Monday, December 10, 2007

How much will prices fall?

This question is the essential question for all those waiting to buy real estate due to the fact it is over-priced and offers no value over renting right now in the Vancouver area. For a value oriented individual, no premium should be paid to own versus rent.

For comparison purposes I have selected two typical 'first time buyer' residences in the Lower Mainland to determine what I consider to be a “fair market value” for these homes.

Methodology:
I am comparing the monthly cash outflow for buying versus renting, with renting representing the fair market value of the monthly cost of the housing in question. Sources for data are the Multiple Listing Service for local asking prices and Craigslist for local asking rents. I have tried my best to find units that are as similar as possible.

Mohican's fair market value is based on the fundamental price of the housing (rent) minus any extra owner incurred costs plus any principal paydown

Assumptions:
- 100% financing
- 6% fixed five year mortgage rate with 40 year amortization
- Inclusion of maintenance fees and property taxes

1) Our first candidate is MLS # V673124 in the Central Park area of Burnaby. It is a two bedroom, 1 bath condominium. Maintenance fees and property taxes are approximately $400 / month. I assume the purchase price to be the asking price at $309,000. In this scenario a buyer would have monthly cash expenses of $2,084 = ($1,684 + $400with only $158 of principal pay-down for a total net cost of $1,926 / month. For comparison I found a comparable unit for rent in the same neighborhood, with the same features for $1200 / month for a net savings to the renter of $726 / month. Based on these numbers the mohican fair market value of this condominium is $183,456. This represents a 41% decrease from the current day asking price.


2) Our next candidate is MLS# F2730243 is a 3 bedroom, 3 bathroom townhouse in the quickly growing Clayton area of Surrey. This townhouse has an asking price of $334,900 and maintenance fees and property taxes are approximately $350 per month. In this scenario a buyer would have monthly expenses of $2,175 = ($1,825 + $350) of which only $172 is principal paydown. This gives us a total net cost of $2,003 per month. I found a comparible unit for rent in the same complex for $1600 / month. This gives the renter a monthly net savings of $403. Based on these numbers the mohican fair market value of this townhouse is $266,012. This represents a 21% decrease from the current day asking price.
What do you think? What would you be willing to pay for these places? Do you think prices will fall by the amount stated and when?

47 comments:

Matt said...

I live in the Toronto area (just west actually) and although things have been booming for several years I do wonder if we will see a price drop, or simply a flattening out? I'm 40km from downtown Toronto and a townhouse (1400 sf) in my area goes for around $300,000. Down by Lake Ontario (Oakville/Burlington) it is a lot worse as these are established/ritzy areas.

I've heard horror stories of how much real estate costs in Vancouver and it always makes me think of New York (manhattan).

It seems odd that the prices in a lot of these major metropolitan areas are so high for so little, but I do wonder if this is just the price to pay for living in the "big city"?

johnnyrent said...

My prediction is for a 28% drop in prices. 28% has been the average of the last four corrections, at least according to VHB and he could normally be relied upon for accurate data.

Although the 28% figure was skewed by an almost 40% drop in the early 80's, judging from the famous chart of Vancouver area RE prices since the 70's the longevity of this run-up has been precedent setting. Also, there is a tremendous amount of speculating going on, together with what appears to be over-building.

My estimate may be on the conservative side.

Clarke said...

Hi Mohican,
Great methodology, very sound, and (regrettably) completely lacking in most people's rent vs. buy decision making.

I think your sample illustrates that the respective drop depends a lot on the type of property. Some areas may only see 20% drops. Given the valuations I see in my area, 50% or more is a real possibility.

solipsist said...

I would revise your numbers downwards some.

The rationale being that those rental rates seem inflated, and more than I would be willing to pay. I believe that there is a glut of rental properties well on its way, which will lead to lower rents. Especially as the economy, bull market, Olympic construction, etc., wind down.

Rent for condo - $850/month
Rent for town house - $1300/month

Fencesitter said...

I agree with your Clayton (Surrey) example.

Those units sold quickly, however just up the street there are several other townhouse complexes that have not yet sold out and are now sitting. This may put some pressure on the price of the one in your example.

As far as rents go, $1600 is accurate for that unit. A block away is a project called Manhattan Skye, which has several units available for $1750-1850, but they are also brand new.

