Saturday, April 12, 2008

It's Starting

Real estate inventory is now ballooning in all major Canadian housing markets. Most notably inventory is skyrocketing in Greater Vancouver, where many so called experts have said that the market won't have a price correction. The not so far away Fraser Valley market is already saturated with over 7 months of inventory and the inventory keeps hemmoraging through the normally strong spring selling season.

The few lonely voices that have been predicting this exact scenario are being vindicated in their own eyes but villified as doomsayers by others. Many real estate industry pundits are touting this new market as a 'balanced' one but this one doomsayer says 'balanced' is just another word for on the way to the real estate apocalypse.

Mohican thinks that it is becoming pretty conclusive that 2008 is the year the real estate market will enter a prolonged buyers market and prices will moderate from this point on for several years. I fully expect that urban condos, where the price to earnings ratio has hit astronomical levels above 30, prices will correct to bring P/E levels to the 10 to 15 range. This means that prices in urban condos will correct by 30%+.

Suburban markets where the price to earnings ratio has not reached such lofty heights will likely see less of a correction but a hefty price reduction nonetheless. Price decreases ranging from 15-25% will be common in markets from Pitt Meadows to Langley to Chilliwack. Wherever rents cannot sustain the purchase price, we will see prices correct to the level that rents can sustain them.

Mohican's advice at this point in time is do the math. Figure out what a property is worth and don't pay any more than that. If you must shop for real estate, make lowball offers that make sense using this formula.

{Fair Price} = [1/{Five Year Fixed Mortgage Rate}] * [{Annual Rent} - {Property Taxes + Maintenance}]

For example:

A townhouse rents for $1500 per month has maintenance of $150 per month and property taxes of $150 per month. The five year fixed mortgage rate is approximately 5.9% right now.

{Fair Price} = [1/0.059] * [{1500 * 12} - {150 * 12 + 150 * 12}]
{Fair Price} = [17] * [18000 - 3600]
{Fair Price} = $244,800

Have fun and don't get robbed.

44 comments:

Coton said...

Hi Mohican,

What do you think about Victoria? People here think that prices will never go down because everyone in the WORLD want to live here. They also think that because it is an Island it is protected from any economic down-turns.

I would love to here input.

npp302 said...

Very interesting stuff. I've been looking at townhouses recently in the south Surrey area. I've found that the ones built in the mid-2000's are listed for about $400K-420K while ones built in the late 90's are about $50K lower. However, it is interesting to see some price drops starting to happen. One in particular has gone from $395K to $385K and is now listed at $375K while others in the same development are still around $400K (unfortunately I don't know how long the particular one has been on the market). When I see multiple units for sale in the same development (question - what is a normal % of units for sale?) and the amount of new supply coming on stream I would expect further price preasure.

For someone who is looking to buy it is great to see prices coming down. At the same time it is very scary that I may buy too soon.

Coton said...

Sorry. Can't type and spell this morning.

"I would love to hear input" about Victoria - from people who are not from Victoria.

Cheers!

Montery said...

Hi Mohican,

I used your formula on a couple of 2 bedroom, > 1000sqft, condo test subjects. One located in south van, the other located in the west end. I then did a quick google search to find an equivalent rental (NOT using craigslist because we know rents are skewed to the high end there).

I found that for my two subjects priced in the 500K range, the fair market value was about half the asking price.

Based on this, plus my "gut feel", I would say that a 30% decline in real prices is conservative. I'm expecting 50% declines in the Vancouver area!

Don't know if that's realistic or not, but if I was to go offer a purchase price on something right this moment, I would target 50% of asking price. :)

mohican said...

npp302 - I have noticed the same things from my vantage point too. Asking prices are coming down - assessments/appraisals are falling.

I wouldn't worry too much about trying to time the bottom. That is impossible to do just like timing the top. I've been wrong about that for a while now! Things always go further than seems rational.

If purchasing, I would focus on getting 'Fair Value' and wouldn't worry about timing the market.

coton - That whole - "everyone is moving here" stuff is complete garbage. It is a well documented social behaviour called 'uniqueness bias' where people feel their country, province, city, neighbourhood, street, and house is immune to the fundamentals. It is total crap and people are foolish to delude themselves that way.

montery - there are going to be pockets of SEVERE pain in our local market. The situation you are looking at is where the most pain is going to happen.

Robotman said...

Hey Mohican,

How did you derive this equation? Every rent vs. own equation I've seen prior to this is considerably more complicated.

Robotman said...

