more rational and informed decisions.

So let’s understand the fundamentals of real estate. Oscar Wild said that cynics are very good at knowing the prices of everything but the value of nothing. That is because value is in the eye of the beholder, and is very subjective, and people overvalue or undervalue things. Maybe in a later blog post we can discuss a bit on the recent research of behavioural economics so we can start to understand how we place value on things, but for now let’s focus on how to determine if prices are overvalued or not.

In my research on metrics people use to to assess the valuation of real estate in a given market I came across three metrics: Price to income, Price to rent and deviations from historical trends. Let’s discuss what these are.

Price to income

The first one is the price to income ratio. This metric looks at what the prices of a location are, sorts them from small to high and picks the middle price (median price), and then looks at the incomes of the people in that city and does the same, picks the median value. Then it divides the two median values (median price divided by median income) and voila, you get your price to income ratio.

So what should this value be? Well, apparently for years it was thought to be around 3 (Globe and mail article), and you might wonder why. Well, it has to do with what the banks will lend someone to buy a home. Although the formula is complicated and takes into account income, interest rates and other living expenses, if you play with one mortgage affordability calculator and enter the historical 5-year mortgage interest rate of 7.2% (see how interest rates have changed over time below), you’ll get that roughly you can borrow 3.5 times your income if you have a decent downpayment. Hence it is reasonable to expect to have a price to income ratio of ~3.

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Price to rent

The second metric is the price to rent ratio. This takes into account the price of the property in question and compares it to the annual rent for the property. According to investopedia, Trulia established thresholds for the ratios as follows: a price-to-rent ratio of 1 to 15 indicates it is much better to buy than rent; a price-to-rent ratio of 16 to 20 indicates it is typically better to rent than buy; and a price-to-rent ratio of 21 or more indicates it is much better to rent than buy. You might wonder where these numbers come from. Well, think about it as the yield or ‘interest’ that you get from owning a property. If you buy a property for $500,000 and you get $25,000/year on rent your ratio is 20. That is the equivalent of getting a 5% yield or interest on it. This is of course ignoring all the costs that come from owning a property (taxes, maintenance, strata fees, etc). If you invest that money in the market you can conservatively get very likely >5%/year in the long term, so if the price to income ratio is >20, the property is overvalued in terms of the opportunity cost you pay for not putting the money in the market instead. This table summarizes this metric, remember that markets tend to yield 6-10%/year in the long germ depending on your risk tolerance and asset allocation (more on a future blog post).

You can also think of the Price to Rent as the equivalent of the Price to Earnings ratio, a very common metric used to evaluate the value of stocks.

Price to rentRental yieldRecommendation
1010.0%Buy, this is much better than the market
156.7%Buy or Rent, you can get more or less the same in the market with more volatility
205.0%Rent, with all costs, the market is probably better.
254.0%Definitely rent, the market is most likely better.
303.3%Do not even think of buying! Even GICs will give you more money!

Deviation from the trend

The third metric is how much the prices have deviated from historical trends. One of the first people to really look back in time to understand changes in property values was Robert Schiller (Nobel Prize Winner in Economics). He went back more than a 100 years and looked at how much house prices have changes when adjusted for inflation. This is what he got (source: Irrational Exuberance, Figure 3.1):

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Heavy solid line (left scale): real (inflation-corrected) home price index, 1890 = 100, for the United States, constructed by the author from various existing indices and raw data on home prices; top thin line (left scale): real (inflation-corrected) building cost index, 1979 = 100, constructed by the author from two published construction cost indices; middle thin line (right scale): U.S. population in millions, from the U.S. Census; lowest thin line (left scale): long-term interest rate constructed by the author from two sources. (Shiller, Robert J.. Irrational Exuberance: Revised and Expanded Third Edition (p. 20). Princeton University Press.)

As you can see, over a period of more than a 100 years, house prices in the US have remained very close to the inflation rate, so plotting property price changes with respect to time, and adjusting them by inflation, you can get a sense on deviations from the trend. For example, in Schiller’s plot, you can easily spot previous house price bubbles, including the big one from 2008 which resulted in the Great Financial Crisis (GFC).

Summary

Three metrics were discussed here that help people assess the if the price of real estate is overvalued or undervalued. The price to income ratio tells us whether people in the community can afford properties. The price to rent ratio tells us whether it makes sense to buy in a location or maybe it is better to rent and invest the money somewhere else. Finally, charts of changes in real prices (which are adjusted by inflation) with respect to time tell you whether there is an anomaly in the housing market.

Now I will look at where Vancouver sits for these three metrics in my next blog post.

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