I would like to hear your thoughts on valuations of bare land. Perhaps a separate post that analyzes some of these multi million dollar listings for "development" land with an old timer on it? How about those properties that are not sub-dividable? It seems like they are just drawing numbers out of a hat.

Fencesitter said...

solipsist said...
I would revise your numbers downwards some.


The townhouse shown will rent for $1600/month. There is quite a bit of demand in that area for rentals. I do however agree that there will be a glut of inventory soon. If you want a eye-opener, take a drive around clayton / willoughby and you'll see the amount of supply in the queue for the next couple of years.

the pope said...

Great post, but why the 40 year term? Do the numbers change significantly with a standard 25 year term?

capcialist said...

I like the style of 'Real Homes of Genius' From the Dr. Housing Bubble Blog and would love to see a similar analysis for Vancouver . RHOGs are based off of median income, basing correct valuations off of incomes instead of P/E.

I know that the principal tenet of value investing is based off of P/E, but I believe affordability is a stronger driver of RE. This is because most RE is not an investment, per se, but a principal residence. 76% of RE owners can't be wrong.

the pope said...

..guess I could've answered my own question - you're looking at around $300 extra a month for the 25 year term on that townhouse. Are many people really locking in for 40 years?

Love the term Mohican's Fair Market Value™, its got a nice ring to it.

Warren said...

Good analysis. I don't know if prices will fall to the level of being equal to buying with 0% down over 40 years, but anything is possible, as it has been on the way up.

That $400 maintenance is killer though, that seems really high for a place that size. That's one thing to watch for all you buyers out there. Fees tend to go up a lot in the first 5 years of a building, but slowly after that. There are significant variations in fees out there, and that's money going out the window every month you'll never see again.

jesse said...

Peak to trough, I am looking for prices dropping even more than this. Either that or the "long term average" moves permanently higher.

My bet is prices will be rocketing through the long-term average so quickly, not many will want to buy back in until prices level off.

Panda said...

I get essentially the same values as you Mohican, although I assume as a thought experiment an interest-only mortgage and a slightly lower interest rate. Nice to see I calculate valuations similar to other people :-)

Man! them condo fees are brutal...

freako said...

28% has been the average of the last four corrections, at least according to VHB and he could normally be relied upon for accurate data.


I don't think any of the previous booms had such a runup, so for that reason alone 28% seems tame. It'd take us back, what, late 2005?

There is quite a bit of demand in that area for rentals.

The question remains whether rents will come under pressure as completions flood the market.

Great post, but why the 40 year term? Do the numbers change significantly with a standard 25 year term?

The length of the term should absolutely zero impact on the fair value of a property.

Nice analysis Mohican. I think you do need to take a density/growth potential factor. For example, a tower is 85%+ depreciating building and little appreciating land. An SFH off Broadway would have huge densification potential, whereas a townhome in rural Surrey would have relatively little. I think the towers (especially the non downtown ones) are much easier to analyze. The OUGHT to have positive cash flow from day one because in 75 years give or take they will be crumbling hunks of concrete. That is true whether Vancouver growth is strong or mediocre. For low density, future growth rates are critical in valuation.

mohican said...

the point of this exercise was to illustrate that different properties will depreciate different amounts during the upcoming bust. This will be based upon the fumdamentals of each specific situation. Clearly, as in every other bust, babies will get thrown out with the bath water and this will be a great time to pick up an investment property.

Property taxes and maintenance fees/costs are something that so many property owners fail to consider as an added cost compared to renting and it makes a huge difference when considering whether to buy or not.

I did use the asking price on the mls and the asking price for rent understanding that both are negotiable. Indeed, rents will come under pressure as oversupply hits the market and the construction job market dries up and many temporary workers leave town.

I did try to choose properties that have no immediate densification benefit - a different sort of formula would be necessary in those circumstances where densification seems to be an immediate possibility.

The term of the mortgage makes no difference to the calculation. The results are the same with 25 year, 40 year or interest only mortgages. I just chose 40 year amortization because it is the most common right now.

freako said...

I did try to choose properties that have no immediate densification benefit -

Yes you did. I only mentioned to caution people from blindly calculating FMV on ANY building anywhere. The Burnaby one is already high density, the Surrey one is medium/low density in a rural area and won't face in densification pressures in this century.

All else the same, I would have expected the townhome to have worse cashflow (and hence a bigger discount compared to MFMV) but perhaps its non-central location more than compensates.

