Wednesday, June 18, 2008

Look out bottom here we come


I've enjoyed reading some of the recent comments. Thank you for participating.

I'm off for a few days so here is an open topic post to discuss the turning of Vancouver's housing market.

None of the so called experts have declared it yet but the Greater Vancouver real estate market is definitively over the hump with sales plunging, listings skyrocketing and its all downhill from here. Just wait until we get some momentum behind us.

Where will the market bottom?
Will we overshoot to the downside?
Will fundamental values be restored?
What is fundamental value?
How long will this process take?
What lessons can we learn from other bubbles bursting around the world?

I heard an anecdote yesterday of a developer who is trying to unload the last few condo units in a decent project but they just aren't selling at the asking prices. The developer is currently asking $365,000 but would accept $275,000. My question is - if they want to get rid of it so bad, why don't they just drop the ask price? Oh, I know, greed. They'd like to see if there is another greater fool out there who doesn't have the cajones to go in with a ridiculous lowball offer. If you are buying right now make ridiculous lowball offers. Developers and long term owners have a lot of margin to work with so they may surprise you and accept.

mohican out.

36 comments:

jesse said...

"Will we overshoot to the downside?"

If we don't it means the long-term average changes and we have entered a "permanently high plateau" of sorts.

Octagonian said...

Your condo developer anecdote jibes with what I discovered when surveying realtors on SFH in West Vancouver: price cuts of up to 25% are in the cards.

Historians of RE bubbles will look back at Spring '08 and marvel at the slo-mo car crash we are in now, especially in fragile areas like West Van...

Funshine said...

You know what Octagonian, there are real historians of Vancouver real estate. And these folks don't look at trends over the last few years.

Folks like Alan Artibise at UBC have considered Vancouver real estate over the years, and their work has shown, for example, that after the 1913 crash, Vancouver real estate prices didn't recover until 1945.

What made Vancouver real estate so valuable in 1913? A time when Vancouver basically didn't exist as a residential area south of 16th Ave? Speculation.

JT said...

My thoughts;

Where will the market bottom?

35% of the peak, only to shoot up 10-15% before leveling out.

Will we overshoot to the downside?

Oh ya. This market has been fueled by emotion. The only thing that's going to change is the type of emotion fueling it.

Will fundamental values be restored?

see above.

What is fundamental value?

cost of rent plus the ownership premium. In the short term, ownership will likely stop commanding a premium, but that won't last long.

How long will this process take?

I think it'll happen pretty quick. We saw price compression on the way up, but now we have $1.50/liter gas. I this will cause the reverse compression to happen faster than it might have if gas prices had stayed where they were. This may create some serious velocity.

What lessons can we learn from other bubbles bursting around the world?

Hasn't happened here yet. We MUST be different.

patriotz said...

What is fundamental value?

cost of rent plus the ownership premium


Sigh.

Fundamental value is the present discounted value of net rental income.

It has nothing to do with intangibles like "ownership premium". And BTW, investors, who determine market value because they are the marginal buyers and sellers, are not interested in the intangibles of RE ownership, any more than they're interested in the intangibles of stock ownership.

jesse said...

"What is fundamental value?
cost of rent plus the ownership premium. "


I think a lot of people confuse added utility of a property that suits an owner with an "ownership premium".

Put another way, a property with high end updates, to be profitable to an investor, would require charging a premium to rent. Many investors do charge large rents for properties with updated amenities as long as there are renters available willing to pay the premium.

Comparing SFHs with no serious updates should come with no "premium" to an owner -- these types of properties are common and charge market rents based on basic utility only, no frills. Owners may add "value" with subsequent updates and renovations and charge a premum for this value when selling. However if the pool of buyers is dried up and the rental market for such a unique property is not strong, these updates will bring little value to an investor. That is exactly what is happening in areas of California now.

JT said...

I'm not sure how exactly you would calculate ownership premium as a percentage of value, but it does exist.

If I can buy a place with zero down and command a rent that covers all my costs (including vacant months, prop taxes, repairs etc.) for 25 years, I then own the house and it has cost me nothing (minus the risk of holding).