Never mind, figured it out. It assumes that in a fair market, the carrying costs of owning a home (interest, taxes, maintenance) should equal the costs of renting it.

This ignores property appreciation/deprecation as well as opportunity costs, but it's still a useful short hand.

jesse said...

"If you must shop for real estate, make lowball offers that make sense using this formula."

This is the "net asset value" calculation. Often an "ownership premium" is added as well that aggregates the intangible benefits and costs of owning such as stability, control, densification, lack of liquidity, etc. I think a lot of analysts calculate about a +20-30% premium in metropolitan markets with decent economies.

That said, if depreciation instead of appreciation starts to be extrapolated, the ownership premium would disappear and can turn negative (as is the case in some US areas where pop growth is negative). mo, in your case your ownership premium is zero, meaning the trade offs of owning roughly balance each other out. I believe most in BC put a premium on ownership, but other factors may prevent them from making a purchase with the premium. It's a good question to ponder what will prevent people from buying, forcing the premium zero or negative. I believe the market premium over NAV has gone negative before in Vancouver area but I'm not certain.

pricedoutfornow said...

Coton-Victoria?? Last I heard "everyone" is moving to Kelowna! lol oh these people...it's so hilarious to travel throughout the province and hear the same argument for high housing prices. Seems "everyone" is moving just about "everywhere" including the Okanagan, the Kootenays and of course our favourite Olympic city. What a joke.

Coton said...

pricedoutfornow,

Now it is areas. I was talking to someone today and they said property in "Oak Bay" will never goes down because everyone wants to live in Oak Bay. Not necessarily Victoria but Oak Bay.

Last week a friend in Toronto said property in Leaside will never go down because everyone wants to live in "Leaside".

Nest time it will be streets. "Everyone wants to live on Elm Street - I am okay!"

Newcomer said...

I would have thought that the down payment would be a reasonable ownership premium. If we accept that, then Mohican's formula works well as applied to the mortgage, but in order to calculate the fair price, we should add the down payment to the price the formula gives us.

mohican said...

I would agree that there is such a thing as an ownership premium but logically it should only apply to the land and not the building. The more of a land component the piece of real estate contains the higher the ownership premium.

Condos and townhouses should not have a high ownership premium since the land content is low and the densification possibilities are also low.

patriotz said...

I would agree that there is such a thing as an ownership premium but logically it should only apply to the land and not the building

That's not an "ownership premium", that's a densification premium over present yield based on higher future yield on the property due to higher density.

And it's quite logical - look at a vacant lot, of course it doesn't sell for free even though it yields no income at present. It's the present value of future income that always matters. Likewise an undersized house will sell at a high multiple.

The "ownership premium" the bulls tout is the idea that prices - even for properties like condos which have no densification potential - can stay above the PDV of rental income in the long run because of "intangible benefits" of owning rather than renting. This is BS because landlords, who drive both sales and rental markets at the margin, are strictly in it for the money.

patriotz said...

They also think that because it is an Island it is protected from any economic down-turns.

Da plane! Da plane!

Welcome to Fantasy Island.

That place is going to get clobbered.

mohican said...

patriotz - I completely agree. What I'm describing isn't really an ownership premium - it is a densification potential premium. This is the only rational way to justify paying more for a property than the yield justifies - eg - my calculation.

In the long run there is no ownership premium as landlords would eventually sell all their rental properties because of the low yield and consequently prices would fall and rents would rise bringing things back into balance again. This is the process we are at the beginning of right now.

Robin in Vancouver said...

On Vancouvercondo.info's site this friday, it mentions that city hall has increased taxes by 5%, and will likely increase taxes again next year by 10%.

Taxes are levied based on property values, property values are influenced by tax rates. There's a feedback loop.

What do you think will be the effect of a cash-strapped city being forced to raise taxes during a property bust?

Crabman said...

Mohican,

In your excellent √úberpost, you pointed out that it is a good time to buy when mortgage payments are roughly equal to rents. This would imply that the ownership premium in Vancouver is roughly equal to the other costs of owning (taxes, maint., ins., etc)

Using this as a guideline, the fair value of your example would be more like:

{Fair Price} = [1/0.059] * [{1500 * 12}]
{Fair Price} = [17] * [18000]
{Fair Price} = $306,000


Coton,

The whole "everyone wants to live here" BS, is easily proven false. I posted some numbers a week ago on another blog:

10-year population growth rates:
British Columbia: 19%
Washington State: 21%
Arizona: 40%

Everyone wants to live where????

jesse said...

