Monday, July 14, 2008

What to do?

It is clear that home prices in the Vancouver area have only just begun their downward descent with the Fraser Valley leading the way. It seems that developers are catching on quckly to the notion that they must provide steep discounts to move their product now and private sellers are slowly catching on to the same fact.

Now here is the background for my question:

I have found a home for sale that would likely meet my criteria. My criteria is this:

1) Walking distance to grocery store and other shopping (10 minutes or less). Preferably a rec centre as well.
2) Within 5-10 minutes drive to work. Preferably walking distance.
3) Does not need any major repairs or updates.
4) Price must meet pricing standard as follows:
Fair Price = {[1/(5 Year mortgage rate)*100] * [Annual Rent (estimate) - Annual Strata Fees/Maintenance - Annual Property Taxes]}

This is how my formala works out in this specific case:
Fair Price = (1/5.7%*100)*(19,200 - 2,000 - 1,500)
Fair Price = 17.5 * 15,700
Fair Price = $275,378

The asking price is higher than the current fair price but I'm fairly certain that I could get my fair price in the next couple months if conditions stay as they are. The price was just reduced 10% so it popped onto my radar.

But here is the question: Should a person purchase with the full knowledge that the property they are purchasing will likely fall in value even further? Why or why not?

I am personally comfortable with the risk of further price declines as long as the fair price criteria is met but I may not be the norm. I will also be purchasing with a 30-40% downpayment and well below my affordability level as the lenders see it so even temporary job loss wouldn't be a major issue.

21 comments:

Ryan said...

I can't imagine spending that much money on something which is currently overpriced and virtually guaranteed of dropping. If you decide to buy an iPhone rather than wait for a price drop, you're paying an extra $50 or $100 for your lack of patience. Not chump change but still not a life altering expense.

If you buy a house early, you're talking about tens or even hundreds of thousands of dollars. That very much is life altering. You're talking about years worth of mortgage payments, or maybe a new car or early retirement.

If it's your dream house and you may never see one like it on the market again, then maybe it would be worth over-paying. But if it's just one of many that meets your requirements for consideration, why buy now? Is owning a year or two earlier worth five or more extra years of working?

mohican said...

The price was just reduced 10% from asking and 7-8% below recent comparable sales and in order for it to meet my criteria it would need to come down an additional 7-8% and then it would definitely not be 'overpriced' in my view since the ownership costs would be lower than renting costs. I would be effectively saving money every month.

Ryan - You bring up an interesting point though and that is timing. Can we be succesful at timing the bottom of the market? I am not very confident that I am able to do that although I timed the top damn near perfect. I have generally held to the view that I would buy when I found a home that met my strict criteria. That said, we are in no rush to buy and we will wait and shop around before making any buying decision.

johnnyrent said...

Mohican

I don't think one can ever absolutley time the bottom of a market except through sheer luck. I certainly didn't time the top right when I sold my home at the end of 2005.

With our decision to sell beginning to look like it might be vindicated, we're targeting buying back in during the first quarter of 2010. I don't think that will necessarily be the bottom but I do think there will have been enough of a correction to render prices half way acceptable from totally absurd. In any event it will likely be our final resting spot so short term minor depreciation won't be an issue.

If you're buying for the very long term you'll be fine if you buy now when all is said and done but I'd wait a bit. Relative to the whole buying and selling public, only very few are aware of the degree to which things have changed. The market is still very much in the denial stage. Although inventory is way up and prices are flat or going down, the rush to the exits hasn't really started yet. There is in my view a lot more correction to come so unless you have some other pressing reasons to buy now, you'd want to avoid catching a falling knife.

Ryan said...

~20% off current prices makes it cheaper than rent? Wow! That's not what I'm seeing around here. 7% is still about $20,000 on a $300,000 house, though, which is nothing to sneeze at.

