The price-to-earnings ratio, or P/E, is a standard tool to estimate the price and value of a public company’s stock. CBRE just pointed out that the same calculation can help determine whether the price of a commercial real estate property would allow for a strong potential return.
The first step CBRE took was to take the current all-property cap rate to an implied P/E ratio of 17.7. Then they compared the figure to the “projected five-year forward average return.”
There is a negative correlation between the P/E ratio and five-year time horizon future returns. The higher the price-earnings ratio, the lower the expected returns. Similarly, the lower the P/E ratio, the higher the return.
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CBRE noted that the current P/E of 17.7 is low compared to a historic P/E average of 18.2 and it suggests real estate is relatively cheap at the current time. That makes some intuitive sense as prices and valuations have come down in the last couple of years, given higher financing costs and significantly lower transactions. Less demand should mean lower prices.
As one might expect, anticipated future returns hit a high point as investors emphasize property earnings, leading to a P/E increase. This happened during the 2001-to-2003 and 2010-to-2011 downturns, and it also seems to be the current market dynamic.
In the equities market, the same basic relationship occurs. At some point, stocks get cheaper in the sense of offering a lower multiple of expected future earnings. The lower the P/E ratio, the potentially better buy the shares are, assuming that other basics like the company’s fundamental performance are in place. Similarly, for a specific property, an investor would want to be sure that NOI allowed for a strong DSCR, the occupancy rate was good, future leases were strong, and there were no other negative considerations.
Given that a P/E ratio can suggest whether an asset type seems relatively cheap or expensive, it isn’t a guarantee that all properties at the time are a smart investment.
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