"In the long run there is no ownership premium"

Maybe in the long run there is no NET ownership premium. The arguments used by bulls around stability, the ability to control the property, and (let's face it) status DO have value and deserve a premium. However there are things that warrant owning having an opposing discount, such as the property being illiquid. Also the average monthly maintenance calculations can often be underestimated.

As you mentioned the densification premium will be less in high density however I would argue that reasons for owning having a discount and the underestimate of maintenance costs are not well understood and not necessarily accounted for properly by most homeowners.

I believe part of the under appreciation is because the discount is made up, to some degree, of low chance high stakes risks that are approximated as absolute zero (i.e. ignored) on an individual's basis. Second the process of liquidating a house tends to be not well understood and often abstracted into something more simple than it turns out to be. Third a person's "free time" used for administration and maintenance of property is often calculated at zero cost and the justifications for this can be illusory (e.g. repairing the washing machine is a hobby).

macho slob said...

Although they are obviously in the minority, some folks would be able to pay cash (from proceeds of residece and/or rental property sales)to re-enter the market at the right time.

Anybody in this situation only needs to compare rent with investment income from those proceeds. That is a very simple comparison, and so far I have had no problem whatsoever finding (fairly conservative) investments that are yielding more than what it costs me to rent my comfy and very respectable digs.

Anyway, by the looks of the inventory explosion, I might be looking for bargains sooner than I had hoped.

BobbyBear said...

Maybe we will see that 500 new listings day soon.

Strataman said...

anecedotal; walkin the dog corner of beach and richards 14 open house signs from one vantage point at the entrance to George Wainborn park. I've been living there for three years and never seen more than one at a time. This is definitely a "differant" year. There is limited parking but a few spaces were vacant. If you were looking to buy in this area you could not have gone to them all in one day even though they were all in the same four towers.My take on the lookers were they were "browsing" not to serious.

patriotz said...

landlords would eventually sell all their rental properties because of the low yield and consequently prices would fall and rents would rise

Rents do not rise as landlords get out of the business, because each lost rental unit is matched by a renter who becomes an owner.

What matters for rents is growth of total housing stock versus total households. During a housing busts, growth of housing stock slows considerably and this is what results in higher rents down the road.

patriotz said...

Taxes are levied based on property values

No they're not. They are based on budgeted city spending. Property values are irrelevant to total tax load. They are used only to apportion the tax load among properties.

Anyone who has owned a property through the last couple RE cycles can tell you that taxes went up by a single digit percentage each and every year, Regardless of which way property values were moving.

If the city has decided it needs 10% more money next year (now the Olympics wouldn't have anything to do with that would it) that's what it will get, whether prices continue to rise or there is a bust.

patriotz said...

Maybe in the long run there is no NET ownership premium.

There is no "maybe" about it. Over the long run, any asset will return - in aggregate to all owners - only its future earnings.

If you pay more for an asset than the PDV of its future earnings, either you or a greater fool are going to take a capital loss. There is no getting around it.

markoz said...

Does anyone know where I can get stats on the P/E of real estate in Vancouver over time?

mohican said...

http://langley-financial-planning.blogspot.com/2007/11/price-to-rent-ratio-stinks-in-vancouver.html

markoz - check my november 19, 2007 post.

jesse said...

"If you pay more for an asset than the PDV of its future earnings, either you or a greater fool are going to take a capital loss."

Yes, if someone truly believes there are net benefits to ownership, for whatever reason, they will take a capital loss because they receive an offsetting benefit in other ways. Either that or they're not rational.

Cynixinc said...

"Either that or they're not rational..."

...or they've been duped by a very effective marketing and sales juggernaut (banks, brokers, realtors, HGTV) into making bad investment decisions.

markoz said...

Thanks, Mohican. BTW "Real Estate Apocalypse" ... I love it! Maybe you should copyright that just like they did with all the Olympic catch phrases!

Roger said...

I just received the Vancouver Island single family dwelling (SFD) stats today and thought the readers might find them interesting. If the Sales/New Listings Ratio (SNR) is between 40-60% we have a balanced market. Here are the numbers:

Campbell River - SNR 38% (65% last March) - 6.4 months of inventory - BUYERS

Comox Valley - SNR 33% (56% last March) - 8.3 months of inventory - BUYERS

Parksville-Qualicum - SNR 34% (58% last March) - 7.9 months of inventory - BUYERS

Nanaimo - SNR 52% (58% last March) - 4.6 months of inventory - BALANCED

Cowichan Valley - SNR 47% (71% last march) - 5 months of inventory - BALANCED

Greater Victoria SFD - SNR 56% (63% last March)- 2.7 months of inventory - BALANCED

Greater Victoria Condos - SNR 54% (82% last March)- 6.2 months of inventory - BALANCED

North of the Malahat things have cooled down considerably in the last year. The condo market in Victoria is rapidly building up inventory.

macho slob said...

