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).
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:
RSS 2.0 comments feed. Both comments and pings are currently closed.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.
October 6th, 2009 at 5:13 pm
[1] find me a condo in a decent area that rents for 1300 and can be bought for 350k.
October 6th, 2009 at 5:37 pm
If it corrects 30%, the condo purchased for 350k becomes a higher yielding investment? Or once the correction happens, and 30% comes off the 350k, does the condo become a higher yielding investment? confused
October 6th, 2009 at 5:49 pm
I’m a bit confused on how the correction might affect rent.
If there’s a correction of 30%, the monthly payments would be (350k-30% = 245k-100kdownpayment = 145k @6% 25 years) $927/month. How can one rent it out for 1300 still?
October 6th, 2009 at 6:05 pm
Sorry, didn’t read the additional points about rents.
Is this the general argument?
How can we achieve 6+% yield over 25 years (With a 30% crash) when historical S&P500 avg is 3.8? I guess the opposite question can be asked. How can we maintain 1.1% yield over 25 years (no crash) when historical S&P500 avg is 3.8? Who wants to invest in that?
Be interesting to see at what percentage correction will it yield 3.8%.
October 6th, 2009 at 6:05 pm
#1: Price was based on downtown condos listed on realtylink.org
#2: It’s the latter. If you buy after a 30% drop, you’ll get a higher yield.
#3: Rents will drop with falling home values but not as steep (just like rents didn’t rise as steep as the price increases). Also, you can’t compare $927 with $1300 because the $927 is based on the size of your down payment.
October 6th, 2009 at 6:09 pm
#4: I mentioned that the current yield is poor and so we should expect a crash. The question I am posing is: Why should the crash be as large as 30%
October 6th, 2009 at 6:13 pm
bob rennie was on the 6 o’clock news. it’s ironic vancouver is rushing to rennie to sell millenium underwater at the highest price possible so we can break even on the development costs.
he was asked who the buyers were, and he said west van homoaners. i wonder why he didn’t say rich .
but he’s confident because he’s selling sub zero fridges and hardwood floors over the water in the city that has a $60 million hole in the budget with bigger holes to come.
i have to say he looked a little haggard on tv. does he normally look like that?
October 6th, 2009 at 6:23 pm
GG,
I took the same downpayment (100k), same rate(6%), 25 years.
Without correction: $1,629/month – rent for 1300
With correction: $927/month – rent for ????
But thats not the argument here.
Looks like 19% correction will yield about 3.8%?
Interesting question though. I’m not sure where the 30% came from.
October 6th, 2009 at 6:31 pm
Faulty comparison. Corporations do not pay out all of their earnings in dividends. They use retained earnings to buy more capital. That is, you are ignoring the capital appreciation of the S&P500. By comparison, your condo will eventually depreciate to zero as the land value is negligible (or require capital injection out of your pocket which amounts to the same thing).
You can see that the historical earnings yield of the S&P500 is far higher:
http://pages.stern.nyu.edu/~ad.....spearn.htm
Dividends+capital appreciation = total return. From the link above the capital appreciation of the S&P500 from 1960 to the end of 2008 (which was near the recent market bottom, it’s gone up 25% since) has been 903.25/58.11=15.54 which is an annual rate of 5.9%. Add the dividend yield (an average of 3% over this period) and you get 8.9% annual total return.
Or compare the yield against an income trust which does pay out all its earnings. Pengrowth Energy (which I own) currently yields 7.8%.
The plain fact is that current yield on Vancouver RE is absolutely dreadful by any investment metric. Take a look at Boardwark REIT’s 2008 annual report. Its properties are valued at $2.2 bn (page 30). Rental revenue is $424 million (page 31). That’s a gross yield of 20%.
October 6th, 2009 at 6:31 pm
i still want to know where u can get a 350k condo that rents for 1300! that seems rather cheap (price) to me (not rent).
October 6th, 2009 at 6:32 pm
Link to above:
http://www.boardwalkreit.com/F.....2008AR.pdf
October 6th, 2009 at 6:33 pm
@Anonymous: “i have to say he looked a little haggard on tv. does he normally look like that?”
Maybe the Miami Vice unshaven look is back.
I agree, Rennie looked run down. I wonder why.
October 6th, 2009 at 6:42 pm
#8:
Considering prices have almost doubled since ’02, a 50% crash would bring us to pre-bubble levels and would represent a worst-case scenario.
The “30%” value was chosen because that the minimum correction the US market has faced according to the Case-Shiller US Home Price Index.
October 6th, 2009 at 6:43 pm
@GG:
Rents are in no way dependent on the market price of RE. You have the functional relationship backwards – the market price must adjust to rental value in the long run. Rents are determined by actual demand for and supply of housing.
In particular, Vancouver rents continued to rise during the great bust of 1981-82. That was because nominal wages kept rising (general inflation was still rather high), and also because the preceding bubble was so short that it did not result in significant oversupply. They also kept rising during the bear market of the late 90′s.