REsteven said...

I ran roughly the same calculation on a slightly higher-end downtown condo. Luckily the exact same unit was listed on MLS and on craigslist.

Pomaria unit #904
MLS# V672596

asking price: $918,000
fees and taxes: $500
monthly expenses: $5,503
principal paydown: $433
net cost: $5070 per month

asking rent: $2500
net savings: $2570

fair market value: $458,650
50% decrease

jesse said...

I'm not sure if you're including the normal decennial special assessments (roof, plumbing, etc.) and non-strata maintenance (such as appliance maintenance) in the carrying cost calculations. I have seen these items add up to $100 per month on average (definitely if you include labour), though not in the form of regular payments.

I agree with you that most will underestimate carrying costs of property ownership.

patriotz said...

I do wonder if this is just the price to pay for living in the "big city"?

The price you pay for living in the big city is the market rent. That's the true value of the utility of the property.

The price you pay for buying a place is something else altogether, and as Mohican points out, if it's more than about 150x monthly rent, you are not getting what you are paying for.

patriotz said...

I know that the principal tenet of value investing is based off of P/E, but I believe affordability is a stronger driver of RE.

These measures are not independent. Rents, i.e. earnings, are affordable by definition because they are pay as you go. If P/E is out of whack, prices are unaffordable. If P/E makes sense, prices are affordable.

This is because most RE is not an investment, per se, but a principal residence.

Well yes it is an investment per se, whether the owners, or Canada Revenue, consider it to be one or not.

76% of RE owners can't be wrong.

The vast majority of RE owners bought before the current runup when prices made sense. Why do people have to be reminded of this?

Luc said...

The term of the mortgage makes no difference to the calculation.

I punched in the numbers for my own situtation and I get different results. I used the mortgage payment calculator from ING

Downpayment: 200,000
Mortgage: 109,000
Term: 5 years
Interest Rate: 6% fixed
Amortization: 5 years

Total Paid: 25,242 a year
Note that over the years the prinicipal payment grows while the interest one shrinks (in your example they don't change).

First year:
principal: 19,301
interest: 5,941 = 495/month

Thus monthly cost: 495+400 = 895/mon, a saving of 305/mon over renting

What is Mohican's fair market price now?

I neglected the interest on 200K in the rental scenario.

capcialist said...

Patriotz,

Don't misunderstand me. I was just wishing out loud for a similar analysis to the Dr. Housing Bubble methodology, based off of affordability (and a sane credit market).

This blog post and ensuing conversation is using P/E, which means that we're now both off-topic. Sorry all.

Your first point brings up an interesting observation, though:

Reasonable valuations are all directly related to local incomes, whether using P/E or affordability limits. Affordability moves beyond the mean due to insanity in the credit markets and bubble psychology.

cheers.

mohican said...

luc - you should always include the opportunity cost of your downpayment. In my example I assumed a opportunity cost equivalent to the mortgage rate of 6%. In your case this is the equivalent of $1000 per month which puts you at a $700 / month savings by renting. This is where the difference is compared to my examples.

resteven - nice example - downtown condos are particularly overvalued in many cases

jesse - I did not include the big repairs or assessments (just too complicated to write into the post) but a potential owner should consider these things.

mk-kids said...

"The vast majority of RE owners bought before the current runup when prices made sense. Why do people have to be reminded of this?"

So then who has been buying all these properties in the last 5 years and running up prices???

wombatos said...

I must be math challenged (#1)...

Total cost of mortgage:
1,684 * 12 * 40 = 808,320

which means from each payment

309000/808320 = 0.382

is paying off the principal which amounts to:

0.382 * 1684 = 643.28

What am I missing?
(you have "with only $158 of principal pay-down")

mohican said...

wombatos - your math is correct - my scenario is only applicable to the first payment after which the principal pay down increases - albeit very slowly - about one dollar per month!

The reason I did this is because within the term of the mortgage (5 years) we know with certainty what the payment will be and the principal and interest breakdown is largely unchanged during this time - at least not enough to affect the calculation. After the term is up, we have no idea what the interest rate will be - perhaps it will be 4% or maybe 8%. This would again change the calculation dramatically either in favour of buying or in favour of renting.

