• Don't pay too much for the earth, and
• Don't pay too much for the business.

Don't pay too much for the earth is simple. For a real estate STOCK, I don't pay more than a 10% premium to the market value of the properties. And when it comes to buying a HOUSE, you'd better think long and hard before you'd consider paying a 10% premium to comparable values in the neighborhood. Some of the best real estate investment advice out there-and often the hardest to come by-is to buy property at a 20% discount. If you're not too picky, it's actually not hard to do (if you're willing to do a little sprucing up after buying).

The second value rule regarding real estate investment advice is also simple: Don't pay too much for the "business." Just like a stock, look at the P/E ratio… "The P/E ratio? Of real estate?" You're probably thinking I've lost my mind…I haven't. A lot of real estate out there has "earnings" - it's called rent. While real estate prices can fluctuate in the short run, in the long run, property prices are significantly driven by rental values. If you look at the "Price-to-earnings" ratio of your property, you can learn about your home's true "intrinsic" value…

As a good real estate investment rule of thumb, net rents in real estate (by "net," I mean after expenses) have averaged about 1% above Treasury bonds (that's the way it's been with real estate stocks since 1990). The Treasury bond is at 5.15% as I write, so we might guess that the nationwide average net rent is 6.15%. (6.15% is the "earnings-to-price" ratio, so we need to find the inverse of it for the P/E of your house.)

If that "1% above Treasuries" rule is correct, that means the "fair" value for a home now, based on net rental earnings, should be a price-to-earnings ratio of 16. Where I live, that means the big gains in real estate so far have just brought us up to FAIR value now - there's still plenty of room to run before things get overpriced.

However, the same can't be said for some other cities nationwide. According to the June 10, 2002 issue of Forbes, Boston real estate sells for 38 times net rental earnings. And San Francisco is around 30 times earnings. These markets make New York, at a P/E of 20, look downright cheap. Chicago, at a P/E of 17, looks cheap compared to the majors. Just like stocks, as you might imagine, real estate property values vary widely.

How can you figure the P/E for your property? Forbes suggests the only real way to know: "To get rental data for homes comparable to the one you're buying or selling, check with the relocation department of big real estate agencies." You've got to know what the comparable net rents are to your property.

This is all a very rough guide. Once you've figured your P/E, it may be very different from the current nationwide fair value P/E guess of 16. If your P/E is low, you may have gotten a good deal, or you could collect high rents from your place. If your P/E is twice as high as 16, my advice is that you ought to consider selling…

The tricky thing about selling real estate is that real estate is not liquid. Unlike stocks, where we have the luxury of being able to sell whenever we want and the luxury of trailing stops to get us out exactly when we want out, in real estate, it's not so easy. You unfortunately need to be a good guesser, because you actually need to sell into an "up" market, and buy in a down market.

While this can't be done successfully on a regular basis, you can improve your chances considerably by doing what works in the stock market as well. The P/E ratio is our value indicator in our 1-2-3 Model in the stock market - and I found that you NEVER make money in stocks over the long run when the P/E of the market is above 17. While I don't have the data on homes, the number may be very similar.