Dot-Coms vs. Real Estate
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.
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.
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!).
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 . . .
Real Estate Instead of Dot-Coms
MOTOKO RICH and DAVID LEONHARDT
NYT: March 25, 2005
Investors Slim Down as Property Prices Bloat
Wall Street Journal, March 25, 2005; Page C1
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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).
Posted by: godement | Mar 26, 2005 9:38:04 AM
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