How do you guage when a market is too risky to invest in?

[Gary Dezoysa]

I'm not that interested in marketing timing other than getting a sense of when risk is relatively high (due to very high prices). I look at the case shiller index to get a sense of this: http://us.spindices.com/index-family/real-estate/s...

Are there any other things you guys do to avoid risky investing periods?

[Michael Hacker]

In Phoenix we can look at prices relative to the cost to build.  This probably works better here because we have a virtually unlimited supply of desert to develop so land cost is normalized.  For example, during the crash you could buy a house for $45K which would cost $150k to build, pretty good indicator that risk is low and homes are undervalued.  Houses now sell for slightly more than RE+construction, the difference being the builder's margin which is why home building is starting to come back, which is more normal.  Not sure how well this works in SoCal.....

Also look at prices relative to rents, essentially the same as mentioned above.  If prices are low relative to rents, you have cashflow.  So if you are talking about rental properties, buying with healthy cashflow should equal good value.

One other metric to look at is affordability.  Locally, the Cromford Report tracks the average mortgage payment (which accounts for median home price and interest rates) vs. median wages over time.  To me, this is a great metric because it compares home prices against wages and it seems wages are more stable and a better representation of normal inflation growth.  If you were to look at this chart, you can easily see how unhealthy the market was in the 2004-2006 period, as homes became completely unaffordable and prices were driven by speculation.  Behind almost every home value is someone going to work, collecting a paycheck and making a rent or mortgage payment, so values and wages will always be closely connected.

This approach also helps to critically analyze the market when prices go up.  It's easy to assume that we are overvalued right now, simply because we have had a sustained time period of price increases.  But you have to keep in mind that prices always go up over time because of inflation.  So somehow you have to compare those prices to another metric, like wages.  I'm sure my grandfather would think home prices are absurd right now, but consider that he probably bought his first house for something like $18K.  However, look at minimum wage during that time period and it helps to put the values into perspective as apposed to a simple emotional reaction to the number.