The price-earnings ratio (P/E ratio) in finance has been around for along time, and versions of it have proven to be great long run indicator of where the stock market is likely to go. Barclays created a rather interesting chart that compresses all elements of the P/E ratio into one chart.
In property, the P/E (price-earnings) ratio is typically called “yield.” But unlike in finance, there is another metric to consider: the ratio of house prices to average incomes. This ratio serves as a measure of affordability, perhaps a truer reflection of actual ‘prices’ to actual ‘earnings.’
We looked at the quarterly average sold prices and earnings across regions of the UK from 1983–2016. The most frequently occurring P/E ratio was 3x (with 2.5x and 4.5x second- and third-highest, respectively). We hypothesised that lower P/E ratios would lead to higher levels of price changes in the following 12 months. As expected, this was proved to be correct.
Logically when properties are more affordable, demand will result in more transactions and prices subsequently increase with bidding over the next 12 months. Price changes of more than 20 percent occurred most often when P/E ratios were at 3.5x. (For reference, the average 12-month price increase at 3.5x was 16 percent.) Meanwhile, the frequency of periods of negative change was relatively evenly distributed, with slightly more in the 3x P/E interval.
It is important to note that when the P/E ratio was above 5.5, the average price change was -2 percent. That means that low prices relative to earnings are a buying opportunity while high prices relative to earnings are a risk.
In fact, the chances of having a “positive year” versus a “negative year” when the P/E ratio is greater than 5.5x are only 3:2. At this level, every 18 months of increases are likely to be followed by 12 months of decreases. On the other hand, when the P/E ratio was 5x, there was a 5:1 ratio of the frequency of positive to negative returns. That said, a P/E ratio above 5 has only occurred twice during housing and credit booms: once between 2006-2007 and again now.
On the basis of P/E in real estate, it appears that entering the market when the ratio is at the lower end of the spectrum—but not so low that it is undesirable (≤3 P/E)—will more likely yield positive returns. The graph below shows the frequency of high return years related to the P/E ratio at the start of the year. When prices were between 2.5x and 3.5x earnings, there were 31 instances of annual returns exceeding 10 percent in the following year. Meanwhile, there were only 10 occurrences for all other P/E levels.
It is useful to use low P/E ratios as a leading indicator of future positive returns, however, given the relatively lower levels liquidity in the real estate sector, it may be difficult to act on these signals immediately.
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