We can't tell the future so I feel my methodology is sound. This is one of the risks/uncertainties of ownership which a buyer could be compensated for by a rising asset price or increased rent from the property. The thing about risks is that they aren't known and we don't know what the situation will be like for interest rates, prices or rentals in 5 years so to calculation applies to today and only today and represents a fundamental value based on today. The future will be different than today we just don't know whether it will be favourable to buyers or favourable to renters.

Many people feel the need to overpay for property today because they feel the asset/income appreciation will compensate them for the risks they are taking or, as I believe is largely the case, they are unaware of the risks.

freako said...
This comment has been removed by the author.
wombatos said...

thanks mo

Aleks said...

"Luckily the exact same unit was listed on MLS and on craigslist."

Ha ha ha, that's awesome. Apples to apples indeed, although the rent might STILL be too high, because it's Craigslist and not necessarily the rent that somebody will pay.

patriotz said...

So then who has been buying all these properties in the last 5 years and running up prices???

A small minority of owners, which is what I said before. People who are buying earlier in life than usual, and just plain speculators. These people are responsible for the increased demand, not the majority who live in the same house they had 5 years ago, or people who are just selling one house and buying another. As if that weren't obvious.

RE has a large stock and a relatively small flow (because it lasts a long time). Combined with quite inelastic supply in the short run, this means a small number of buyers can cause large runups of price.

But this works going in the other direction too.

Warren said...

I agree with patriotz. I think housing is also not something quickly sold when the price spikes, like oil, gold, or stocks. I've witnessed the price of my RE grow quickly, but I'm hesitant to sell, as its always been my goal to hold it long term. In a bubble market in tech stocks for example, I might have already sold, helping to deflate the bubble.

freako said...

People who are buying earlier in life than usual, and just plain speculators.

Yup, that has been my argument all along. The 2006 census showed that the Vancouver ownership rate had gone up, something like 64% to 69%. That does not sound like a lot, but it is a huge number for the relatively slow moving RE market to absord. Even at record sales, it would take many years to find houses for all these people, especially since investors didn't sell (as they ought to have).

Obviously, the ownership rate can't increase forever. When it does slow, the rate of sales will fall. We also need to ask ourselves if the ownership rate went up as a permanent shift in the propensity to own (across owners of all ages), or if it was merely a result of panicked renters buying earlier than otherwise planned (as Patriotz suggests). If it is the latter, there will be a dearth of natural demand, and the ownership rate will start to decline to a natural level. This trend has already started in the U.S. The dearth in demand will meet record completions, a formula for large price declines.

talus said...

Love it Mohican,

"I just chose 40 year amortization because it is the most common right now."

- That just freaks me out

condohype said...

That 40-year mortgage stuff scares the hell out of me too. I was at a bar on the weekend and a bartender was telling me about how he bought a one-bedroom in Yaletown. He's on the 40-year plan with the bank. I figure the guy must be around 35 years old. Do the math and his lovely condo won't be paid off until he's 75.

Let me put this another way in case that's not impactful enough. The dude's paying a mortgage until 2047.

Patiently Waiting said...

I wonder if the rent on the Surrey townhouse includes utilities. If it doesn't, than you are looking at over $1800/month for all housing expenses.

Consider that the family that occupies will likely earn no more than the median family income in BC, approx. $4500/month (gross).

1800/4500 = 40%

That's a lot to ask from renters. One parent loses a job, or even loses some hours, and the rent cheque is arriving late, if at all.

Patiently Waiting said...

condohype,

All of the 40 year borrowers don't believe they'll be paying the same mortgage 40 years from now. Instead their condo will double in value in the next few years, so they'll have a nice down payment for something bigger. Since their next home will have double in value too, they'll need to get another 40 year mortgage at that time. And so on...

patriotz said...

Instead their condo will double in value in the next few years, so they'll have a nice down payment for something bigger

Er, but if the condo doubles in price, so will everything else too. That will make it harder to trade up, not easier, because the amount of the new mortgage required will be higher.

City of the math challenged.

Patiently Waiting said...

Yep, I've tried to explain to young condo owners that they should want a crash for the move-up opportunities, and received a blank stare.

patriotz said...

But if there's a crash recent condo purchasers will be underwater and won't be able to move anyway.

IOW, they are screwed no matter what happens.

Maybe they should do some research on how people in Eastern Europe, China, etc. raise families in 500 sq. ft. apartments. Welcome to the Third World Class City.

Gianni33 said...

