Should Real Estate Be Valued Like Stocks?

Whenever we see a market correction, whether it’s the stock market, the housing market, or some other market, we should take some time to evaluate why it happened. With the objective of determining how much was the result of bad luck or bad timing and how much could have been predicted and consequently avoided.

In the most recent real estate collapse, there was ponzi scheme mentality of buy, ride the wave of appreciation, and hand off the hot potato to the next buyer. As long as there was another buyer willing and able to pay the higher price, the game continued. We all know what the result was, but it begs the question, how were we to know that these properties were overpriced? What determines the true value of a property?

One of the most commonly used ratios for stock valuations is the P/E multiple. The idea being that a stock should be worth the discounted value of future cash flows. Or to say it another way,it’s worth the stockholder’sshare of the profits.

I’d like to pose a similar argument for the value of housing. A house is worth what someone will pay to rent it. By comparing a home’s Price/Rentratio to history you can get a feel for how a specific property is priced. According to a recent CNN Money article, moving from renting to owning makes the most sense at P/R ratios below 15. The long term historicUSratio has averaged roughly 16.