"NO!!!"

Since late 2003, I've been bearish on real estate, as it seemed quite obvious back then it was building the same bubble as the stock market of the late 1990s. I've been telling friends and associates all 2008, "that I believe real estate is still over valued, and no more so than in California—The Bubble State". It's hard to hear that as a home owner or real estate investor, and most wanted to know why I felt that way.

I've used the website www.city-data.com to compile some interesting statistical data regarding median California real estate values and median California household income levels. The table below reflects that data in a sampling of 10 cities in California:

The city-data website reflects 2007 median home values and the corresponding 2007 median household income within each city. The next column in blue is a ratio of this data or in essence a PE Ratio = Price to Earnings Multiple for real estate.

The first thing you'll notice is the ratio differential from city to city is quite dramatic, which reflects the unique demand-supply qualities and/or wealth-income disparity for each city. What I feel is far more important is the general level of those PE ratios themselves.

The 2007 PE ratio expanded sharply compared to the 2000 PE ratio in green derived from the city-data website. Almost across the board the ratio almost doubled in every city. What's really interesting is the median income levels were only up 10-30% compared to the doubling to almost tripling in median real estate prices from 2000 to 2007.

Just like the high tech. bubble of the 1990s, earnings or in this case income didn't matter anymore when evaluating real estate prices. Speculation was fueled by greed from increasing prices, which was fueled in large part by exotic (no money down, stated income, and alternative payment structures) loans coupled with low interest rates. We experienced a new gold rush in California that turned everyone mad for easy profits.

Most markets in California peaked between the summer of 2005 and early 2007. The 2007 data above and the PE ratio reflect a significantly over valued market in California real estate. So, with the continued correction in 2008, where are we today?

The city-data website also had graphs for each city reflecting the median home price as of the 4th quarter of 2008, which is summarized in the table below:

I took the 4th quarter median home price and divided it by the 2007 median income data (It's the most current since 2008 just completed) and we have the latest PE ratio for the current market.

Only Sacramento and Stockton have fallen back into line with 2000, as they have been some of the hardest hit markets so far. The remaining markets are still to far from their 2000 PE ratio.

When I first got into the finance industry back in the early 1990s, the theme of affordable real estate was 3 times your income level. In essence, you should seek to buy a house for no more than 3 times your income. During the past decade we've seen many stretch that PE ratio with the use of easy money programs, and low rates.

The 2007 PE ratios behind California real estate explains in great detail the over valued nature of the real estate market. While the current 2008 PE ratio has improved, I would argue in theory the median home value should be 3 or 4 times the median income level in most markets! Clearly in 2007 that was not the case, not even close. The ratio itself also provides greater context behind the painful re-pricing of real estate.

So why is this ratio so important? In general, the ratio reflects the value of real estate based on personal income levels (affordability), and in the long run, home values should trade at a consistent multiple of general income levels or rental income levels. Those historically normal levels are quite a bit lower than the 2007 and 2008 ratios above.

I've done something new in the above table. If we use the 2000 median home price level and divide it by the most current or existing income data (2007 median household income) we get a new PE ratio. Almost all of the cities experience a decline in the PE ratio back to historical norms, which supports the thought that the 2000 median price level is a minimum price target for this real estate correction.

If we are going to reverse the real estate bubble gains, than the gains of this decade should reverse completely much the same way we reversed the gains of the high tech bubble, so by dividing the 2000 price level by current income levels we get a new or target PE ratio and an overly simple target for real estate prices in general (the 2000 median home price). Personally, I think we could correct past those levels.

As prices have corrected in 2008, we experienced a reduction in the PE ratio in each city. What's interesting is only Stockton and Sacramento has experienced a correction in their PE ratio levels close to the 3:1 level. The remaining cities are still quite a bit higher than 3:1 and further corrective behavior in most California cities should be expected, so the ratio can fall back into normal levels and thus reach a state of price to earnings equilibrium in California real estate.

The most important factor to consider is the current median home values in those cities, while down sharply during 2008 and we are no where near the 2000 median price level, and thus the ratio of home values to income is still significantly too high. Yes, home values in California are still too high, and in some cities that might equate to 20-40% of over valuation from current levels.

Rule of 15: I found an interesting rule of 15 on the website of CNBC a couple months ago. It's a simple rule to help people calculate if it's financially smarter to rent or own a home. In essence, the value of a home should sell for no more than 15 times the annual rent of a similar home in a given market to support owning that home versus renting.

In my home town (I live in one of the cities in the above table) of California, there are several 3 bedroom homes for rent on www.craigslist.org . I'm going to use a 3 bedroom-2 bathroom home with 1650 square feet renting for $2,350 per month as an example. That monthly rental expense equates to an annual rental figure of $28,200. So, based on the rule of 15, it would make sense to buy that house for no more than $423,000 (15*$28,200).

