As part of a continuning series of academic fisking, let’s have a go at a pair of charts based on data from Yale Prof Robert Shiller in Friday’s NYT. The first looks at home prices relative to inflation (but adjusted for "construction quality"), while the 2nd chart looks at the SPX’s trailing 10 year P/E, again adjusted for inflation:
(NOTE: The NYT gets the blame for the charts; they are not Prof Shiller’s)
click for larger chart
graphic courtesy NYT
Try as I might, I cannot see the value of using these two charts as a method of comparison. They are certainly worthless if the goal is to compare these two separate asset classes — Real Property and Equities — in order to draw a conclusion that one or the other is overvalued.
First, these two charts measure totally different things: The Equity chart looks at trailing 10
years earnings, while the Real property chart looks at Home values. That’s an Apples & Orange comparo. Wouldn’t it make more sense to either 1) compare stock market capitalization to real property values?, or alternately, b) compare earnings with a commensurate graph of real estate rents (the closest thing to
corporate revenue)?
Second, why adjust these two charts — with identical time periods — for inflation? Its kinda silly, considering that the impact of inflation over the same 100 year period applies to both and is therefore irrelevant.
And if inflation applies differently — Real Estate prices are driven in part by inflation sensitive interest rates via mortgages, while Equities can find borrowing and/or raw materials more expensive due to inflation — why adjust both for inflation? Isn’t that part and parcel with whether one or the other is cheap or not?
Next, I note the hedonic adjustment for "construction quality." Why? Are new homes in similar price ranges better constructed than older homes? Certianly not in my experience. It became a cliche for a reason: They really don’t make ’em like they used to . . . Indeed, many older homes are more desirable than the new McMansions going up everywhere.
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Counterpoint: In all fairness, Shiller is a rational observer of all things financial, and generally has a sober, well-informed perspective. His book, Irrational Exuberance, was a timely warning about high stock prices, and came out a few months before the crash. It has stood the test of time (compared with embarrassments like Dow 36,000).
As to the article the chart is from, its a fairly balanced look at the pros and cons of Real Estate these days.
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UPDATE: March 26, 2005 7 6:44 am
Before posting, I wrote Prof. Shiller, asking his thoughts about these two charts. He was kind enough to respond to my request about the chart. He writes:
"The data these charts were based on are my data, but these are not my charts. I did not display these two series together in my book.
I can, though, imagine why they might have chosen to display these two charts together. The home price chart is, to the extent possible, the price of a standard home, which does not "reinvest earnings." So, to correct for the uptrend in stocks due to reinvestment of part of earnings, they decided to divide the stock price by ten-year earnings, to make the two series more comparable. Dividing by earnings takes most of the uptrend out of stock prices.
You are right one could argue that inflation might tend to have the same effect on both series.
Homes have gotten larger over the decades, that is a documented fact. It seems that some adjustment is called for."
That makes sense, and also lets the Prof off of the hook for this poor comparison. It does not convince me that the comparison is remotely worthwhile for trying to determine when this particular asset class (real property) is overvalued.
And while homes have gotten larger, so have companies (so have us Americans!).
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UPDATE II: March 26, 2005 7 7:29 am
Despite the market being closed Friday, there was a WSJ yesterday (is that a first?). I bring this up to direct your attention to an article titled: "Investors Slim Down as Property Prices Bloat"
"With commercial-real-estate prices hitting records in many markets, some of the shrewdest players are cashing out.
The sellers range from old-line real-estate families to pension funds, insurance companies and other big investors. The buyers are often real-estate investment trusts, whose returns have soared recently; investors shifting money into real estate from the stock market; and eager foreigners taking advantage of a weak dollar.
Among the biggest sellers is Calpers, which often joins with other big investors when it buys real estate. Together with those partners, Calpers has sold $6.5 billion of office buildings and shopping centers in the past three months alone, accounting for half of its real-estate investments. Those properties often sold for record prices, and Calpers has more real estate on the block. It has on the market a $1.4 billion portfolio of industrial buildings it owns with Chicago-based Jones Lang LaSalle Inc.’s LaSalle Investment Management."
Smart. But note (once again): There is a huge difference between selling an overpriced asset, and the non-stop declarations heard that we are in a real estate bubble . . .