As far as timing the bottom, I don't think it will be that hard. I don't foresee a sudden jump in prices after the bottom, I expect a long flat hangover before our next boom. You might miss the absolute bottom statistically, but I would expect a buyer's market for a while after, not a sudden return to the bidding wars and first-day sales of the past few years.

I also wouldn't be at all surprised if we see a drop in rents as unsold condos come onto the rental market and unemployed construction workers move away. It happened in some areas of California. If your calculations are based on rent equivilents, the target moves if rents change.

jesse said...

Two things to keep in mind are that owners invariably underestimate the costs of owning versus renting, both in time and in materials. I would be so bold as to suggest that you include time spent on repairs in with material expenses as part of your expense calculation. Remember we are comparing to landlords that do put a value on time.

Further to this there is the "nickel and dime" trap that invariably eats up more expenses than you think. I would put a fudge factor into the expense calculations to account for all the small items that may not get a line item on a budget.

Remember to compare apples to apples expenses with what a landlord would pay for a similar property. All luxury add ons (like landscaping, flooring upgrades, etc.) should not be included unless you are directly comparing a property for rent with these luxuries.

Second, and we have talked about this before, the 5 year mortgage rate is a bit low by 1-2% compared to a calculation that would be used by a landlord. It all comes back to a same property must make a landlord a profit so an owner would receive a discount.

Personally I would hold out for more.

RentingSucks said...

Could we possibly time the bottom? It's been a few months now of rising inventory signalling a top. It was pretty clear this spring was different and if you were watching the stats everyday you would know. We have access to data that very few people have ever had in history. We have the US to guide as as well (will we still be 2 years behind their recovery). We've also seen how a big runup starts and ends. Won't we be able to see the signs next time?

Make It Fit said...

Mohican, in my view, owning a house near work, public transit, schools, and stores within walking distance at a cost equal or less then renting is very good strategy for minimizing costs of living and maximizing time value. Go for it.

siMonster said...

Wow, we have the same criteria as you... and have been living in Toronto, looking to move to Vancouver for the last 4 years.

Correct me if I'm wrong, but its impossible to find something in Van East at that price, right? (under 300k)

VancouverGuy said...

We can also examine a numerical answer based on comparative risks and returns.

Under the scenario that you outlined, and based on inflation at 2.0% (I believe this is a reasonable estimate of inflation after the first couple of years), and rents growing at inflation (potentially an aggressive scenario given your asset depreciating), you will be earning an 8.9% post-tax return on your investment relative to renting (renting is not tax-deductible, and therefore the foregone costs are also post-tax). If you were an investor, you would be earning an 8.9% pre-tax return instead (because your earnings would be taxable).

If we assume that you have a 25% average tax-rate, then this is the equivalent of about a 11.8% return on an income (not dividend) producing asset. It's lower is you have a lower average tax rate. That's the tax rate for someone who makes $75k for next year in BC. This is the equivalent of an 8.3% return on a dividend paying corporation for you. Why only 8.3%? If we assume all of your income is derived from dividends over time, then you should actually get a tax benefit from the dividend because your tax rate would be below the corporate tax rate.

So what can we compare that to? Utilities are supposed to pay something like 8-10% on equity over time on a dividend basis.

Some of the power trusts are trading at massive yields at this time (which are on an income basis right now). For example, MPT trades at a 14.8% yield. That is not return, but yield.

How about some banks? RBC yields 4.8% right now. CIBC yields 6.8%. Their long-term returns should of course be a fair bit better than that.

The market long-term historical return has been better than that (I can't remember the number off the top of my head).

So what are some sensitivities we can run on your return?

If your horizon is cut to 30 years from 60, your return goes down to 6.3%. So if you are in a condo and it has shoddy design, your return gets hammered.

What if cost of finance suddenly got a lot more expensive than 5.7% and stayed that way? At 6.7% your return goes down to 8.2%. Not that terrible.