If I rent that smae house for 25 years, I have nothing.

In a perfect model with everything held constant, ownership premium does exist and should be quantifiable. Basically rent plus x%. I skipped too many economics classes to actually do the math.

Octagonian said...

That giant sucking sound you are about to hear, is the sound of commodities-based and Chinese cabbage draining out of the lower mainland. Big stock market and credit collapse coming down the pipes this summer. Majorly deflationary. Will pull the guts outta whatever is left of Vancouver RE. West Van will look like a neutron bomb hit: the houses will still be there, just all the people will be gone. Except for the cockroach realtors. Don't take my word for it; look what no less a sobre financial house than the Royal Bank of Scotland says:
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/18/cnrbs118.xml

Sweet said...

...no less a sobre financial house than the Royal Bank of Scotland ...

Those clowns just did a $24 BILLION rights offering to make up for their subprime losses and horrific acquisition strategy. And their offices have just been raided by anti-trust regulators.

This is a definition of "sobre financial house" with which I am unfamiliar.

Octagonian said...

...no less a sobre financial house than the Royal Bank of Scotland ...

Those clowns just did a $24 BILLION rights offering to make up for their subprime losses and horrific acquisition strategy. And their offices have just been raided by anti-trust regulators.

This is a definition of "sobre financial house" with which I am unfamiliar.

What are you -- anti fun?!

They are obviously in a position to know -- once bitten, etc.,.

Plus what bank did NOT buy into the bygone boom? And anti-trust -- aren't those clowns from the same organization whose clowns inflated the money supply to goose the RE bubble in the first place?!?

Octagonian said...

...no less a sobre financial house than the Royal Bank of Scotland ...

Those clowns just did a $24 BILLION rights offering to make up for their subprime losses and horrific acquisition strategy. And their offices have just been raided by anti-trust regulators.

This is a definition of "sobre financial house" with which I am unfamiliar.


What are you -- anti fun?!

They are obviously in a position to know -- once bitten, etc.,.

Plus what bank did NOT buy into the bygone boom? And anti-trust -- aren't those clowns from the same organization whose clowns inflated the money supply to goose the RE bubble in the first place?!?

Sweet said...

They are obviously in a position to know -- once bitten, etc.,.

So by that logic, the "sobre financial house" we should pay the most attention to is Bear Stearns, since they got the nastiest bite.

:-0

Seriously, this makes about as much sense as the bulls quoting the NRB as an authority.

Gabriel said...

deflation, unlikely.

If Central Banks chose between inflation or deflation they'd choose inflation.

Most of the tame inflation that we witnessed in the past 15 odd years was because of globalization, that shifted labour to low wage countries. As you see their cost of living rise, you're going to see inflationary pressures on products we buy. If you look at CPI in asian countries a larger proportion of it is in food. So, crop yields are most important. Poor people switch diets as they get richer to meats and it's a 1:10 ratio approx depending on what type of grains to meats. China also doesn't really produce things, they're more of a assembly plant. So, in other words most cost savings is labour only.

If you've even been to China, the projects going on there is immense. They're trying to build a road network similar to USA. I was there for a month. I rode the train from beijing to shanghai to Chengdu and the amount of roadways, bridges and train tracks, tunnels... good luck seeing that economy dieing off in the next 5 years. You don't go from a growth rate of 11% to nothing in a year, that's with China forcing banks to have a 19% tier 1 ratio.

If there is a chance for deflationary pressures, I sure didn't see it in that article.

jesse said...

"If I rent that smae house for 25 years, I have nothing.

Of course your landlord has something. He has something by charging you rent that is paying off his mortgage or going into his pocket.

In a perfect model with everything held constant, ownership premium does exist and should be quantifiable. Basically rent plus x%."

This means an investor in the same property must, like you, carry rent + x% but can only take in rent. He loses x% every period.

patriotz said...

If I can buy a place with zero down and command a rent that covers all my costs (including vacant months, prop taxes, repairs etc.) for 25 years, I then own the house and it has cost me nothing (minus the risk of holding).