That said, nominal rents appear to be declining now (as they are in many US markets) and will probably continue to do so for some time. But that is not correlated with prices, which of course have staged a strong recovery since the bottom last winter.
October 6th, 2009 at 6:50 pm
@GG:
Las Vegas and Phoenix are already down over 50% from peak. San Francisco and LA are close to it.
And please, don’t use any US-wide (or Canada-wide) figures to make projections for possible declines in Vancouver. This city is practically on its own planet.
October 6th, 2009 at 6:59 pm
#14 – Patriotz
You are correct about rents being established by the supply-demand of rental units. However, as prices fall there is some downward pressure on the demand side, as some renters will find it more affordable to become buyers. But the main reason for my expectation of falling rents is because I hold a deflationary outlook.
October 6th, 2009 at 7:08 pm
#15 – Patriotz
The fact that I used the US-wide correction value of 30% makes my analysis conservative. Why should we even expect 30%?
Also, thanks for your comments on the historical S&P500 yield. Some more reasons why it doesn’t make a good comparison is that RE has a very different risk profile and may therefore command a different yield.
October 6th, 2009 at 7:35 pm
“he was asked who the buyers were” re: Bob Rennie/6 o’clock News
Didn’t he say something about a “100 mile radius” they would cast for buyers?
Whatever that means.
October 6th, 2009 at 7:55 pm
can someone show me how the 1.1% yield was calculated? thx
October 6th, 2009 at 7:58 pm
Maybe I’ve missed something, but I don’t see how you’ve accounted for the opportunity cost (i.e., forgone investment income) for the down payment in the scenario that uses one.
Another omitted cost is special assessments and increased maintenance fees. It’s just about impossible that the very conservative maintenance fee of $200/month would apply for the whole amortization period in the absence of repeated and substantial special assessments. Our building has seen one special assessment after another since we’ve lived in it, and these have been substantial. From what I see, the assessments in our building are about par for the course, adding up to a major expense that probably exceeds the standard maintenance fee.
Also, while price appreciation over the full 25 years of the amortization may be a safe assumption, can you assume that the price will have appreciated over the near term, say, by the time the mortgage comes up for renewal the first time? At that time relatively little principal will have been paid off, and the possibility of trying to renew an underwater mortgage ups the risk a lot.
October 6th, 2009 at 8:07 pm
GG, in your analysis, the mortgage payments are interest only and nothing goes towards the principal. In other words, after 25 years, you would still be on the hook for the whole mortgage…
October 6th, 2009 at 8:12 pm
There’s no contingency here for basic upkeep in your scenario, here: vacancy loss, damage, upkeep & updating, (unforeseen rainscreening needs!), and the time it takes to do all landlord related activities.
Just a wee pet peeve of mine. There’s a lot of amateur landlords out there now who think it’s space->money, and it certainly can be for a time, but there is more to the business (for it isn’t a one time investment, but an ongoing business), than buying something and watching the returns roll in.
Also, if that $350K is one bedroom and is renting at $1300, that’s a high end rental price overall, and I’m not sure if the comp justifies that (although the location may). I know the rental market in the downtown area quite well, and I know that there’s quite a bit of vacancy loss being absorbed because everyone’s competing at the high end regardless of what they’re offering.
Statscan median incomes from 2006:
Family (ie: 2 bedroom and up) – $62,900
Single (bachelor, 1 bed) – $24,100
At around 30%, then, you have 2 bed and up being priced to median (with local incomes still supporting local economy) being $1600, and bachelor/1 bed coming in at $600.
Since the curve of incomes in the rental population will likely skew lower than the population as a whole, putting the renter’s median income at beneath the general population’s median, a healthy and sustainable (not credit based) local economy will fix rents around these numbers. Of course, arguably, you have to take the GVRD as a whole into consideration, rather than Vancouver proper, as many commute from suburbs; so location and quality matter.
So, to sum up: it is possible that some $350K condos will garner $1300/month rents over the long term without exposure to the usual costs of business, but I very much doubt this represents anything but a minority of places on the market.
October 6th, 2009 at 8:18 pm
I would agree with Patriotz that 3.8% is far too low of a yeild to use as a comparison. In March of this year, (just before the BoC crashed interest rates further) I got a 2 year GIC at 3% (thats per year). And that is with historically low interest rates.
It is very reasonable to assume that when this mess is over I would have no problem getting a GIC at 4-5%. Hell in 82 they were giving GICs away at 16%!
There is basically no risk, no work and no headache involved in getting a better yield than what real estate could deliver with only a 19% correction.
Also on a purly psychological basis when prices do start to fall again there will be overshoot on the downside. I believe we will get to a point where it will make sense to invest but prices will continue to fall as everyone will be scared to invest in an asset that is falling in price.
