Country, country, country
When it comes to real estate we all know that it’s about “location, location, location”. While that may be true, few of us think of the location in terms of country and rather in terms of state, town and neighborhood. In this global world that we live in we should also evaluate real estate from an international perspective. What holds true for micro also makes sense for macro. The best way to assess valuation of real estate is via the “price to rent” and “price to income” ratios.
Price to Rent When it’s cheaper to rent than to own, house prices must depreciate until renters are lured into buying. Vice versa when rents are more expensive than buying a property, a renter will then seek to become an owner, thus pushing up the price of real estate.
Price to Income This ratio can also be explained as the affordability of real estate. The higher the income to house price the more affordable the property. Also, the lower the mortgage interest rates are the more affordable a home becomes to a borrower.
Take a look below at house prices across the industrialised world. As you can see there are large differences in over- and undervaluation. As circled in the chart, it is notable how overpriced UK real estate has become. At the same time, real estate in the US is rather undervalued as the price to rent ratio is in equilibrium while home affordability is high thanks to low mortgage rates and depressed home values.
For those of you that know me personally and think of me as a perma-bear in US real estate, this is not the case anymore. It is true that I have been critical of housing since 2005 but if anything, US real estate is slightly undervalued at current levels. While I am still no friend of property taxes, maintenance bills and insurance premiums(who is?), the alternatives in the investment world are very unattractive.
As I have recently written https://rpreschern.wordpress.com/2013/06/01/building-the-perfect-beast/ , the US stock market is currently trading at a 30% premium over the long-term historical average. Bonds yield less than inflation and have effectively become instruments of risk without reward. As for cash and Treasury bills they guarantee a loss in purchasing power as interest rates are next to nothing. Take a look at the graph below showing an 80 year history of annual returns for major financial assets.
Now compare this to US real estate below:
As you can see, this chart also implies that US real estate is priced about right. Given the fact that stocks and bonds are pricey and one may not want to own gold only in their portfolio, residential real estate is a reasonable investment at this point in time. For those of you that have been somewhat reluctant to ask my opinion regarding real estate in fear of negative opinion, feel free to bring it up if you need some encouragement. For those of you living outside the US, please refer to the chart above to gauge how your real estate market fares. Of course, it’s still about location, location, location inside respective countries.
What if the economy turns down?
It is true that a downturn in the economy will negatively affect house prices but it will also impact the alternative assets discussed the same way. Whether rising interest rates or declining GDP, both factors will weigh on stocks and bonds. As for the economy, I continue to think that we are in stagflation in the US and most of the developed world. GDP grows at about 2% while inflation amounts to 3-5% causing negative real interest rates and growth. I see neither a significant up- nor downturn in the very near future. Take a look at the current US leading economic indicators. I believe they confirm my stated opinion.
For my international readers
While I have pointed out that the US stock market is historically overvalued how about other global stock markets and their comparative value with real estate? UBS just released a “book value” based graph that shows current over and undervaluation of global stock indices. Anyone with a global portfolio should take a closer look(click on graph to see it clearly).
Dark blue (very cheap) = current relative valuation < -1.5 standard deviations from historical average.
Light blue (cheap) = current relative valuation between < -1.5 and <-0.75 standard deviations from historical average.
No colour (neutral or N/A) = current relative valuation between > -0.75 and <+0.75 standard deviations from historical average.
Peach (expensive) = current relative valuation between > +0.75 and <+1.5 standard deviations from historical average
Red (very expensive) = current relative valuation between > +1.5 standard deviations from historical average
Source: UBS research.
While financial media keeps telling us that we are in a “TINA”(there is no alternative) stock market and even the ridiculous “Goldilocks” story has reappeared, from a purely mathematical point of view, residential real estate is currently poised to outperform both stocks and bonds in the medium to long-term. It feels good to finally be cautiously positive regarding housing after eight long years of doom and gloom. I long for the day when I can say the same about the global economy…