Friday, January 4, 2008

Stock prices are to Earnings as Home prices are to Rents

Wall Street analysts throw around P/E (price to earnings) ratios all the time when digging into a stock and discussing whether it is under/overvalued. Historically, stock prices and sectors basically trade within certain a range of these P/E ratios. Remember the dot-com implosion? Of course you do. Why did it happen? Basically, because there were little, zero, or even negative earnings to support the exorbitant stock prices. When the dust settled, the market eventually returned to a state of normalcy where actual earnings reflect the value of the stock.

This fundamental principle does apply to housing values as well. As rents have climbed historically, so have home prices. Their relationship can fluctuate a little to a lot over the short- and medium-terms, sure. But not like they have in recent years. Three Fed economists (1 former, 2 current) have released a study - summarized here in the Wall Street Journal - proclaiming home prices need to retract 15% over the next 5 years, coupled with annual rent growth of 4%, in order to return back to normal levels. If rent growth is less than 4% or the correction period happens sooner, the drop could greatly exceed 15%.

Don't think you are the only one who feels it's insane that a $900k condo or house that carries $5000 in monthly debt service can only rent for $3000. It absolutely IS insane.

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