Professor Mankiw has also prospered. He became a tenured member of the Harvard economics department at a young age. He has written several economics textbooks and has earned millions from their sale. Professor Mankiw is currently the chairman of President Bushs Council of Economic Advisors.

Is Your Home Overvalued?

Housing has had a great run in the United States for more than 50 years. Is it likely to continue? This question can be answered in three parts: (1) Determine a price to earnings ratio (P/E) of your home, (2) estimate a fair P/E for a home, and (3) salt to taste (adjust for local market dynamics).

What Is the P/E of Your Home?

A first step is to determine the fair value of a property. As with stocks and bonds this is impossible to do precisely, but easy to approximate. The calculation of fair value relies upon calculating a price to earnings (P/E) ratio.

A stocks P/E is calculated by dividing the price of the stock by the earnings for the stock. In the stocks chapter, for example, we looked at Microsoft. The current price of Microsoft (July 2004) is $28, and the predicted earnings for 2004 are $1.27 per share. Thus, Microsofts P/E is 22.

To calculate the P/E of a house or other piece of property, we divide the price of the property by the income it produces. This is easy for a rental property (as long as we are careful to adjust for taxes). For a property that is occupied by the owner, however, there is no rent. In this case, the earnings are the estimated rental payments if someone else occupied the property.

For example, I live with my wife and our new baby in a condominium near Harvard University and Harvard Square. As our place has filled up with cribs and baby toys it has become obvious that we will need to move. Accordingly, I have been getting some estimates for the value of

TABLE 9.1 Key Investment Characteristics of Stocks, Bonds, and Real Estate

our place. The market price for our condominium is something like $650,000.

What is the value of our property? Because I dont assume the market price will stay constant, and Im not sure when we will sell, I estimate the value independent of the current price. The key is the going rental price for the property. Even though we arent currently earning anything on our property, I will use the market rental rate as the earnings for my P/E calculation.

The going rental rate for our apartment is about $2,800 a month. To calculate the P/E we need to factor in all costs including taxes. After our costs, we could generate about $2,000 a month in rental income from our property. So we could earn $24,000 a year in rent, after expenses. So the P/E for our condominium is the price ($650,000) divided by the earnings ($24,000). The P/E for our apartment is 27.

What Is a Fair P/E for a Home?

What is the fair P/E for a home? One way to answer this is to compare the P/E of a house to that of stocks and bonds. Table 9.1 makes this comparison and summarizes some key attributes of the different investments.

The U.S. stock market as measured by the S&P 500 has a P/E of about 18; this calculation uses the estimates for 2004 earnings ($61.50) and the current figure of the S&P 500 (1101).7 The 10-year Treasury bond currently yields 4.4%. This converts to a P/E of 23.

How does a house compare with these two major alternatives? Table 9.1 lists four important investment characteristics and then analyzes the trade-offs between stocks, bonds, and real estate. When comparing two investments, the more favorable the investment attributes, the higher the fair value and the higher the P/E that can be justified. For example, if two investments are identical except for tax treatment, then the investment with the lower tax rate deserves a higher P/E.

Attribute #1, Risk: An investor in U.S. Treasury bonds is sure to get the original investment returned. Those who own stocks or houses risk losing their investment.

Attribute #2, Potential for Gain: The U.S. Treasury bond investor can make modest capital gains (if interest rates fall). Both the stock market investor and the home buyer have the potential for substantial gains. Because houses can be bought with very modest down payments, however, they have the highest potential for gain.

For example, Fatimas $5,000 investment in real estate became more than $250,000 in just a few years. An investor who bought the Dow Jones Industrial Average in 1927 would have achieved the same 50-fold increase if she or he had held the stocks until 2004.8 So a few years investment in housing can provide a lifetimes worth of gains in the stock market.

Attribute #3, Tax Treatment: Stocks are treated more favorably than bonds. Both dividends and long-term capital gains have lower tax rates than interest payments on bonds. Houses have the most favorable tax treatment. This ranges from the tax-deductibility of interest payments to the exemption of taxes on substantial capital gains from sales.

Attribute #4, Inflation Protection: Normal U.S. Treasury bonds are not protected against inflation (though some bonds do have such protection). Both stocks and housing are protected against inflation.

How, then, do housing investments compare with stocks and bonds?