October 6th, 2009 at 8:19 pm
#20: Calculation for the 1.1%:
PV = -$100K
FV = +$350K
PMT = -$629×12
N = 25
Solve for the rate (using Excel or financial calc). You get 1.15%
October 6th, 2009 at 8:47 pm
#21: Opportunity cost is the reason I’m comparing the absolute RE yield with an alternative investment such as the S&P500. Ideally, I would make the comparison on a risk-adjusted basis (divide the yields by their historical standard deviations). And yes, maintenance fees and rents will rise with time. But factoring this in will only increase the RE yield and the question remains: “Why should we expect a significant drop in prices?”
#22: The analysis assumes you sell the property after 25 years and recover your $350K. You are not on the hook for anything after 25 yrs. The monthly payments include principal + interest.
#23: In the analysis, I mentioned property damage as a risk with real estate when I was comparing today’s yield with the risk-free return. Regarding the price & rent value – That’s the approx going rate in my downtown neighbourhood. Prices and rents can be varied slightly in the analysis, but the end question remains the same – “why should we have a large correction?”
#24: You said “There is basically no risk.” As I pointed out in the analysis, RE has lots of risk. There’s liquidity risk, high leverage, property damage, missed rent income, and chances of market prices falling.
October 6th, 2009 at 8:51 pm
@GG: #24 – sorry, i think you were referring to GIC’s when you said “basically no risk”
October 6th, 2009 at 8:53 pm
A couple of remarks (the usual ones).
You have assumed a certain figure for the down payment which is arbitrary. Obviously, the more down payment you put down, the greater the return. If you buy cash, your return would achieve the current 3.4% annually
You have assumed that RE prices will never go down in the long term and so in 25 years you can at least expect to sell it for 350K. In the past, this assumption was probably correct because credit was given to the right economic players in society and housing prices were close to fundamental values. But now prices are so far above fundamental prices, it is entirely possible that housing prices will fall to fundamental prices and stay there. Period. So you may only be able to sell your place for $200,000 in the long term. Period.
You do make the point that if prices correct, the yields on RE investments will go up. This is obvious. The other obvious point you did not make is that you can only get these higher yields if you buy after the correction. The point about room for price appreciation is not correct because as I mentioned above, it is entirely possible prices will simply correct to fundamental values and stay there (so no growth in real prices after prices correct to fundamental values).
By the way, can you tell me what is the present value of your hypothetical apartment at a historical interest rate of 6% based your future stream of constant annual cash flows?
I ask this because you use the jargon term above but don’t actually calculate it (instead you are essentially calculating a cap rate).
October 6th, 2009 at 8:59 pm
I am talking about your example with 3.4%
In that example, your mortgage is $350k at 3.4% and your monthly payment matches the rent of $1300. The condo fees are $200/mo, taxes are $100/mo – that leaves $1000 for the mortgage payment. If that’s the case, then you are only paying interest. There is no space for principal in your example and your total debt stays constant.
The 6% example does include the principal in the payments, though.
October 6th, 2009 at 9:03 pm
@GG: I think what Brad is pointing out is the first part of the analysis when you assume the mortgage rate equals the annual return rate of 3.4%. In that case, you’ve only balanced your NOI to cover interest payments only. You need more NOI to cover the principal repayments or you need to assume the interest rate is lower than 3.4%.
October 6th, 2009 at 9:08 pm
@observer: Exactly!
October 6th, 2009 at 9:12 pm
GG – This is my point: the going rate for both in your downtown neighbourhood isn’t as stable as you’d think. Advertised prices went up quite a bit downtown over the past few years – and were being taken, sure! – but it’s showing. There is a higher level of vacancy than traditional downtown. This increase is based on gentrification, not on higher incomes.
Rents overall haven’t been shooting upward, but there has been price compression; your numbers might represent a good deal for an owner on the top tier – ie: renting to the majority of the bears on this blog – depending on quality and location. Only there’s a lot of competition out there on that tier, as anyone on this blog who’s renegotiated their rent can tell you.
Where there is less stock is in the low and middle tier places. They’re trying to get that high end money.
Only, rental HAS to be based toward income.
What I’m saying is your scenario may work for a very few places, but *based on income*, $1300 for anything less than 2 bedrooms is necessarily priced to the higher end of the market. I agree that in adverts, that end is currently seeming like the only tier out there. (In fact, $1300 seemed to be the point of maximum price compression over the summer, from bachelors to two bedrooms, regardless of quality.)
So $1300 is a bit of a unicorn number.
If rents are actually lower than $1300 for bachelors and one bedrooms, then your scenario is not overall market reflective.
October 6th, 2009 at 9:23 pm
@observer:
The question I am asking in my analysis is for the situation when you buy after a 30% price drop (ie. at $245K). Only then can you earn a 6% yield. And at $245K, chances are decent that you will recover at least your purchase price after 25 years.
