Is there a housing market bubble?

Here are some yardsticks to avoid buying in bubble markets:

• Price to Rent Ratio (or Yield)
• Relative Prices
• Affordability
• Price to Replacement Cost

What ought a house to be worth?

To be supremely unemotional, a house can be considered, from a certain perspective, to be a money-making asset (especially if you don't live in it but own it to rent).

Now the most comprehensive set ideas of how to value such assets has been developed in connection with the stock market. The value of a share is its Net Present Value, i.e., the value of all expected future earnings from the share, discounted for risk, for financing costs, and for time-preference. Since no-one knows what the risks, etc, are, stock analysts fall back on rules of thumb:

Valuation Tool 1: The price to earnings (or price to rent) ratio

In the stock market a very popular rule of thumb involves the price-earnings ratio, which measures how high the company's net earnings are, in relation to the price of the stock. For an ordinary company, a price earnings ratio of between nine to 18 would be considered within the normal range. Anything above that is considered high. Alternatively yields from the company's shares of between 5.5% to 10% are considered normal (the price rent ratio is the reciprocal of yields).

Because the stream of future income can be expected to be higher for a company which is rapidly growing, it might be considered normal for a 'growth stock' to be priced at up to 20 or 30 times earnings.

It's the same in the housing market. What's generally viewed as reasonable is similar to what's considered reasonable in the stock market, although houses tend to be expected to yield slightly less, perhaps because a house's value depreciates less over time than the assets of a typical company. The price/rent ratio (or gross rental yield) is the housing parallel to the price/earnings ratio.

Here is a set of rules of thumb for the housing market:

When strong future growth in value is expected, e.g., land on an undiscovered but beautiful beach, or dwellings in an area whose communications infrastructure is being upgraded, or land in a high-growth area, then relatively weak present earnings can be acceptable

The common sense man raises an objection!

The ordinary house buyer may well feel these reflections don't answer his main concern.

He wants to live in a house. Why should he value housing for its rental earnings?

As he looks around, the average person sees that while housing is expensive, it also seems generally to increase in value. He needs a house, and if he waits he'll probably have to pay more for it. And if he buys in a city where housing tends generally increases in value, he's not going to lose money if he buys now, never mind what signals are sent by all those ratios.

Perhaps 90% of all house-owners have no intention of renting their house out. So what's the relevance of the price/rent ratio?

There's a lot of practical sense to this objection. Buyers do tend to treat houses-for-owning-and-living-in as sui generis, and not precisely equivalent (e.g) to rented houses. But there are several good reasons why people should pay attention to the 'valuation parameters'.

Low P/Rs 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 housetoo. 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.

High P/Rs 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.

Low P/Rs tend to put downward pressure on house prices.

House prices tend to revolve around a P/R range. The house price cycle 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.

The house price cycle can be viewed as a kind of circle:

In broad international perspective the 'range' is likely to be fairly similar in different countries (because real interest rates are broadly similar) but not entirely similar.

Countries with higher nominal interest rates, and countries with weak mortgage markets, will have relatively low P/Rs. As their housing markets develop institutionally, house prices will also adjust upwards - as is now occurring now in Eastern Europe.

Every market will have a range. To imagine that a market can escape totally from its range of P/R ratios is bubble thinking.

EASTERN EUROPEAN YIELDS ARE HIGH

Gross housing rental yields in Europe span an enormous range:

• Returns in Moldova, Poland, Bulgaria, Romania, the Slovak Republic, Ukraine and Russia are quite attractive (though their attractions must be balanced against risks). Good yields are also to be had in Amsterdam and in Paris.
• Yields in Monaco, Spain, Ireland, and Lithuania are very low.

Valuation Tool 2: Relative Price Comparison

People may not have infinite choices about where they live. But they do have some choice. Friends are constantly relocating because housing in County X is half the price of housing in County Y.

It therefore makes sense to pay attention to square metre (sq. m.) costs. People tend to actively look for cheaper and better alternatives, and where houses are very highly priced, people will seek more affordable alternatives.

To some extent, that logic applies internationally, as well. Consider - is the average Muscovite's income-earning potential really enormously higher than that of the Parisian, Roman, Dubliner, or Viennese? Clearly not. So Moscow's apartment prices, at €10,000 per sq. m., seem overvalued.

The table below throws up another case. Brussels (Belgium) is apparently undervalued - located in a high-income country, its housing is valued at prices similar to Eastern Europe.

Valuation Tool 3: Affordability

Putting more flesh on the previous idea, the affordability of housing is a useful yardstick. If house prices are so high that very few people can afford to buy them, then their value will likely fall in future. A reasonable measure of value is GDP/cap as a multiple of house prices per sq. m.:

This table shows that 15.4 sq. m. of housing can be bought with Luxembourg's GDP/Capita while Moldova's GDP/Capita can only buy 1.3 sq. m. per annum.

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.

However, note that housing in poor countries always tends to be relatively highly priced relative to the local standard of living (they're poor, right?), so a substantial difference between countries at different income-levels is unsurprising (that's why the poor countries cluster at the bottom of the table). This GDP/Sq. m. yardstick is best used to compare countries at the same GDP levels.

Valuation Tool 4: Price-to-Replacement Cost

Developers will tend to construct new buildings if house prices are much higher than new-build construction costs. Over the long run that will tend to put pressure on prices, as new supply comes into the housing market. So when house prices are far greater than new-build costs, it's a danger sign.

There is one obvious exception to this. In cases where (as often happens) regulations tend to restrict the construction of new buildings, new-build prices have less significance. Europe is replete with building codes, permits, quantitative restrictions, etc, which limit the amount of new housing supply. Such regulations tend to mean that house prices are above new-build costs.

How useful are our four valuation tools?

Housing markets tend to move in long, cyclical waves. We appear to be the peak of such a wave. Our four indicators are good pricing yardsticks. Use them to make judgments about housing prices, and above all, to remain skeptical and hard-headed about today's valuations.