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With the 2005 version of King Kong (starring Jack Black, but not as the
monster) coming to theaters can it be long before we have more super
monster battles on the big screen? In 1962 King Kong fought Godzilla,
who in turn has fought many other beasts. Perhaps the most surprising
was the defeat of Godzilla by the caterpillar children of Mothra
(“Mosura” in the original Japanese).
When it comes to housing prices, there was an interesting”albeit
unknown”superbattle that took place in Massachusetts back in the late
1980s. On the one side stood world-famous Harvard economics profes-
sor Greg Mankiw. In opposition was Fatima Melo, a Portuguese immi-
grant with no college education. In the battle to predict housing prices
whom would you bet on?
In 1989, Professor Mankiw and David Weil (who was a graduate stu-
dent at the time, and is now a professor) published an article entitled,
“The Baby Boom, the Baby Bust, and the Housing Market.”6 In it, these
two esteemed academics concluded, “real housing prices will fall by
47% by the year 2007.” They went on to write, “indeed, real housing
Real Estate 197

prices may well reach lower levels than those experienced at any time in
the past forty years.”
The academic duo speculated on the spillover effects of their predicted
housing bust. They write, “Even if the fall in housing prices is only one-
half what our equation predicts, it will likely be one of the major eco-
nomic events over the next two decades.” These professionals predicted
that housing prices would decline substantially and seriously harm the
Not too far away from Harvard University, our young immigrant was
facing a decision. Should Fatima and her husband buy a small house or a
much larger one? Their family was growing and faced the decision of
buying a house for their current needs, or something a bit roomier (and
more expensive) to expand into. Fatima urged her husband to buy the
biggest house they could afford.
Fatima anticipated that housing prices would rise (she was fortunate to
never have taken an economics course). If prices were to rise, the bigger
the investment in real estate, the more profits. Fatima advocated taking a
risk, and she convinced her husband to swing for the fences. Accordingly,
the young couple took their savings and borrowed as much money as the
bank would lend them. They bet big in anticipation that a rising real
estate market would make them money.
So who was right about housing prices? Was it the book-smart aca-
demics with their complex mathematical equations, or was it street-smart
and gutsy Fatima putting her family fortune on the line? Figure 9.1 shows
the answer. U.S. housing prices have soared. The price index is calcu-
lated by using repeat sales of the same property. This is a perfect measure
as it compares apples to apples and exactly tracks changes in housing
The professors predicted a 47% fall in housing prices after adjustment
for inflation. In reality, housing prices”even after adjusting for infla-
tion”have risen dramatically.
The professors were exactly wrong.
Furthermore, the professors predicted that the decline in housing
198 Applying Science and Art to Bonds, Stocks, and Real Estate

U.S. Housing Prices (1980 = 100)


* annualized rate from first part of year

FIGURE 9.1 U.S. Housing Prices Have Surged
Source: Office of Federal Housing Enterprise Oversight

prices would put a drag on the economy. Exactly the opposite has
occurred with rising housing values contributing to rising wealth and
supporting the economy during a period when stocks have not risen.
The U.S. housing boom has been nothing short of amazing. Not only
have prices risen dramatically since the professors issued their dire pre-
dictions, prices have been rising continuously since World War II. Fur-
thermore, U.S. housing prices rose in every single year since at least
1975”no down years for three decades! That is absolutely stunning.
How did our dueling pair of forecasters perform? Fatima has parlayed
her real estate investments into some serious wealth. She put $5,000
down on her first house and borrowed $90,000. She sold the house for
$358,000. With the profits, Fatima and her husband bought a house that
was three times larger. The new house has appreciated considerably so
the couple has accumulated household equity in excess of half a million
dollars. In spite of their modest incomes (“jobs that pay shit,” in their
words), Fatima and her husband have become rich by aggressively buy-
ing real estate.
Real Estate 199

Professor Mankiw has also prospered. He became a tenured member
of the Harvard economics department at a young age. He has written sev-
eral economics textbooks and has earned millions from their sale. Pro-
fessor Mankiw is currently the chairman of President Bush™s Council of
Economic Advisors.

Is Your Home Overvalued?

Housing has had a great run in the United States for more than 50 years.
Is it likely to continue? This question can be answered in three parts: (1)
Determine a price to earnings ratio (P/E) of your home, (2) estimate a fair
P/E for a home, and (3) salt to taste (adjust for local market dynamics).