Yes, its obvious that yields go up when prices drop. That’s not my thesis. I am trying to raise a question of why prices should drop by 30% or higher.
October 6th, 2009 at 9:27 pm
Or, n’other words, everyone’s trying to rent to yuppies, and we don’t have the industry to create enough yuppies for all those investors.
So if you can find a yuppie to make your scenario work, it makes sense.
But there is a demographic yuppie shortage, in Vancouver, which most investors are blind to, because everything, everything, everything has been marketed to “living the lifestyle”.
October 6th, 2009 at 9:39 pm
Observer & Brad:
PV = (R, N, NOI, FV)
where,
R = 3.4%
N = 25
NOI = $12K
FV = $350K
This gives PV = $350K
This result can also be obtained by:
PV = NOI/R.
This is because rent is assumed to be collected forever (perpetuity) either by you, or those you sell the property to.
October 6th, 2009 at 9:47 pm
Isn’t the breakeven cost of the Olympic Village units now over $1.2 million each? I think Boobie is going to have to travel a lot further than 100 miles to find that many fools.
Great units for social housing though. The Vision team would be able to fulfill their campaign promise of eliminating homelessness by 2015. as a society we should all be proud to be rich enough to donate this project to the poor. Now excuse me while I get this tongue out of my cheek.
October 6th, 2009 at 9:51 pm
@GG: Could you explain how your calculation disproves what I wrote? Maybe I am missing something…
October 6th, 2009 at 9:56 pm
This thread is full of dumb.
October 6th, 2009 at 10:16 pm
As pointed out by others, you don’t seem to be taking wear and tear and extra maintenance into account. A brand new condo may rent for a premium, but even without a big assesment for repairs think about upkeep on the interior. Once the appliances start breaking down and the laminate is scuffed up its going to be a lot harder to get a premium rent.
October 6th, 2009 at 10:25 pm
Median S&P return is 10.88% from ’88 to ’07 and 10.36% from 1957 to 2007. Where does 3.8% come from? I highly doubt it’s accurate.
(Wikipedia and imarc.org for the stats)
Given that the rate of return is nearly triple what you were calculating it stands to reason that all your figures are out in your calculations by about 3x.
Does that cover it?
October 6th, 2009 at 10:26 pm
@GG: Did you answer my question about the PV of your future income streams (in perpetuity) assuming an interest rate of 6%? The answer should be a number.
October 6th, 2009 at 10:27 pm
Ahh I see Patriotz already beat me to it. That’s what I get for not being a regular anymore…
October 6th, 2009 at 10:45 pm
@GG:
You shouldn’t put N = 25 if you are assuming the income is in perpetuity.
As was pointed out before, if you assume interest rates are higher, you must start to take into consideration opportunity cost on your down payment.
If you aren’t able to answer what the PV of your income stream of 12,000 per year at 6% interest rate, then I think you have missed the very point you are trying to make!
October 6th, 2009 at 11:02 pm
You have to make more than your cost of capital or else it isn’t a sensible investment at all. If you assume mortgage rates are 6% you need to get north of 6% yield or you would be better off in the mortgage business. The numbers for real estate as an investment don’t come close to working in this city.
October 6th, 2009 at 11:10 pm
Off topic but:
Robertson: Strong real estate market needed for Olympic Village to break even
http://www.news1130.com/news/l.....61819_6192
October 7th, 2009 at 12:15 am
@GG: Interesting analysis GG. Despites criticisms i find it an interesting take on the subject. It would be interesting to take an inventory of all the different pricing methods on here and other sides to get a comparison given that they use different variables for their calculations. You could even take this a step further an use an aglgorithm to create weights for a pricing model. Housing analysis touched on this briefly with their liniar regression models i believe.
October 7th, 2009 at 2:11 am
@realpaul:
It’s not a promise, it’s a “goal” as they put it. The City has neither the mandated responsibility nor the fiscal resources to handle social welfare problems. That is the primary responsibility of the provincial government. That said the City can and should lobby senior governments to do more and this is what Vision says they will do.
One criticism I can make is that Vision appears to be viewing homelessness as a housing market problem, rather than a symptom of other problems (mental illness, drug addiction, etc). They are not alone in this of course.
You have to address the primary problems to get rid of the symptoms. Increasing shelter capacity, etc. is OK in the short term but is just a band-aid solution so to speak.
http://www.visionvancouver.ca/solving-homelessness
October 7th, 2009 at 6:28 am
Also take a look at this from page 9 of the Boardwalk report:
They had planned to acquire 1000-2000 units in 2008 but only bought 298 because they found that yields were too low.
Now “cap rate” means net yield, which is gross yield minus all property expenses (taxes, maintenance, utilities etc. but not financing). Their target cap rate is 8% which means a gross yield (rent/price) of over 10%. That’s that kind of yield that professionals who know what they’re doing want when buying investment RE.
http://en.wikipedia.org/wiki/Cap_rate
October 7th, 2009 at 8:25 am
Thanks for this thread and for the discussion.