I'll buy when the average family making $50k/year (the average family income) can afford a suburban townhouse at 25% down with a 25 year mortgage. Right now, that means the average suburban townhouse would need to cost around $200k. I believe your average suburban townhouse costs $300k on the very low end, and over 500k at the higher end, so that would call for a roughly 50% price reduction.

Drachen said...

I think it was a pretty unrealistic analysis Mohican.

Most units on MLS are for sale by an agent. An agent will set a realistic price relative to the market and they have generally a pretty good measure of the market.

Most units for rent on Craigslist are rented out by amateurs who, all things being equal will probably ask for a lot more than they can realistically get.

Generally your methodology is sound but I suspect Craigslist prices are 25-30% inflated over normal realistic prices.

For example on the Gateway page, they have a similar suite to the Burnaby one that is only $980. I couldn't find a similar unit to the Cloverdale one.

So increase your predicted drops into the 50%+ range and I'd say you're closer to the money. Also I suspect rents will settle downwards a bit once the bubble bursts.

Johnnyrent:

The increase in prices (inflation adjusted) in the last four bubbles has been approximately equal to the drop at the end of the bubble. You're comparing the wrong stats. It's like dropping 4 medium sized rocks off a peir, then getting a rock that's twice the size and saying, "I predict that the splash will be about the same as it was with the last four rocks." Makes no sense. Historical analysis is great but please compare apples to apples.

jesse said...

"I predict that the splash will be about the same as it was with the last four rocks."

They will fall at the same rate though. I choose to live my life in a vacuum thanks very much.

johnnyrent said...

Drachen

If I understand your rock-splashing analogy correctly, you would have prices correct to the point they were at as they started rising. I'd like to think that was possible but I don't consider it to be probable.

My point was that there has been justification for price increases over the past five years or so. As I envision it, some of those increases will be given back, not all. My 28% (albeit conservative) correction prediction still stands.

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patriotz said...

My point was that there has been justification for price increases over the past five years or so. As I envision it, some of those increases will be given back, not all.

Are we talking real or nominal here? The current runup started in 2001, and I think the impending decline will not bottom out any time before 2012 or so. That's over a decade of general price inflation, so we could go all the way down to 2001 real and still be quite a bit ahead in nominal terms.

Drachen said...

I think we're both talking real patriotz, it doesn't make much
sense to be talking about such a long cycle in nominal dollars, it just confuses the issue. Personally though I believe the run-up started at a very slow rate around 85. Those increases have not yet been compensated for but I think the reversal in psychology we SHOULD see with a collapse will bring us back to the pre '80s flat Case-Schiller line where RE has remained for the past century (with the exception of the depression-ww2 era). This is of course all hypothetical and would probably only mean another 5-10% reduction beyond 2001 levels.

Johnnyrent:

The problem is that in ANY bubble there are 'justifications' for the price increases. Be it tulips or real estate people aren't QUITE so stupid to buy into the scheme if they can't see any value being added at all. The problem is that (in most cases) all of the justifications turn out to be nothing more than hot air once the bubble bursts and they do nothing to soften the fall on the way down.

What you're saying is (to my mind) just a variation on the "We're different" mentality that is driving the bubble in the first place.

First rule of Bubble Club, we're different!

Second rule of Bubble Club, no really! We're different!


Third rule of Bubble Club, rules one and two are just for the gullible who don't read the fine print.

Siobhan said...

Let us not forget that a US election is coming in 2009. My experience has been that the government-of-the-day will not do anything to jeopardise the election of its members. I would not expect any dramatic changes in the interest rate until a new government is formed which of course will blame the previous administration for all of the follies and institue draconian measures to fight inflation. Canada, of course follows the US in its policies and would be akin to the status of the 51st state. So expect similar political rhetoric here.

Also, construction jobs will be lost in late 2009 with the completion of the Olympics.

Expect, a dramitic increase in the unemployment rate and a net loss of population in the major city centres, an increase in the vacancy rate, decrease in rental rates and eventually a recession in both countries. A precipitous drop in property values that will revert prices below the mean for a temporary period.

I'm thinking 2010 for the full empact.

"Just the opinion of one small cog"

Costas Piliotis said...

Actually Clayton is still selling like hotcakes - Kew sold out not too long ago and Townline did really well too.

I don't get it - I work downtown and live in Clayton and can't stand the commute.

I'm looking to cash in - anyone want to buy my listing for $529k?

=D