Nov 15 2013, 11:14 AM, updated 12y ago
The collapse of the US housing market bubble emphasizes how important it is to figure out what property is really worth, from a fundamental perspective. Make sure you’re not over-paying!
There are 4 yardsticks to avoid buying in bubble markets:
•Price to Rent Ratio (or Yield)
•Relative Prices
•Affordability
•Price of new builds
VALUATION TOOL 1: THE PRICE TO RENT RATIO
The gross rental yield) is the housing parallel to the price/earnings ratio. Here is a set of rules of thumb for the housing market:
VALUATION YARDSTICKS FOR THE HOUSING MARKET
PRICE/RENT RATIO GROSS RENTAL YIELD (%)
5 20 Very undervalued
6.7 15 Very undervalued
8.3 12 Undervalued
10 10 Undervalued
12.5 8 Borderline undervalued
14.2 7 Fairly priced
16.7 6 Fairly priced
20 5 Borderline overvalued
25 4 Overvalued
33.3 3 Overvalued
40 2.5 Very overvalued
50 2 Very overvalued
But there are exceptions to this. When strong future growth in value is expected e.g in areas where transport infrastructure is being upgraded then relatively weak present earnings can be acceptable.
There are several good reasons why people should pay attention to the 'valuation parameters':
Higher rental yields push the housing market higher
If rental yield levels are high, this will tend to mean that the interest cost of buying a house is low, compared to the cost of renting a house:
•Potential buyers will pay less to borrow from the bank (in order to buy) than they pay when renting a house. Many will move from being renters to buyers.
•Entrepreneurs will find it makes sense to buy houses to make money, i.e., buy in order to rent them out.
Both these factors put upward pressure on house prices.
Lower rental yields put downward pressure house prices
If rental yield levels are low, this will tend to mean that the interest cost of buying a house is high, compared to the cost of renting a house:
•Potential buyers will find that to buy a house involves paying much more to the bank, than it costs to rent a house. Buyers, especially first-time buyers, may have difficulty financing housing. Banks will be worried about over-lending at loan-to-income ratios which mean that a slight increase in interest rates will mean financial crisis for the borrower.
•Entrepreneurs will find that buying-to-let won't pay.
The house price can be viewed as a kind of circle, with houses prices moving from yields of (say) 4% to 11%
•Yields shifting down to 4% would represent danger.
•Yields rising to 11% would signal opportunity.
VALUATION TOOL 2: RELATIVE PRICES
People tend to actively look for cheaper and better alternatives. Where houses are very highly priced, people will seek more affordable alternatives. So if you’re buying property that’s amazingly expensive on a sqaure foot basis compared to its surrounding developments – BEWARE!
VALUATION TOOL 3: AFFORDABILITY
If house prices are so high that few people can actually afford to buy them, then their value will likely fall in future. A reasonable measure of value is a country’s GDP per capita. In a country where the ratio of house prices to GDP/capita is high, it’s a fair bet that houses are overvalued.
Relative to GDP/Capita levels:
•House prices in Luxembourg, Belgium, Norway, Denmark and Austria seem cheap.
•House prices in the UK, Italy, France and the Netherlands seem comparatively expensive.
VALUATION TOOL 4: PRICE OF NEW BUILDS
If house prices are much higher than the cost of building (construction costs), developers are motivated to put up buildings. So when you see a rush by developers to build, that’s a danger sign. As new supply comes into the housing market, that tends to put pressure on prices. So when house prices are far greater than new-build costs, it's a very clear signal that prices are likely to come down.
Investment 4 Critical Signs of a Bubble Market, Property Investment
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