Thus far it appears that ALL additional considerations that have been posted are arguments for a significantly greater than 30% price drop.
So, it doesn’t look like RE will become an attractive investment at 30% off, and hordes of investors will NOT be stepping in to buy at that point.
In fact, I’d say that the 20-30% price drop range will be where we see hordes of amateur speculators ‘seeing the light’ and deciding to sell their cash-flow-negative ‘investments’ that were purchased purely for price appreciation and with no consideration for the metrics that we’re studying here. The result will be a massive increase in supply (possibly 10,000 condos coming onto the market?) and this’ll be one of the catalysts to take us past ’50%-off’ pricing.
October 7th, 2009 at 8:59 am
I’ve followed this blog for a while and the analysis is quite good but people that are calling for a 50% drop are just completely out to lunch and are either just simply stupid or have an agenda….
October 7th, 2009 at 9:39 am
@stockwhisperer: Okay, you’ve shared your OPINION. Now, where’s your ANALYSIS that a 50% drop in prices is improbable?
October 7th, 2009 at 9:45 am
As much as I want to market crash, you are looking at the wrong direct at this particular moment.
Looking fundamentals are worthless. They have been out of whack for a long long time and continue to be like that. The most important thing is AVAILABILITY OF MONEY and people psychology for this funny little vancouver housing market.
It will correct to fundamental someday, but the reasons for correction wouldn’t be out of whack ratios of household income or ROE. It takes me 5-6 years to learn this, don’t be too stubbon.
October 7th, 2009 at 9:48 am
@patriotz:
#46 P, you’re absolutley right about the ‘problem’ of homelessness being misunderstood and horribly mishandled. You are astutley correct by differentiating between the drug addicted, the mentally ill from the working poor and street population.
Mentally ill persons were turned out of institutions and were expected to show up to the clinics (envisioned but never established) for care and medication supervision. I hate to put too fine a point on it, but the reason these persons were institutionalized in the first place was because they couldn’t be responsible for themselves or their actions.
I guess thats why they call it ‘insane’ as opposed to ‘sane’. The politicians and all associated with the perpetuation of this degradation of helpless and sick people should be utterly ashamed of themselves. Lets start there and work our way up to solving the ‘problem’.
Meanwhile I see that the IOC is publicly distancing itself from the ‘rabid dog fest’ the RCMP have envisioned for the games. The atmosphere is so vicious and Stalinistic that only N.Korea would agree to the ‘security plan’ as envisioned by the RCMP.
http://www.vancouversun.com/
Entities, citizens groups and organizations all are appalled by the actions taken so far and are speaking out. Finally, the dark spectre of a police force out of control is barking in peoples faces and its a scary scene the the RCMP are planning.
PS, I’m pretty sure I heard Greg ( the boy mayor)state that he would eliminate homelessness by 2015. Thats why I have been laughing at the Vision teams antics to misdirect the issue to bike paths , silly bridges and world tours. C’mon you have to admit that its all been a real goon show from the get go.
October 7th, 2009 at 9:57 am
“I’ve followed this blog for a while and the analysis is quite good but people that are calling for a 50% drop are just completely out to lunch and are either just simply stupid or have an agenda…”
You are out to lunch. 50% is definitely in the cards. 60-70% is not out of the question in Vancouver. It is one of the most overpriced areas in the world and completely detached from fundamental reality.
Look at some charts and develop some math skills.
October 7th, 2009 at 10:05 am
They are just plain stupid and ignoring the pure Chinese factor behind the Van real estate.
October 7th, 2009 at 10:06 am
Based on this analysis I now believe that Vancouver prices are pretty inexpensive by international standards. Since Vancouver is soon to be a internationally known OLYMPIC CITY™ it only makes sense for the yield on rental units to be lower than S&P yields. It’s about status. Uropeans and international sissy pants don’t believe in profits and yields they believe in status and global communities and sitting around listening to terrorists make rambling speeches.
October 7th, 2009 at 10:10 am
Interesting posit on ‘gold-real estate’ valuations
http://urbansurvival.com/week.htm
October 7th, 2009 at 10:33 am
I would want double what a risk free bond would yield and I would like it to be managed by professionals not me and the maintenance should include special assessments. The monthly cost for these two items is substantial. For example a $50,000 special assessment every 10 years would amount to $416 per month. You can ask Mr Chipman or Strataman what they would charge to manage the place or you can just pay yourself nothing as most amateur landlords do.
My $50,000 over 10 years may be high but here is a link to repairs costs of $118,000 over a 14 year period or $702 per month.
http://www.cbc.ca/canada/briti.....owers.html
October 7th, 2009 at 10:45 am
“You are out to lunch. 50% is definitely in the cards. 60-70% is not out of the question in Vancouver. It is one of the most overpriced areas in the world and completely detached from fundamental reality.
