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| Fortunes Are Not Made on Shaky Intelligence |
| Written by Jonathan Smoke | |
| 11.07.2007 | |
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Discuss this article on the forums. (0 posts) As a housing geek, I am always on the lookout for new analysis and articles about housing trends and forecasts. Luckily since doom and gloom sells, it seems every major publication these days has at least one article focusing on real estate. So I wasn’t surprised when I picked up the latest issue (November 12, 2007) of Fortune and saw prominently highlighted on the top of the cover the housing-related feature: “Real estate: Buy, Sell or Hold?” But when I read the article, I was surprised to find some of the worst analysis I have seen to date on home prices and their likely direction in the future. The author, Shawn Tully, seems to get input from a complete pantheon of housing’s most quoted luminaries—Robert Shiller, Jonathan Miller, Mark Zandi, and Bob Toll to name a few. But I have to believe that the experts quoted weren’t counseled on the analysis and its so called “disturbing conclusion” that home prices in most markets will fall by double digits over the next five years. This conclusion is based on a set of dubious forecasts arising from a model built upon a questionable hypothesis that relies on a very suspect and shaky calculation.  The multipage article is not yet available online, despite all other feature stories being available. So, I’ll save you $5 by summarizing the seven-page article.The hypothesis teeters on: “…the most reliable guide to home values is rents.” The logic then follows that because rents are so influential of fundamental home values and therefore prices, a “price-to-rent ratio” that is presumably similar to price-to-earnings for stocks, can be used to determine when home prices get untethered from underlying fundamentals during speculative periods. Furthermore, like P/E, P/R ratios will revert to the historical mean. Therefore, the historical mean can be used to determine where home prices must go in the next five years, which in most markets is dramatically down. The basic logic sounded worthy of consideration, but the way the calculations were made discredited the whole analysis. First, the ratios calculated compared a total home price to an annual rent estimate. Yet the more proper way to compare the two is to compare the level of home prices to owner’s equivalent rent or imputed rent. This method would eliminate differences in quality/quality of life differences between renting vs. owning as well as the true financial cost of ownership because it properly factors in important variables like mortgage costs and taxes. Likewise, use of imputed rent instead of total home price would eliminate the awkward and irrelevant comparison of a home’s total selling price to annual rent. This isn’t just my opinion. You can look for academic arguments regarding how to do this properly in widely respected and cited papers such as this article from the Federal Reserve Bank in San Francisco or this article from the Federal Reserve Bank of New York. If you doubt my analysis already, please take the time to read the academic papers. I’ll post more of my thoughts on this Fortune article tomorrow. 
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