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Sources:
Real Estate Instead of Dot-Coms
MOTOKO RICH and DAVID LEONHARDT
NYT: March 25, 2005
http://www.nytimes.com/2005/03/25/business/25boom.html
Investors Slim Down as Property Prices Bloat
Sheila Muto
Wall Street Journal, March 25, 2005; Page C1
http://online.wsj.com/article/0,,SB111170550360089201,00.html
I haven’t read Shiller’s book yet, so I don’t really know and would not be surprised if he had already covered the following.
Fundamentally, I would say that the price of a home is the discounted value of the services that it will render over its remaining life. The services can probably be approximated by the rental values. We need a discount factor. How might it look ?
Over the past 25 years, US inflation has come down a lot. It still fluctuates of course over the cycle, but it seems to be much lower these days than it used to be even in the early nineties. Let’s say inflation averages out to 2.5% over the course of present day business cycles, whereas it was more like 4% in the not-too-distant past. Add in 2% real interest rate today against 3% yesterday. Add in some small risk premium today – because inflation is also a lot less volatile -, say 0.5%, compared to maybe 1% yesterday. You end up with a long run discount factor of 5% compared to 8%. That is a huge difference when houses have a long life, say 50 years.
Calculating this way would suggest a fair value today as opposed to say, 10 years ago. You would then compare actual prices and make a judgement that homes are over-priced today or under-priced compared to 10 years ago.
Does this sound silly to you ? (i’m not in the real estate business and am just curious).
We’re certainly seeing old-line real estate money in liquidation mode here in San Francisco. A telling quote from NYTimes last week from Doug Shorenstein, the biggest of the private old-money players here:
“Prices are staggeringly high relative to the returns and the underlying fundamentals,” said Douglas W. Shorenstein, the chief executive of his family business, in an interview in his 49th-floor corner office at the Bank of America Center overlooking San Francisco Bay. “If somebody is willing to pay a lot more than I would pay, then we’re a seller.”
Whether or not you want to use the ‘bubble’ word, I think it is safe to say that real estate—at least here in Calif—is profoundly overvalued, much more so than at the peak of previous booms.
In regards to commercial, it appears the REITs are the primary buyers. That makes sense because they have received so much cash during the past few years and they are “putting it to work.” They are motivated less by compelling valuations than by having to invest the groaning amount of cash they have accumulated.
To me, this is the very definition of dumb money buying from smart money. Commercial property here in SF has doubled in value over the past five years, while the vacancy rate has gone from under 2% to nearly 20% and while rents have been cut in half.
Buying assets into the teeth of historic overvaluation will likely result in significant underperformance in the years ahead. Just don’t call it a bubble.
The thing about real estate, is that it’s a tangable good. People need to live somewhere. So there is a certain real demand for real estate that can drive these things. The high price of housing right now, I think I attribute to the after affects of the 90’s VC shakedown, as well as low interest rates making high-cost housing more attractive.
To compare it to stock prices, which is not very much of a tangible good, it’s just a vague investment in…something…well it’s not going to make any sense. It’s comparing apples to oranges.
For a graphic depiction of the disparity between the ‘shelter cost’ as used to calculate the CPI (rent based) and the purchase cost as calculated by OFHEO (Office of Federal Housing Enterprise Oversight) go to : http://www.contraryinvestor.com/mo.htm
I’m not sure of the predictive value, but it would appear that the indexes criss cross periodically over time and to cross again would require either a sizable increase in rents (and CPI) or a decrease in prices. So do we go the USA in 70’s route and inflate? Or the Japan route of the 90’s and deflate?
From where I sit either way is not positive for stocks. But if Cramer is correct about the fed targeting real estate the Japan route becomes a greater possibilty.
Along those lines what scenario would hurt the most investors? I believe the Japan path as it would lead to falling stocks (investors too complacent), falling materials and energy (bulls and bears now long), emerging markets getting a major whack (way too much public excitement there) and finally the long treasury would rally BIG (and it seems 99% of investors are negative on bonds).
But, we really have no experience with this sort of real estate market, or, is it more me? Earnings growth for the REIT index has been negative for the last 4 years, which seems to tell us that REITs are appreciating not partly because of income growth but solely because of price appreciation of owned properties. Since the REIT index has led growth in the broad stock indexes since 1973, it is not as though real property is playing catch up.
Am I seeing the earnings data of REITs for what it is, or am I mistaken in understanding?