Thanks for those numbers roger.

What I find more interesting than anything else, is the whopping 44.3% change in the average ratio from last year.

looks like the party is ending everywhere.

jesse said...

"There is no 'maybe' about it."

patriotz, I know what you're saying and I agree, only to add that time scales for net premiums summing to zero can be generations long.

patriotz said...

That's possible of course, but the historical experience has been that the premium only lasts until the bottom of the current RE cycle. Vancouver hit rent equivalence around 2002 and 1985, and saw long periods of equivalence or better before the inflation of the 70's.

And before that there was the Great Depression, which saw a rental premium of around 100%.

scoop said...

Mohican fans, this should be self-explanatory. See below and send an email.

Agog Over Blogs

"Found any good blogs on personal finance or investing? Members of the Globe Investor team are compiling lists of our top choices and readers are invited to submit their favourites or introduce blogs they themselves produce.

"Later this month, we'll publish our lists and invite readers to vote on ReportonBusiness.com for those they think are the best.

email: rcarrick@globeandmail.com

(Mohican, I think you should start a new post to draw attention to this)

kicker said...

Roger,

Thanks for posting the Vancouver Island single family stats. I am in Nanaimo and waiting out the market so I very much appreciate you info. Please continue to post your stats as you get them.

Roger said...

Kicker

Here are some Up Island & Nanaimo stats you might find interesting:

Nanaimo Sales, Average and Median Prices fall in March.
VIREB Jan-Feb-Mar Stats

Roger said...

Kicker

Here is the complete stats package for Nanaimo as a pdf file.
VIREB Nanaimo Stats

Check the link below in the middle of every month for updates.

http://tinyurl.com/5h5oqj

BobbyBear said...

There is a distinct possibility that R/E in the U.S. will overshoot on the downside. Thus the premium on rent.

Bear markets tend to be much shorter and sharper than the preceeding bull market. At least....American style.

freako said...

In the long run there is no ownership premium as landlords would eventually sell all their rental properties because of the low yield and consequently prices would fall and rents would rise bringing things back into balance again.

You cannot imagine how times I have had to post the above. The topic comes up again and again. Usuaully because some RE "investor" argues that prices can detach from rents because of this "premium".

I have said it before, and I will say it again. The reason this bubble was allowed to grow out of control is because very very few professionals in the RE business have the competence (and/or incentive) to understand BASIC financial analysis. It's as if it has its own universe, the dumb leads the dumb. The true state of the market was identifed by financially astute bloggers, leaving a various "experts" looking like the incompetent b**bs they are. Builders. Realtors. Lenders. Economists. Heck even Wall Street blew it.

freako said...

I am in Nanaimo and waiting out the market so I very much appreciate you info.

British Columbia: 19%
Washington State: 21%


What is the connection between these unrelated comments? The insane fact that a Metro Seattle SFH is cheaper than a Nanaimo SFH. What is wrong with this picture.

patriotz said...

There is a distinct possibility that R/E in the U.S. will overshoot on the downside. Thus the premium on rent.

Absolutely. Significant rental premiums occur when potential buyers believe that nominal RE price declines are likely going forward, or when financing becomes so difficult that only the strong hands can buy. Both these factors are growing rapidly today in the US. Both were present in spades during the 30's, of course.

Can it happen (again) here? Stay tuned. Of course, a rental premium in Vancouver would mean over a 50% nominal decline. The bulls say that's impossible, of course. Well some US markets are getting close to that, and they have a lot farther to fall.

patriotz said...

If you want to see what house prices are in a socioeconomic peer of Nanaimo south of the border, take a look at

Aberdeen, WA

freako said...

If you want to see what house prices are in a socioeconomic peer of Nanaimo south of the border, take a look at

Now that really brings down the point that we have been totally desensitized to our obscene prices. Even as bearish as I am, I was startled soon as the page loaded.

And I betcha Aberdeen has actually had a runup of its own, and prices there are actually heading down.

johnnyrent said...

Freako

If you really want to get startled by pictures closer to home, check out Paul B.'s latest post.