It cost you the compounded value of the principal part of all of your mortgage payments. Remember the principal part of the mortgage payment, which results in the house being paid off in 25 years, is savings, not an expense of ownership.

This may be more, less, or the same as the market price of the house at that time.

patriotz said...

I will add that if the tenant is also paying the principal part of the mortgage payments, plus all ownership costs, the house has indeed cost you nothing.

The reason is simple - the price you paid was less than the fundamental value of the house. Buy any asset below fundamental value, and you really do get a free lunch. The problem is that fundamental value can only be estimated, not known exactly, wbich is the reason why there is a risk premium.

joycer said...

Interesting report comparing Canada, US, Australia, and UK housing. If you hadn't guessed, we're quoted as being "severly unaffordable" in Vancouver.

http://www.demographia.com/dhi-ix2005q3.pdf

JMK said...

The problem is that fundamental value can only be estimated, not known exactly, wbich is the reason why there is a risk premium.

I agree. But what should that risk premium be for residential properties in Vancouver?

A couple of times you and jesse have claimed that a cap rate of 8% is appropriate. That's like a before-inflation return of 10-11%. i.e. 6-7% more than a treasury bond. Are the net returns from a rental property really that risky?

If you are insured all that can happen is depopulation of the city you buy in, driving vacancies way up. The risk of that happening in Vancouver seem pretty low to me. Migration has been from the heartland to coastal cities for a few decades now - do you see that reversing? What else am I missing that makes you and others here assign such a large risk premium?

patriotz said...

A couple of times you and jesse have claimed that a cap rate of 8% is appropriate. That's like a before-inflation return of 10-11%

No, I said a nominal rate of 8%, not real. I never talk about real yields nor do most other people on this board as far as I know, altough I do talk about real total return. But when I mean real, I always say real.

8% gross yield is a price/yearly rent of 12.5 and a price/monthly rent of 150. That's towards the high end of historic multiples, so 8% gross yield is towards the low end of historic yields.

And yes I would buy at that multiple.

Traciatim said...

Hey Joycer, that's a nice report. I really like that my city in Saint John, NB tied for 5th most affordable.

The problem is for May 2008 the CREA lists the average sales price for my city going up 22% YOY. It was probably a great time to buy two to three years ago, I purchased last year at an OK time, and in the next year or so things will get skewed as the price to rents go out of whack at this rate.

Lets put it this way, last year I purchased my 1152 sq ft bungalow for 102K (List 119K, Tax Assessed 113K). This year a home down the street of near the same design went for 130K (List 144K, Assessed 115K) and now my next door neighbour is attempting to sell a very similar design (List 139K, Assessed 97K).

The reasons for the increase are a pile of large construction projects attempting to make the area an energy hub. These include an LNG plan, LNG pipeline, New Refinery, Nuclear plant expansion, possible new nuclear plant, possible new high rise in town core, and Potash mine expansion. Of course, after the 6 years of the major boom in construction a lot of the workers will be leaving putting a pile of housing on market all at once . . . I'm starting saving now just in case ;)

JMK said...

A couple of times you and jesse have claimed that a cap rate of 8% is appropriate. That's like a before-inflation return of 10-11%

No, I said a nominal rate of 8%, not real.


Real estate is a "real" investment. If the price of your home goes up with inflation and your rent goes up with inflation, an 8% return rate today is going to be a real return, not a nominal one. You will get an 8% return rate in tormorrow's dollars and your capital will increase with inflation. That is the definition of a "real" return. Your expected return is the equivalent to a 10-11% bond (for which neither the return nor the capital increase with inflation.)

You can claim historic multiples are whatever, but I've not seen those for Vancouver, and I have no idea if they have been constant with time. It doesn't change the fact that you want a really high yield for real estate.

joycer said...