What Is the P/E of Your Home?
A first step is to determine the “fair” value of a property. As with stocks
and bonds this is impossible to do precisely, but easy to approximate. The
calculation of fair value relies upon calculating a price to earnings (P/E)
A stock™s P/E is calculated by dividing the price of the stock by the
earnings for the stock. In the stocks chapter, for example, we looked at
Microsoft. The current price of Microsoft (July 2004) is $28, and the pre-
dicted earnings for 2004 are $1.27 per share. Thus, Microsoft™s P/E is 22.
To calculate the P/E of a house or other piece of property, we divide
the price of the property by the income it produces. This is easy for a
rental property (as long as we are careful to adjust for taxes). For a prop-
erty that is occupied by the owner, however, there is no rent. In this case,
the “earnings” are the estimated rental payments if someone else occu-
pied the property.
For example, I live with my wife and our new baby in a condominium
near Harvard University and Harvard Square. As our place has filled up
with cribs and baby toys it has become obvious that we will need to
move. Accordingly, I have been getting some estimates for the value of
200 Applying Science and Art to Bonds, Stocks, and Real Estate

our place. The market price for our condominium is something like
What is the value of our property? Because I don™t assume the market
price will stay constant, and I™m not sure when we will sell, I estimate the
value independent of the current price. The key is the going rental price
for the property. Even though we aren™t currently earning anything on our
property, I will use the market rental rate as the “earnings” for my P/E
The going rental rate for our apartment is about $2,800 a month. To
calculate the P/E we need to factor in all costs including taxes. After our
costs, we could generate about $2,000 a month in rental income from our
property. So we could earn $24,000 a year in rent, after expenses. So the
P/E for our condominium is the price ($650,000) divided by the earnings
($24,000). The P/E for our apartment is 27.

What Is a Fair P/E for a Home?
What is the fair P/E for a home? One way to answer this is to compare the
P/E of a house to that of stocks and bonds. Table 9.1 makes this compar-
ison and summarizes some key attributes of the different investments.
The U.S. stock market as measured by the S&P 500 has a P/E of about
18; this calculation uses the estimates for 2004 earnings ($61.50) and the
current figure of the S&P 500 (1101).7 The 10-year Treasury bond cur-
rently yields 4.4%. This converts to a P/E of 23.

TABLE 9.1 Key Investment Characteristics of Stocks, Bonds, and Real Estate
Stocks Bonds Real Estate
S&P 500 10-yr Treasury Your House
Risky or Safe? Risky Safe Risky
Potential for gain $$ $ $$$
Tax treatment Favorable Neutral Very favorable
Inflation protected? Yes No Yes
P/E 18 23 ??
Real Estate 201

How does a house compare with these two major alternatives? Table
9.1 lists four important investment characteristics and then analyzes the
trade-offs between stocks, bonds, and real estate. When comparing two
investments, the more favorable the investment attributes, the higher the
fair value and the higher the P/E that can be justified. For example, if two
investments are identical except for tax treatment, then the investment
with the lower tax rate deserves a higher P/E.

Attribute #1, Risk: An investor in U.S. Treasury bonds is sure to get
the original investment returned. Those who own stocks or houses risk
losing their investment.

Attribute #2, Potential for Gain: The U.S. Treasury bond investor
can make modest capital gains (if interest rates fall). Both the stock mar-
ket investor and the home buyer have the potential for substantial gains.
Because houses can be bought with very modest down payments, how-
ever, they have the highest potential for gain.
For example, Fatima™s $5,000 investment in real estate became more
than $250,000 in just a few years. An investor who bought the Dow Jones
Industrial Average in 1927 would have achieved the same 50-fold
increase if she or he had held the stocks until 2004.8 So a few years™
investment in housing can provide a lifetime™s worth of gains in the stock

Attribute #3, Tax Treatment: Stocks are treated more favorably than
bonds. Both dividends and long-term capital gains have lower tax rates
than interest payments on bonds. Houses have the most favorable tax
treatment. This ranges from the tax-deductibility of interest payments to
the exemption of taxes on substantial capital gains from sales.

Attribute #4, Inflation Protection: Normal U.S. Treasury bonds are
not protected against inflation (though some bonds do have such protec-
tion). Both stocks and housing are protected against inflation.
How, then, do housing investments compare with stocks and bonds?
202 Applying Science and Art to Bonds, Stocks, and Real Estate

The answer is that houses share many characteristics with stocks. Houses
offer more potential for gain and better tax treatment than stocks. While
the higher potential gain in houses should come with more risk, this has
not been the case over the last decades.
So what is the right P/E for housing? Based on the characteristics of
risk, return, taxes, and inflation protection, housing investments look
similar or better than stocks. In addition, the finite supply of land might
argue for a bit of a premium. Based on this analysis, housing could
command a fair P/E as high as 30. Housing P/E™s are categorized in
Table 9.2.

Salt to Taste
As we all learned in elementary school, the three keys to real estate are
location, location, location. While there is a single market for IBM
stock, there are many, many different markets for real estate. While
we have just made some general conclusions about “fair value” for a
house, those P/E categories should obviously be adjusted for local
When people look at real estate at a local level they tend to analyze by
city and region. We can read that housing prices have gone up by 15% in
Phoenix, but declined in Buffalo. In reality, however, “location” is a
much more fined-grained notion than an entire city.
My friend Jon, who lives in Charlotte, North Carolina, learned the

TABLE 9.2 Is Your Home Overvalued?


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