Housing a Screaming Sell - DMcW (Sbpost)

Read house prices like the stock market for a different picture
20 April 2008 By David McWilliams
On a price-to-earnings basis, how much is your house really worth?

The other day - when farmers were marching on the Dáil - a friend asked where the bottom of the Irish housing market might be. He was one of the lucky ones who never got involved in the house mania, but he was interested because he couldn’t reconcile the farmers’ poor mouth with the fact that agricultural land prices had been rising for years.

If the price of land was rising, the productivity of land must be rising exponentially to justify the rise in prices. If the productivity of land was rising, so too must a farmer’s profitability and income. As a result, he could not understand why they were complaining.

If things were as bad as the farmers’ leaders were claiming, surely Irish land prices should not have risen in the past few years? Presumably farmers were buying land, driving up prices. Either the farmers were lying about their incomes or they were irrational when it came to valuing land and were happy to pay over the odds for it.

Thinking about this took me back to my granny’s bar in Cork in the late 1970s. The hierarchy of the local village displayed itself in the supposedly democratic environment of the bar. Village status was based on the ownership of land. The men who had land drank and played cards in the tap-room, under the old photos of famous county hurlers.

In contrast, the labourers downed their Beamish and Murphys at the bar. On Sunday, the lads with land sat at the front of the church, while those without congregated at the back door smoking their Navy Cuts and scanning the Sunday World.

A system that covets agricultural land over agricultural productivity has resulted in a very rigid agricultural base in this country. This base was ideally suited to the ‘free-money’ days of the early Common Agricultural Policy, when money was linked to production, rather than productivity. Now, as the world opens up to agricultural products all over the world, the folly of paying high prices for land with low productivity is being questioned.

Now transfer this mentality to houses and their valuations. Are we displaying the same hopeless hierarchy based on that most over-valued attribute - ownership? During the boom, the price people put on houses was ‘hope value’. The game was to buy, watch prices rise and hope to sell on to someone else before the market dipped. There was no real value other than the price the last fella paid and the price the next fella was likely to cough up.

Now if we look a bit more scientifically at prices, using normal valuation techniques employed by the financial markets, what do we see? The smart boys in the stockbroking firms - the ones who last week were on the radio telling people to buy houses - have put a value on big Irish property companies. The beauty of the stock market is that it provides us with an approximate value of assets.

The stock market does not think that Irish land companies are worth much. Shares have fallen precipitously over the past year. If you would like exposure to Irish land and construction companies, you now have to pay on average five times’ annual earnings for household builder names and large property companies such as Grafton and Kingspan. This means that the stock market believes that, if a property company has earnings of, say, €100, the whole company today is worth €500.This gives us an approximation of value.

So if the whizz-kids in the financial market claim that companies with portfolios of Irish land are worth five times their profits, surely individual houses which are being used for investment purposes should be valued somewhat similarly?

After all, if you want exposure to the Irish housing markets without the hassle of tenants, estate agents, taxation and fees, surely you would buy a few shares, rather than a new shoebox in the commuter belt?

Now here’s where the story gets really interesting. The average price of a Dublin house is still circa €370,000.The average rent is about €14,000.Thismeans that, individually, Irish houses are trading at 26 times earnings!

Wait a second. If land companies with a collective portfolio of land and houses are trading at five times’ earnings, but individual houses are trading at 26 times’ earnings, either Irish houses are still dramatically overvalued or Irish stocks are deeply discounted or some combination of both. As it is more likely to be a combination of both, it implies that house prices have to fall and housing stocks have to rise.

Of course, people don’t buy houses with these types of valuations in mind. Most investors buy with a view to capital gain. There are obvious differences between shares and houses, but the general point is valid. If you are in the business of investing, you should have a valuation framework in your head that benchmarks different investments against each other. The bottom line is that the money you are spending has the same value whether you are putting it into stocks or houses.

The level of disparity between the valuations of property companies and property itself is enormous. Granted these valuations can be more than a bit hit and miss, but they do provide some basis, however flawed, for comparison. If you were to value individual houses on the same basis that the financial markets value the general property sector - on a price-to-earnings basis - house prices in Dublin could fall to levels that no one is countenancing.

Even if you meet the financial markets half way, the fall in house prices implicit in a price-to-earnings model is likely to be dramatic. Are we prepared for this? In such a case what would happen to employment, taxation and related factors such as law and order, immigration and the very social contract that underpins our society?

The best thing the state could do now is to ramp up infrastructural spending to put some floor under the general construction industry and to take advantage of tendering for work in a slack market. The last thing you should be listening to is stockbrokers on the radio telling you to buy houses now, when their own financial models are screaming sell!