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House Price to Earnings Ratio Value Category

More than 30 Expensive
Between 20 and 30 Premium
Between 10 and 20 Solid Value
Less than 10 Cheap
Real Estate 203

importance of location (and timing) over the last several decades. He sent
me an e-mail summarizing his real estate experiences. The e-mail enti-
tled, “financial frustration” said:

I bought a condo in 1985, when I was single, two blocks from my
office [in downtown Charlotte] for convenience for $60,000. The
property lost value for years while houses two miles away gained in
value. I sold the condo in 1993 after getting married in 1992 for
$84,000 and bought a home for $180,000. Seven years and two
children later, I sold this home for a small loss after significant
improvements. Finally, I bought my current house for $360,000 just
as the economy was slowing (June 2001). My original condo is now
worth more than $200,000!

Jon has owned real estate since 1985 in a booming market. Nevertheless,
due to family changes he has almost magically missed out on making
money; his timing and movements missed the micro trends within his
area. So there is much more to location than a city or region. In my own
building, for example, the properties on different floors and on different
sides of the building have performed differently.
Accordingly, our valuation ranges should be combined with knowl-
edge of local conditions. Just as an above-average P/E may be appropri-
ate for the stock of a super rapidly growing company, a property in the
right location can justify high valuations.

Is There a Housing Bubble?

A glance through a bookstore can produce some serious fears about
housing prices. Titles such as The Coming Crash in the Housing Market
and How to Profit from the Coming Real Estate Bust are likely to get any
homeowner™s pulse racing. Are we experiencing a housing bubble and, if
so, will the bubble crash?
204 Applying Science and Art to Bonds, Stocks, and Real Estate

There are some compelling clues that allow us to make a judgment as
to the existence of a housing bubble.

Clue #1: Housing Prices Have Risen Far Faster Than Rents
There is no nationwide housing P/E. While we don™t know the absolute
value of the P/E we know that it has risen by 43% since 1982. Figure 9.2
graphs the rate of increase in housing prices divided by the rate of
increase in rents.
Since 1982, housing prices have risen 43% more than rents. My wife
and I have had a similar experience with our property. The market price
of our condominium has almost doubled in just the last 5 years. In the
same period, rents in our building have increased by about 20%.
So housing prices have risen faster than rents. Does this mean that cur-
rent housing prices are too high? No. It could be that housing prices were
too low back in 1982. What is unavoidable, however, is that relative to
rents, real estate is less attractive today than it has been at any time over
the last several decades.

U.S. Housing Prices/Rents

(1980 = 100)


* annualized from first part of year

FIGURE 9.2 U.S. Housing Prices Have Risen Faster Than Rents
Source: Office of Federal Housing Enterprise Oversight, Bureau of Labor Statistics
Real Estate 205

Clue #2: Housing Supply Has Grown Faster
Than Housing Demand
Economists are odd people in many ways. In addition to using the words
supply and demand far more frequently than normal humans, we also
spend a lot of time thinking about elasticity. As I found out in college, the
abstract concept of elasticity can make the difference between wealth and
Once a house has been built, it is not particularly easy to convert it to
something else. Thus the supply of real estate is relatively inelastic. That
means that the supply of housing changes only slowly. In contrast, some-
thing that is elastic can respond quickly to changes.
What about housing demand? Barring some sort of tragedy, the num-
ber of people who need housing is also unlikely to change quickly. Does
this mean that the demand for housing is also inelastic? No. Housing
demand fluctuates far more rapidly than population.
In tough times, people are remarkably flexible in their living arrange-
ments. A recent college graduate, for example, with a good job can™t
imagine living at home. If unemployed, however, the same person
becomes much more tolerant of her or his parents. In good times, there-
fore, demand for housing rises far more than population growth, and in
bad times, people find ways to economize.
Thus the housing market is characterized by inelastic supply and rela-
tively elastic demand. So what? These sorts of markets have the interest-
ing characteristic that price can change very rapidly.
I learned this lesson when I was in college at the University of Michi-
gan. Doug, the millionaire surfer, made a good living each Saturday
scalping tickets at football games. My friend Scott and I decided to get
some of this easy money. We hit upon the following strategy. Go to the
student dormitories farthest from the stadium. Find students groggy from
Friday night drinking and offer to buy their tickets for $1. Then ride our
bicycles down to the stadium, sell the tickets for more, and collect our
206 Applying Science and Art to Bonds, Stocks, and Real Estate

We did this one bright Saturday morning and managed to make about
$100 in a couple of hours. I remember our first sale. A couple was walk-
ing away from a BMW. I approached the man and asked if he needed
tickets. He asked, “How much?” Scott responded with “face value” of
$12. The man instantly agreed, and we had $22 in profit!
The following Saturday, Scott and I were up early aggressively buying
tickets. Buoyed by our success, we purchased more than 60 tickets, each
for $1. As we rode our bikes to the stadium, however, we saw people
offering to sell huge batches of tickets. We soon began selling tickets as
fast as possible. The going prices started low and then plummeted. One
buyer wanted six tickets. I offered six for $0.25 each. A competing
scalper undercut me by offering all six tickets for a total of $1. Scott and
I lost almost all of our investment.
What happened? We learned that like housing, football games have
inelastic supply and elastic demand. While both games that we worked
were against similar quality opponents, the forecast predicted rain on the
second Saturday. The supply of tickets was a constant of just more than
100,000 seats (the University of Michigan™s stadium is known as the “big
house”), but demand was slightly lower the second week.
In markets with inelastic supply and elastic demand, prices can move
very rapidly. As game time approaches there are either more buyers or
more sellers. A relatively small shift in demand makes the difference
between too many buyers and too few. This translates into the difference
between high ticket prices and almost free tickets. On our second week-
end of ticket scalping, Scott and I ended up throwing away dozens of
The housing market has inelastic supply and relatively elastic demand.
There is no equivalent of kickoff time when supply becomes worthless so
the rental effects are not as extreme. Nevertheless, the real estate market
is subject to relatively large changes in rents for relatively small changes
in demand.
Importantly, the supply of U.S. housing has been growing far more
Real Estate 207

rapidly than the population. Figure 9.3 shows the relative growth
between the 1970 and 2000 census.
Over the last three decades, the growth in housing units in the United
States has exceeded the growth in population. As discussed, this does not
imply disaster. Over this time period, the United States has become far
richer. As we have become richer, it is reasonable to expect that we would
have more houses. Nevertheless, the fact that supply has grown so much
more than population is a clue. If times get tougher, it is possible that
demand for housing could drop enough to put significant pressure on

Clue #3: Vacancies Are on the Rise
For the next clue, Figure 9.4 shows the U.S. rental vacancy rate.
The U.S. residential rental vacancy rate is at the highest level on
record. This is obviously good news for renters who have more power in
their negotiations with landlords. On the other hand it is unambiguously

80% 71%
% growth 1970-2000


FIGURE 9.3 U.S. Housing Supply Has Grown Faster Than the Population
Source: U.S. Census Bureau
208 Applying Science and Art to Bonds, Stocks, and Real Estate

U.S. Residential Vacancy Rate










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