Look at some charts and develop some math skills. ”
Stay anonymous…. prices will be up 5-10 years from now without any huge price drops.. and when I say huge I’m saying 15%+.. calling for a 50-70% drop is just a mockery of human intelligence and doesn’t even deserve a response.
October 7th, 2009 at 11:00 am
@stockwhisperer: “calling for a 50-70% drop is just a mockery of human intelligence and doesn’t even deserve a response.”
Yeah, like the idea that Nortel at 125 would sell for 1 buck, or that gold at 250 would go to 1000, or that Lehman Bros would disappear, or that the Olympic Village would be a bust, or that… you get my drift.
In these economic climes, EVERY hypothesis deserves some consideration..
So, stockwhisperer, humour us and share the basis of your position: What analysis leads you to believe that 50%-off Vancouver RE prices is so preposterous a notion?
October 7th, 2009 at 11:16 am
@rentah: So, it doesn’t look like RE will become an attractive investment at 30% off, and hordes of investors will NOT be stepping in to buy at that point.
Indeed. Hordes of people wanting to buy houses will be stepping in, though. Not everyone crunches numbers like some of you guys do because they do not see housing as an investment asset. If 99% of a market segment is using different rationale for buying and selling decisions than your model is using then unfortunately your model is worthless. Even if it’s not wrong (if you know what I mean).
October 7th, 2009 at 11:27 am
@Anonymous: Hordes of people wanting to buy houses will be stepping in, though.
The problem with that concept is home ownership is at record high levels, there simply AREN’T hordes of people on the sidelines and I’d say many if not most of the people wanting to buy right now are sitting out partly because they have some financial common sense and they’ll wait until prices make more sense.
October 7th, 2009 at 11:33 am
@Anonymous:
I’m not so sure. Low interest rates and the overall mass psychology of the RE market here have combined to annihilate future demand. Most of my friends and family could not afford to buy their home now. That’s not the sign of a healthy housing market.
October 7th, 2009 at 11:50 am
@Anonymous: Hordes of people wanting to buy houses will be stepping in, though.
A fair point to raise, but will that be the case?
I agree with Drachen (#61) that we have borrowed from future demand.
Furthermore, I have always maintained that ALL current Vancouver RE purchases (and those from about 2005 onwards) have a BUILT-IN speculative component in that even those seemingly innocent young FTBs, and move-upper families, who appear to simply be buying for their own use, are actually buying with the built-in expectation of substantial future price gains.
So, if people were guaranteed that prices would be flat in Vancouver RE for the next 5 or 10 years, how many would be buying to the limits of affordability right now? I suspect far fewer than are actually doing so.
And, what if they now see prices drop 10%, 15% , 20%… the whole speculative magnet will leave the market.
As I’ve said elsewhere, I suspect that the crucial support level is 15% below peak (the prior trough prices of winter 2008-2009). Once that level is broached, we’ll see supply coming in from speculators, and those truly buying for their own use will sit on their hands awaiting the whole thing to play out. Unexpected interest rate drops will not bail the market out second time around.
October 7th, 2009 at 12:08 pm
@Anonymous:
Speaking of pure Chinese, Hong Kong saw a 57% real price decline from 1997 to 2002.
Put that in your wok and fry it.
http://knowledge.wharton.upenn.....cleid=1194
October 7th, 2009 at 12:09 pm
I think ALL purchases might be a stretch, most is more realistic, my wife always says to me that if we win the lottery we should buy a place now even if it means losing lots of money in the long run. There have to be a few other people who share her psychology and simply have enough that they want a home of their own and don’t care that it’s a losing proposition.
Look at Laliberté for example, $35 million on a trip, why wouldn’t someone like that shrug off future losses on a house as well?
October 7th, 2009 at 12:25 pm
@Drachen: Sure, okay, not ALL.
One should NEVER say ‘all’…
October 7th, 2009 at 12:30 pm
TD economist suggest cooling market? says free money may have had an effect? Sic ‘em soupy.
http://www.financialpost.com/story.html?id=2078270
October 7th, 2009 at 12:35 pm
12:27 PM – Ozzie Jurrock on Global TV. SFH +154%. He really sqirmed when pressed if the numbers are yoy.
Buy now or be priced out forever!
PIMP!
October 7th, 2009 at 12:53 pm
If you include a vacancy of 1 month every 2 years, and assume $500/year in repairs/maintenance/assessments (low), this would increase your negative monthly cash flow to:
$629 + $1,300/24 + $500/12 = $725.
Assuming 4% inflation, you will be cash flow positive in 15 years. Over those 15-years, you will have forked out over $91k!
In order to have positive cash flow from day 1 with a $100k down payment, that condo would have to cost $237k (33% less).