I think the report is good because it comes from NZ so they have no vested interest in pumping up or down our real estate. The data is a bit out dated though, according to Paul B's site the most recent REBGV median prices (weekly data) would be around $700,000. The median of income of $60,000 puts us at a ratio of 11.7, the highest on the list of all major cities in the US, Canada, UK, NZ and Oz. In the mean time the US prices have also fallen so I would assume their ratios have also dropped. Vancouver sits head and shoulders at the top of unaffordability worldwide. No wonder Robert Shiller calls Vancouver the most bubbly city in the world.

VancouverGuy said...

"A couple of times you and jesse have claimed that a cap rate of 8% is appropriate. That's like a before-inflation return of 10-11%"

I think his problem was with the statement that this is a before-inflation return of 10-11%. It's a post-inflation return of 10-11% if your rent increases with inflation and you assume a perpetuity or thirty year investment or something like that. And that's return on all capital employed, not an equity return. Your equity return would be pretty good, depending on your cost of debt. With a cost of debt of 7%, rent inflation of 2%, and an upfront cap of 8% you would end up with a 14.2% equity IRR.

I do think that he meant a gross rental yield though, not net of costs, so the return would be a fair bit lower than that. It would be about 11.3% if we made it a 7% all-in cap instead (net of costs).

Is that reasonable? 430bps premium over your cost of debt given 75% leverage and taking all risk on value retention over the long-term? Housing has beta a fair bit lower than one I would say, but your leverage is higher than on comparable investments and you are concentrating your risk and not diversifying it at all, so it would not be a tough argument to say that's a reasonable rate.

JMK said...

Sorry if I got the terminology backwards - by "before Inflation" I meant by "before inflation is taken into account".

Does the cost of borrowing enter into the calculation of "fundamental value"? Clearly no one would pay 7% interest to borrow to buy 4% treasury bonds, so I think you are confusing matters (or at least me) by discussing leverage. Interesting topic, but tangential to determining what a house should be worth based on future incomes.

However, when you say it costs 7% to borrow, are you factoring in predicted future rate increases? Otherwise it is about less than 5.25% for anyone with decent credit and a good downpayment. Even the advertised rates are only 6%.

patriotz said...

It doesn't change the fact that you want a really high yield for real estate.

Nonsense, 8% gross yield on RE is not "really high", in fact it's quite low.

Before the recent bubble era, price/monthly rent fluctuated between 100 and 125.

You also seem to have a problem with defining yield. Yield is simply the monthly or yearly payout (gross or net) divided by the market price of an asset at any given time. Growth of payout or market price over time is factored into total return over a given period.

JMK said...

yes thank you - I meant the total return you want is really high. Equivalent to an 11% return on a bond.

jesse said...

"If the price of your home goes up with inflation and your rent goes up with inflation, an 8% return rate today is going to be a real return, not a nominal one."

Perhaps, should you want to explicitly factor out inflation-adjusted cash flows, a fair comparison would be to an inflation-adjusted bond.

Yield is a proxy for relative value but patriotz and others are right that it's the future cash flows that are important, not necessarily current yield.

Interesting discussion.

jesse said...

It's worth noting that rents on a same property cannot increase with inflation due to depreciation. Also real rents have been falling for a generation.

JMK said...

You can account for depreciation however you like. I'd assumed that was what you have been calling "net" rent.

However, rents themselves can increase with inflation or even faster, even if the building is depreciating, due to densification. In the last few years rents have been increasing 5% a year in Vancouver, significantly faster than inflation.

If indeed real rents have been dropping (though I'd never heard that) the reason may be that home ownership has been increasing. If renters are predominantly composed of the poorest workforce real rents will drop. A lot more people own condos now than 20 years ago, and presumably a large proportion of those would have been renters before the cheaper home ownership option was available.

If you are discussing real rents in Canada, then I expect another part of it is that rent data is collected by the CMHC from commercial apartment complexes only, and there have been very few of those built in the last 30 years. Newer, better quality rentals tend to be in condos. In fact, many of the nicer apartment buildings have been turned into condos in the last 15 years.

jesse said...

"rents themselves can increase with inflation or even faster, even if the building is depreciating, due to densification."

