What Can Brexit Teach Us About The Importance Of Fundamentals?

Two weeks ago, the people of the United Kingdom voted to leave the European Union – hence, “Brexit.”

Brexit has caused financial markets to quake. It has also affected the UK real estate market.

The Financial Times recently reported that £650 million worth of commercial property deals in London had fallen through after Brexit. Meanwhile, the UK Treasury had analysed the UK residential real estate market before the Brexit vote and thought that home prices could fall by 18% if the UK were to leave the EU.

The experience of the London property market thus far can be used to drive home the importance of underpinning one’s investment decisions on fundamentals.

The UK property example

One useful way to value stocks would be the price-to-earnings (PE) ratio. It is calculated by dividing a company’s stock price by its earnings per share and is used to determine how much one has to pay for each dollar of profit a company makes.

In general, the lower the price-to-earnings ratio is, the better it is for investors.

When it comes to valuing residential properties, a similar method can be used. Median home prices can be divided by the median employee’s income to come up with an affordability ratio.

According to The Guardian, median home prices in London were 4.4 times the median income back in 1995 (median home price of £83,000 and median income of £19,000). But by 2012 and 2013, the ratio had ballooned to 12.2 times, as the median home price surged nearly four-fold to £300,000 whereas the median income had grown by less than 30% to £24,600.

In other words, the main driving force for London’s growth in home prices from 1995 to 2013 was not an increase in the spending power of the city’s residents. A sample of the other forces that may have played a role in spiking the home price to income ratio can be found in a 2014 article by The Financial Times. The article quoted a real estate consultant as saying (emphasis mine):

“Of course, there’s some concern that the bubble [in London’s home prices] might burst. But at the end of the day there is huge liquidity out there. It’s easy to get out of the market and you have a deep pool of buyers waiting on the sidelines.

 A Foolish Conclusion

Buying stocks with high price-to-earnings ratios have historically led to a poor performance for investors. It could be similar with properties; London may be a good demonstration if its residential real estate prices were to fall in the future given the rise in its home price to income ratio over the years.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Ong Kai Kiat doesn’t own shares in any companies mentioned.