October 7th, 2009 at 1:22 pm
That’s not an investment, that’s an operating loss. You’re selling the use of the property for less than it’s costing you. An investment is when you purchase capital. The loss is actually reducing your savings, i.e. your capacity to invest.
You couldn’t make up stuff like this.
October 7th, 2009 at 1:52 pm
The analysis by GG may require some tweaking as noted in previous comments but the underlying theme appears consistent with what is going on in the market. The units that are selling are the “lower” priced condos as they can still, for now, command a rent that can generate a positive return (whether it is a good return is up for debate). The rents do not keep pace as you get to the higher end of the market as you can rent a million dollar condo for $2,500-$3,000. The compression is happening because of the reality that the salaries in Vancouver do not support higher rents. My anecdotal evidence is only from the downtown area and may not apply to the greater metro region as a whole.
October 7th, 2009 at 2:15 pm
GG,
Great question – good analysis. As your analysis points out, this all boils down to required rate of return in order to hold real estate which in real estate is often summarized by Cap rates, and in my opinion really comes down to your weighted average cost of capital (WACC). To calculate either you need to assume a cost of debt, a leverage ratio, and cost of equity.
1. IMO the cost of debt can’t get any lower so this must rise.
2. Leverage ratio’s with the financial crisis should be coming down
3. Ones desired return on equity (ROE).
ROE is a magical question. As patriotzed points out market ROE for Boardwalk and others is 8%+ today which should rise as interest rates rise to maintain a constant market risk premium. A public vehicle like this has lower ROE requirements when compared to a SFH due to diversification of risk and liquidity of the equity. A private SFH should have a substantially higher ROE.
IMO longterm interest rates are artificially low at the moment due to market intervention by governments, and by historical standards. Coupled with a higher ROE bar I would say my cap rate or WACC on a long term basis should be higher than 6% and therefore RE should drop more than 30%.
Lastly, of high importance. Everyone chooses their own ROE. This is a function of perception of risk and investment alternatives. At the moment I know people of substantial wealth that are happy to clip coupons (rent) at a yield of 3.4% vs. a 30 day BA at 0.25%. Market volatility has driven them to cash holdings and they can touch and feel RE and therefore perceive low risk.
October 7th, 2009 at 3:27 pm
@observer: Don’t bog yourself down with the perpetuity formula and 3.4% yield – it is only for a special point on the yield graph where the 25-yr mortgage rate = yield rate = 3.4%. Only at that point, all curves intersect since the yield will not be affected by your down payment. This is because your 3.4% yield services your 3.4% borrowing cost leaving you with a 3.4% return on your down payment (which can be any value from $0-$350K).
Also note that the present value of the perpetuity on any given date is always $350K. This is because at any given date, the same future (infinite) cash flow stream is remaining. You can therefore sell the property after N years for $350K. You’ll still earn the annual 3.4%, but just for N years.
For this special point, you can calculate the Present Value 3 different ways and get the same result:
1. Perpetuity formula: PV = Annual Income / Rate = 12K / 3.4%.
2. Annuity formula: PV(r = 3.4%, N = 25, PMT = +$12K, and FV = +$350K)
3. The “long way” explicitly takes into account the mortgage payments and down payment. It is calculated by:
i) Mortgage payment = PMT(r = 3.4%/12, N = 25×12, PV = – ($350K – down), FV = 0)
ii) Net annual investment = (Mortgage pmt – Rent + Maintenance + Tax) x 12.
iii) PV = PV(r = 3.4%, N = 25, PMT = – Annual investment, PV = -Down, FV = + $350K).
October 7th, 2009 at 3:28 pm
@Drachen: The S&P500 yield I am using is *Dividend* yield only and excludes stock price appreciation (this is because I want to compare it to my calculated RE yield which excludes home price appreciation). The quoted dividend yield is the cash dividend paid out to investors (no part of it is retained). You can find the data on Standard and Poor’s website: http://www2.standardandpoors.c.....0,0,0.html
@VultureBoy: The RE yields I calculated are net profit after borrowing costs. If you buy after prices drop 30%, then the calculated 6% yield would be your net profit. The profit is made from the rent you collect and the equity you build in the home after servicing the borrowing cost.
@Patriotized: For the example with monthly cash outflow of $629, you’re compensated by a cash inflow of $350K after 25 years. This is where the positive yield comes from.
October 7th, 2009 at 3:41 pm
“I’ve followed this blog for a while and the analysis is quite good but people that are calling for a 50% drop are just completely out to lunch and are either just simply stupid or have an agenda…. ”
I couldn’t agree more! A %70 or higher decline is much more likely!
October 7th, 2009 at 3:57 pm
@GG:
So… That doesn’t make any sense.
You need to factor everything in, just taking one part of the equation and leaving the other part out makes this an exercise in futility. The appreciation in stock prices is a part of the investment and because of the liquidity of stocks it’s value as an asset is higher.