In my home town the median price per square foot of residential real estate is $350-370, which means the above home would list for sale at $577,500 to $610,500. The rule of 15 reflects real estate in my home town of California is about 25-30% over valued, and tends to confirm the PE ratio in the above tables suggesting California real estate is still vastly over priced in many cities.

Gross Rent Multiplier (GRM): Several years ago, I used to have this very wealthy and extremely smart client who was a real estate investor. He bought mostly small apartment or multifamily buildings in San Francisco. He told me once that you buy it at 8 times gross revenues and sell it for 12 times gross revenues. So, if we wanted to be extremely conservative, and use the $28,200 gross rental income figure, that would equate to a home value range for that 3 bedroom home where I live of $225,600 to $338,400 based on a GRM of 8-12. That pricing level suggests real estate is 45-60% over priced in my home town. I'll admit that's extreme, but cash flow at the end of the day is what rental real estate should trade for most of the time, which has been an investment concept lost in the bubble days of capital appreciation.

NOTE: Not all markets in California are the same, and some cities have seen significantly larger corrections and have traded back to mid-late 1990s price levels, but a great deal of California real estate still needs to correct much further.

After reviewing those 10 cities in California, I could not help but review some other cities in the western United States. A summary of that data using the same website is below:

The data above highlights some interesting characteristics behind real estate. First, all of the above locations are well above a conservative PE ratio and suggests further correctional behavior to come in the western United States. Secondly, California's PE Ratios are higher and suggests California is more over valued than neighboring states. A correction in California negatively impacts the western states, because so much money going into other western states comes from California, and thus California should be a leading indicator.

Additional Thoughts:

1. When I gathered the data for this article, what was really interesting was the minimal increase in income levels from 2000 and 2007, while real estate values exploded in that same period. It's eye popping to see such large price gains stemmed by relatively minimal growth in income. It's quite similar to the bubble in high tech. in the late 1990s, where income didn't matter and speculation of price gains ruled the day, until the correction happened and then income became a far more important factor behind the valuation model. The bubble in real estate is not that different from the bubble in high-tech. other than its much larger in scope and carries more significant economic consequences during this correction.

2. It's quite rare for any asset to go straight down 70-80% like oil did in 2008. So, a bounce or sideways real estate market could happen at anytime. There will be continued gov't stimulus to prop up real estate values. Also, there is a gap between the unwinding of subprime foreclosures and the next wave of Alt. A and option arm foreclosures. During this gap we could see some inventory reductions while getting government stimulus. This combination might feel like things are improving, but it just might be a dead cat bounce.

3. I have a friend who is a mortgage broker in San Jose, California who told me recently when rates dropped he did a small marketing campaign, and he could only help 20% of the respondents, as the other 80% had homes where the debt on the property was greater than the value of the home. The number of people upside down is growing, which creates a long term issue that has yet to be dealt with in any real manner.

4. In late 2009 and 2010, we should see a new round of foreclosures stemming from the Alt. A and option arm loan programs, unless the government steps into action. 60 Minutes did a very well thought out piece on this issue a few weeks ago. An interesting difference compared to the subprime foreclosure wave is real estate values in general will be substantially lower when this new phase of foreclosures from Alt. A and option arms begins, which should intensify bank losses.

5. The only potential issue not reflected in the above tables is higher unemployment and potentially a reduction in median income levels. Income is the denominator of the PE ratio, and a back slide in income levels would also intensify the real estate re-pricing issue. Since we are experiencing higher unemployment, and everyone is projecting it to grow into 2009, it's a concern worth noting for real estate values.

6. The areas of California that should be hit next include: real estate markets that are heavily vacation homes, the condominium markets, and areas where unemployment (especially white collar) is intense.

FINAL THOUGHTS:
Lastly, it seems like long term money for the purpose of buying of a primary residence in California would be better suited to wait until price to earnings ratios fall into historical ranges. During the 1960s and 1970s that ratio got as low as 2.5:1 in general, so 3 or 4:1 seems like a no brainer in most cities.

Note: I do know several professional real estate investors who are buying right now, and while I feel they are early, they are buying in areas that have been hit the hardest in price declines, and buying what I would call slum lord type properties simply because there is positive cash flow stemming from that property. And, there are some areas where buying REOs have reached comparatively attractive levels.

That being said, as a hole the California real estate market could take months/years to wash out the issues of the day, and we still have the alt. A and option arm problems coupled with higher unemployment to deal with, so when it comes to buying a primary residence, I'm personally looking for a better fundamental story of affordability driven by the PE ratio to support that purchase. For now, I'm just a happy renter!!!

Hope all is well.