I received this email from reader ‘GG’ and got their permission to post it for discussion here. Here it is in its entirety with a couple of extra notes from the author:
I’ve been reading your excellent blog for over a year, and today I need your help. I am also bearish on our local housing market as almost every sign points to a correction. I say “almost” because I have one analysis that doesn’t seem to fit the puzzle. I’m hoping you could prove it wrong so I can look forward to cheaper homes in the future.
At today’s prices in Vancouver, a $350K condo can rent for about $1,300. The condo has a monthly maintenance fee of $200 and property tax of $100. The annual Net Operating Income (NOI) is therefore $12,000.
Treating the future stream of constant annual cash flows as a perpetuity, the present value can be calculated as: Price = NOI / Return. So, the annual return on the property is = $12,000 / $350,000 x 100% = 3.4%
The above method assumes the mortgage rate is equal to the calculated return over the life of the mortgage. When this is the case, your investment return is not affected by the size of your down payment. Of course, it’s a major mistake to assume a low mortgage rate of 3.4% over a 25-year period. We must modify the calculation to take into account a more realistic mortgage rate (and include a down payment as well):
Assume the mortgage rate is 6% over 25 years with $100K down. The monthly payment is $1,629. Your net monthly investment is then $1,629 – $1,300 + $200 + $100 = $629. Assuming you sell the home after 25 years for $350K, the return on your investment can be calculated to be 1.1% (This calculation does not take into account price appreciation. Over 25 years, the property should appreciate in real terms and the return will be higher.)
The attached graph shows the yield for different mortgage rates and down payments. Assuming mortgage rates are an average of 6% over the next 25 years, we can see that at today’s prices, Van RE is a poor investment yielding the same as the risk-free return while being significantly riskier (liquidity risk, high leverage, and chances of missed rent payments, property damage, and a massive price correction).
What this graph does not show is that we have a significant bubble and that prices must crash by up to 30%. Because if that were to happen, the yield on the investment would be 6% plus lots of room for price appreciation. A yield of 6% would also be higher than the S&P500’s historical dividend yield of 3.8% (from Dec 1936 to Mar 2009). Why should we expect a significant price correction based on this analysis approach? (Apart from investor psychology driving valuations down below fair value just like valuations overshot on the upside)
Some additional points on the analysis from GG:
1. It is taken purely from a Price-to-Rent angle. I am suspecting the trigger for a correction has more to do with leverage ratios, such as Price-to-Income and debt-to-GDP.
2. The yield after a 30% price correction is actually a little less than my calculated 6% – this is because I missed accounting for falling rents. Nonetheless, the yield is still greater than the historical S&P500 yield.