Why don’t you compare to bonds which have a 0% return (using your methods) by that standard a savings account in the bank is better.
What I’m trying to say is there’s a fundamental flaw in your reasoning.
October 7th, 2009 at 4:01 pm
Just to clarify, for an investment decision to make ANY sense you have to look at your total profit, otherwise you’d pass up a stock that’s doubling in price every year for one that has very little growth with a 5% dividend every year, it just makes no sense at all.
October 7th, 2009 at 4:25 pm
Summary of the main valid points that will lower my calculated yield and support a significant correction:
1. The price and rent values need to be revised with more accurate data. The numbers used might be representing a higher price-to-rent value than the aggregate Van market.
2. High transaction costs of RE (GST + HST on new homes, Realtor fees, Lawyer fees, Property Purchase Tax, etc)
3. Missed rent payments will make the rental income lower. (eg. 1 month missed every 2 years).
4. Investor Psychology will bring prices lower than fundamental value.
5. Comparison with S&P500 dividend yield may be flawed. Perhaps compare with S&P500 absolute return. Also, S&P500 and RE have different risk profiles. Should be comparing with risk-adjusted values by dividing yields by their standard deviations.
Please add if I have missed any…
October 7th, 2009 at 4:29 pm
@Drachen: I think GG is saying that the 1.1% return is without any appreciation. So it is comparable to dividend yield. If the property appreciates above 350k, that gain would be on top of the 1.1%.
Of course, any bump in the road (high vacancy rate, big special assessment, declining rents) and this profit will turn to a loss.
October 7th, 2009 at 4:29 pm
*Lower Price-to-Rent value.
October 7th, 2009 at 4:38 pm
@GG: Actually, I think your price and rent numbers are pretty accurate. Downtown rents are in the $2 – $2.20/ft range, and prices are about $550 – $650/ft for decent downtown buildings.
So the price/rent ratio range is 250-325. Your example of $350k and $1,300 would be a ratio of 269.
October 7th, 2009 at 4:44 pm
@crabman:
The problem is that stocks normally post positive gains in the long term, especially if you have a diversified and sensibly planned portfolio. Real Estate normally has little or no appreciation, it’s only since the mid ’80s in Vancouver where things have been different which is more indicative of a Mega-Bubble than a fundamental change in the financial realities of Real Estate. Factoring market realities into the picture even a die-hard bull has to see that significant appreciation is all but impossible from the current state for the next while.
So… While it may be ‘comparable’ to dividend yield it is not a sensible basis for reaching an investment decision. But it’s a little like saying apples have more energy in them than bacon because they have more sugar. Taking one factor that makes up a data set and comparing it to other things does not give any new information about the whole data set.
October 7th, 2009 at 5:49 pm
@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.
October 7th, 2009 at 5:58 pm
@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%?
October 7th, 2009 at 6:19 pm
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.
October 7th, 2009 at 6:32 pm
@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 lot of suites to fill, all of which are small.
Which is my point: yes – on the top tier, 2-3 even is not unusual. But there’s a lot of people competing for that top tier and the discount buildings are gentrifying, heeding Rennie’s call.
Of course, Coal Harbour/Yaletown are different markets with different pricing structures (and different amenities) – but they are almost entirely new and top tier.
It may stay what was sold, Manhattan 2, but I’m not sure it’s going to fully transition to a stable version of Rennie’s vision.
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…
October 7th, 2009 at 6:53 pm
“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.
October 7th, 2009 at 8:06 pm
@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.
October 7th, 2009 at 8:06 pm
(Although 3 months in I would have dropped …)
October 7th, 2009 at 8:54 pm
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.
October 7th, 2009 at 9:07 pm
@read on: True that. Plus, the rate of change is amazing: in purpose built rental buildings it was recently a sliver of a percent.
October 7th, 2009 at 10:15 pm
Lots of vacancies down here in the West End, where this time last year there were very few.
October 7th, 2009 at 11:49 pm
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.
October 8th, 2009 at 1:59 am
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…
October 8th, 2009 at 9:08 am
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/bu.....story.html
October 8th, 2009 at 9:39 am
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 full as possible boys. People are dying like flies now and the vaccine thats being distributed in the UK, Eurozone and US won’t be coming to Canada any time soon. Woops
http://www.theprovince.com/hea.....story.html
Its a good thing the foolish sheeple have such short memories. Otherwise you’d think they’d get a bit angry after all the lies lies lies and more manipulation and lies. Who bets that the politicians get the fuck out of town while the rest of us die like pigs in the street?
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October 30th, 2009 at 10:46 pm
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 looking at a lovely 30-acre oceanfront property with a 4-bedroom house and a retail shop in PEI for $150k, since hubby’s job isn’t tied to where he lives.
October 30th, 2009 at 11:43 pm
jennifer
i would move then
sounds like the wise decision for you and your family
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