Why expect a significant correction?

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:

Hi,

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).

VanREyieldGG2

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)

Regards,
GG

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.

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[…] Rental yield and house price correction probabilities – Vancouver … […]

logic
logic
10 years ago

jennifer

i would move then

sounds like the wise decision for you and your family

Jennifer
Jennifer
10 years ago

You all over overlooking the kindergarten math of the whole situation. Median house prices are overall "acceptable" when they're about 5X the median annual family income for the area. House price/20 years/12 months = 1/3 average monthly family income = happy people in a house they can afford. Cheaper than that = extra happy people. More expensive = sad people in a house they're struggling to pay for. That the median house price right now is almost double that means that, unless you owned a house before prices went up, don't plan on buying one now. It also means that we, as a family who makes more than the median family income for Vancouver, would have to go all the way to Abbotsford before we could afford a 2 bedroom condo, let alone an actual house. It ALSO means we're… Read more »

daylecaden
10 years ago
depressionwatch
depressionwatch
10 years ago

That 'ol jobless recovery thing is pesky in't it? "In the week ending Oct. 3, the advance figure for seasonally adjusted initial claims was 521,000, a decrease of 33,000 from the previous week's revised figure of 554,000. The 4-week moving average was 539,750, a decrease of 9,000 from the previous week's revised average of 548,750. The advance seasonally adjusted insured unemployment rate was 4.5 percent for the week ending Sept. 26, a decrease of 0.1 percentage point from the prior week's unrevised rate of 4.6 percent." Too bad the numbers aren't published for Canada. The fools may take pause in their insanity. Just like another issue that come up. Didn't the government publish just a few months ago that the Swine (Mexican) Flu was a non issue and that it wasn't going to effect Canadians. Yep, keep those hotels as… Read more »

realpaul
realpaul
10 years ago

The 'cocaine high' of free money seems to be wearing a bit thin. Is it because the real economy won't support the bubble without more 'candy'?

http://www.vancouversun.com/business/Home+constru

kooga
kooga
10 years ago

I wouldn't care about the right or wrong reasons why ppl buy into the market… i wouldn't mind them buying, building more and more RE since rents reflect only on overall people's income. It's just pointless telling them what "fundamental" is.

I will be socking away my savings into high yield investments and when I retire, I will move to other place on the planet where it's warmer and sunnier.

IMO, don't get attached to RE…

Arwen
Arwen
10 years ago

Yep. I think the West End rental market has been wounded by Rennie's lifestyle boosterism – in support of (among other projects) Shangri-La, he really talked up the idea of the international pied-a-terre. Maybe that'll happen – but I'd lay my money on the vacancy rate climbing a bit more, and then rents sinking back down. All that inventory coming online.

read on
read on
10 years ago

Lots of vacancies down here in the West End, where this time last year there were very few.

Arwen
Arwen
10 years ago

@read on: True that. Plus, the rate of change is amazing: in purpose built rental buildings it was recently a sliver of a percent.

read on
read on
10 years ago

the 1.5%, as has been repeatedly stated, is a stat for multiple occupancy rental buildings in Van – not a stat for the rental market as a whole. One would think that landlords would do their research and be aware of this. But obviously not.

Arwen
Arwen
10 years ago

(Although 3 months in I would have dropped …)

Arwen
Arwen
10 years ago

@read on: Well, you don't drop the price substantially after a single month's vacancy in a market of 1.5% vacancies. She offered based on the same comps crabman's using – and she'd bought the current assumptions about the Downtown core. (Live the Lifestyle!)

Anyway she found a renter or she sold. It's not on Craigslist anymore…

Interestingly, someone used a link to her ad as an example of inexpensive living space out there – there was a link to her on this blog. I'll see if I can find it.

read on
read on
10 years ago

"For example, there was a single *house* on Comox, with a gorgeous garden, 2 bedrooms and 2 floors, hardwood, etc., going for $2500 that sat open for months. I’d walk by, toured the place, it’s bloody idyllic: and the owner was tearing her hair trying to rent it. That’s a top tier place, but there was so much competition… "

——–

Stupid bint should have lowever her asking price then.

Arwen
Arwen
10 years ago

@crabman: CHMC data on only the West End, as of last year, showed the current *paid* rents, as opposed to advertised rents, between 1-1.75 (lower for larger suites, as per usual.) That's because it's a market in flux, up and then down and then up again, and if I were betting from the sidelines, I'd be gambling at a table too rich for my blood. I certainly would caution people about the numbers there! A lot of speculation: mainly because of Good Old Rennie selling his builds and the "downtown lifestyle". Only it hadn't really been what he was selling – the West End was one of the cities *poor* neighbourhoods, and hell, I went to the raves in the buildings where yuppies sip Starbucks today. So it's a new population, one that Rennie called, and a hell of a… Read more »

stagnate
stagnate
10 years ago

yup, the current cap rate locally is about 2-4%. nothing to get excited about that's for sure. nonetheless i know peoples with 100,000 at ing direct at 1%. yields will rise if government sticks with aggressive reflation. for those that haven't noticed, the central bank has put the boots to the bond market pretty good the last number of months, could be some foreshadowing. history shows societies only have a fully functional bond market when it suits the majority. a 1970's senario has a higher probability than a deflationary debt event.

Arwen
Arwen
10 years ago

@GG: Having just been through the records on the management of a downtown complex, I would also make sure to calculate in the cost of repainting/steam cleaning, the cost of fixing the place when trashed, the cost of bedbug/vermin control, the cost of insurance, and the cost of legal fees. The mortgage was definitely the largest slice of the operating budget, (on a new reno, so newish mortgage) – but it was probably only, what, 70%?

Arwen
Arwen
10 years ago

@Anonymous: I agree with you that availability of cheap money and psychology are what maintains the bubble for now.

I think what the fundamentals point to is a sustainable market. Different people may have different takes on what is sustainable – some, it's that in which an investor in residential real estate can make some money, for others, it's when buying is not an incredible risk to your own portfolio.

But whatever *event* breaks this wave, it *has* to break – because some day the free money will run out. We've borrowed a lot of tomorrows in order to keep this going today.