I urge you to compare rents in a new building in Yaletown to a 30 year old unit of similar size in the West End and let me know which one is higher. Same densification, different price.

VancouverGuy said...

JMK,

You're right I should have been using 6% or something, which is the current 5-year fixed rate mortgage available from TD. It's interesting that on the same page they list their 5-year closed mortgage at 7.15% and say the 6% one is a special offer.

Cost of borrowing factors in if you are looking at equity return requirements for a levered project.

Be careful comparing debt returns to project returns. A bond is not an appropriate, unlevered comparable, because it has preferential treatment in terms of cashflow and security, and so the owner of the bond is not taking risk on variance of cashflows unless they drop below a certain level. Banks are essentially saying that the risk of a preferential interest in a home is 6%, and that's only for five years; you are taking project risk for the whole life. If we said that the WACC was 7.5%, then our required rate of return on equity would be 12.0%. This makes the numbers I was saying were a reasonable equity return look fair, and you can see how a small change in the WACC would leave you with a higher equity return requirement. Generally, my mind thinks in terms of the levered equity return requirement for a project, because except in certain situations we are always investing equity where I work.

At 10-13% you're looking at housing risk as if it's a levered utility kind of project. Regulated utilities get guaranteed rates of return on their invested capital... I think as an undiversified investment, and taking all the risk personally on the structure, that you would need at least that rate of return. If you are investing in a portfolio, then maybe your return of return could be at the bottom end of that, but taking individual risk on a single structure... not so sure about that.

Is the 7.5% a reasonable WACC for the project if we are looking at it on a project basis? 10-yr BBB corporate spreads were something like 250bps on average over the past couple of months. If we just added that to the 30-yr GCAN rate (because I can't remember what the 10-yr BBB spread was, but I can look up the 30-yr GCAN), you end up with 6.7%. Pretty much at our WACC, but for a debt security on an investment grade corporation..... says the 7.5% WACC is too low.

A 7.5% WACC, by the way, is about equivalent to a 7% cap rate with inflation if you are required to amortize your debt over thirty years. The Project IRR is 9.0% of course, as you would expect with a 7% project yield plus 2% growth. In situations where the proportion of debt and equity does not stay the same over time, WACC is less than Project IRR.

JMK said...

Vancouverguy,

Thanks for the commerce lesson - I'm learning lots of interesting terms (mostly by flipping to investopedia)

If indeed the WACC is a useful way to evaluate leveraged return, and it seems like it is, then a 75% leveraged investment is extremely sensitive to what you choose for the WACC. For instance if I use 6.5 for the WACC, only 1% less than what you are suggesting, I get a required return on equity of 8%, a full 30% less than yours. If we assume 3% inflation, that's a 5% cap rate.

This exercise is a very nice demonstration of why leveraging is problematic. The required return on equity to make a given WACC goes up rapidly the more leverage that is used.

patriotz said...

In the last few years rents have been increasing 5% a year in Vancouver, significantly faster than inflation.

According to this source, they haven't been increasing by even half that:

Take a look

Note the increases have been even lower than allowed by rent controls, so you can't blame that.

If you have better data, I'd like to see it.

JMK said...

I don't know if its "better", but CMHC says 4.6% 2007-2008 http://www.cmhc-schl.gc.ca/en/search/search_001.cfm and type in "vancouver rents" to get the pdf report.

I then looked at the data on cansim for Vancouver and got 4.2% for 2006-2007 (the version of the db I had access to did not have 2007 available). UBCs numbers must be for the whole CMA? UBC don't say where they get them, except from cansim, so who knows what they are doing? Its possible they are downloading the inflation-adjusted numbers and then adjusting for inflation again.

Anyway, I slightly exaggerated with 5% - which is Victoria's number. I'd assumed the big city would be similar.

JMK said...

BTW, cansim gets their data from cmhc, so the two should agree.

patriotz said...

I don't know if its "better", but CMHC says 4.6% 2007-2008

That's just the last year.

Given the high amount of construction due for completion in the next couple of years, not to mention the upcoming recession, I don't see that figure holding up going forward.