Monday, March 21, 2005

Housings high P/E may make it the next dot com

The Globe and Mail
Merrill Lynch's David Rosenberg has been a housing bear for some time and you wouldn't look like a genius following his advice. Prices in the United States and Canada keep going up, no matter what the economist says. But he does raise an interesting point. Just because the housing bubble "hasn't burst, doesn't mean it doesn't exist," he told Barron's.

Give it time, in other words; no point having a bubble that doesn't burst.

Many of the fun ratios plotted by economic department gnomes on both sides of the border point to scary valuations. In the United States, the ratio of household real estate holdings to GDP -- now 140 per cent -- is a record high. To some economists, Mr. Rosenberg among them, the figure is the kiss of death. In early 2000, the equity market valuation as a percentage of GDP also reached 140 per cent. As if on cue, popping sounds were heard soon afterward.

In Canada, according to the economists at Royal Bank, the ratio is even higher -- 144 per cent -- up from 125 per cent in 2000.

That's just one indicator of an end that may be nigh. Another is the housing price-to- earnings ratio, a nifty concept borrowed from the equity markets and one that is gaining popularity among housing market watchers. Just as equities can be valued on expected future cash flows (the forward P/E ratio), so can real estate prices. Real estate cash flows are defined as a) what you could rent your house for, or b) what you could save in rent by owning a house.

In both countries, house prices are at record levels, compared with rents. This is another way of saying it may be cheaper to rent shelter than buy it. In the United States, the house P/E multiple is about 135 per cent. In Canada, it's 140. There's the ominous one-four-oh again! To be sure, what's true nationally can have little bearing on what's happening in your home town. The highest P/E ratios -- 150 per cent or more -- are found in Victoria, Calgary and Edmonton. Compared with renting, housing is cheapest in Toronto, Hamilton and Winnipeg. If you want to buy, don't go west, young man.

Canada and the United States are not alone on the high P/E front. According to The Economist magazine, record high P/E ratios, that is, record low yields, exist in Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This either suggests that high P/E ratios in Canada and the United States are becoming the norm, or that housing prices in all these countries are on the verge of turning downward. Don't count on the former. Financial instruments of every description are generally priced on their ability to earn a buck. Those that aren't -- late 1990s Internet stocks, with big Ps and no Es, come to mind -- can have short and tragic lives.

Indeed, prices in at least half of the countries with record high P/E ratios are feeling the temperatures cool in their recently red-hot housing markets. The slowdown (according to The Economist data) is most apparent in Australia, where house prices rose 2.7 per cent in 2004, compared with 18.9 per cent a year earlier. The drop-off was substantial in New Zealand and Britain too. In Canada, the rate of increase last year slowed marginally to 6.2 per cent from 6.9 per cent.

Panic time? Not necessarily, in spite of the fat P/E ratios. That's because economic conditions (in Canada anyway) have changed for the better since the early 1990s, when housing markets across the country, notably in Toronto, went into the tank and stayed there for several years.

Back then, Treasury bill and mortgage rates were in the low teens, the government was running a monster deficit, unemployment rates were in the double digits and there was a recession. Canada was also adjusting to the upheaval of the North American free-trade agreement. A 90-cent (U.S.) dollar didn't help. Although the dollar is rising again, none of the other economic shocks exist today. So, you could argue a higher-than-normal P/E ratio is justified.

This does not mean housing prices can avoid a downturn; it only implies there is a fair chance they will ease gently instead of falling off a cliff like they did 15 years ago. The Canadian market is also unusually "tight" at the moment, that is, the number of houses available for purchase is relatively low. The latest figures tell you that for every house sold, another 1.5 or so are on the market. In 1990 and 1991, for every house sold there were 3.5 or more on the market. The forest of For Sale signs accelerated the downturn. More choice meant fewer bidding wars.

Still, the ratios suggesting an overheated market, perhaps a genuine bubble, can only be worrisome. The high P/E ratio alone says that house prices either have to fall substantially, or rents rise substantially, if the market is to revert to the norm. Because soaring rents make politicians go berserk, house prices are more likely to fall. If you're in search of shelter, renting looks like the most attractive option.

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