If rents went up at 100bps faster than inflation, you would do well with a rate of return of 10.6%. Similarly, if it went up slower you would do poorly versus your rental alternative, at 7.2%.

If you had a one-time major repair of $30k halfway through you would go down to 8.3%.

So is your home a higher or lower risk than regulated utilities, which are priced at around the same return? Regulated utilities get a fixed government rate of return. They also get that return on a lower gearing assumption, which means their levered equity return would be higher than yours. On that basis, I would say you need a higher rate of return.

What else can we think of? I would think that the marginal investor is going to be an investor, and so on that basis I would say their return on a pre-tax basis would also have to look good. They look terrible at the rate you're buying at, because that 8.9% becomes 6.7% post-tax, or you could examine it relative to the bond yield and say 500bps of premium relative to the cost of risk-free debt is insufficient (it is for an equity risk like this).

What else? Your risk is an undiversified risk representing a massive portion of your wealth. As a result, and because you cannot diversify that risk away, you should take into account the massive personal wealth variance you face entering into the investment. This would make me say that it should be priced at a premium to your alternative investments that would be a comparalbe risk on a diversified basis.

Everyone else talked about the price dropping aspect of it, but from just the discussion above, I would say that you should not purchase. It's a massive, undiversified risk not giving you a premium to alternative investments with similar or better risk characteristics.

macho slob said...

Moh, as a financial guy, you're obviously confusing difficulty of timing the stock market with the housing market.

The stock market is constantly adjusting to crosscurrents generated by sophisticated investors with diverse strategies and anticipation. The housing market, which is mostly driven by idiots without any ability to recognise economic fundamentals is an entirely different beast.

After years of irrational insanity, all the ducks are finally in a row for a massive correction, and it's way too early to even think about pulling the trigger.

As for 5 to 10 minutes away from work and shopping, I hope that's not an attempt to economize....with the discount you'l get in another year or 2, you can afford to hire a limo to get you there.

Luc said...

If you won't buy it, I will. Where is it, where? Give me a hint please.

Luc said...

(press Publish too soon)
You're saying that a house which rents for 1,600/mon. would sell now for $300K? The rent seems too low.

patriotz said...

How about some banks? RBC yields 4.8% right now. CIBC yields 6.8%

That's the dividend yield, which is just the amount of after-tax earnings which are paid out in cash. Earnings belong to the shareholder whether paid out as dividends or retained.

The proper comparison is the earnings yield, i.e. E/P which for CIBC is 15%.

Makes you see how utterly dismal earnings yield for RE is these days.

Agree with macho, you can't get a good price on anything when you're competing with idiots, and you only get the idiots out of RE at market bottoms.

VancouverGuy said...

True, that's the cash yield, not the earnings yield. Yet EPS of banks is seen as somewhat questionable at the moment because of potential for large losses, whereas cash is cash. The great thing, maybe, about cash yield of banks right now is that normally it is less than the 10-yr treasury yield, whereas right now it is a multiple of the treasury yield.

The great P/E is why I was super long the financial index a few months ago... and have subsequently lost money. And super long CIBC, too. I've been hammered on that one as well. Contrarian thought would say now is the perfect time to buy bank stocks, because they have been hammered even more and have great yield... but then again there is potential for defaults to rise all over the place, so the correction to the current P/E of the banks might be in an earnings drop, not in a rebound of the ratio.

mohican said...

Great comments and very insightful.

I am not planning on pulling the trigger anytime soom in case anyone is worrying! I doubt that the developer would accept my offer right now anyway. They need to feel more urgency before it meets my current fair price criteria.

A couple comments about the property in question: it is in the Fraser Valley, it is a townhouse, it is brand new, it would easily rent for $1600 / month and have a fairly low vacancy rate, it is about 2000 sq ft, 500 of which is an unfinished basement. All in all a fairly attractive deal, considering it is under warranty and would need very little work at the outset. The developer would probably balk at $275,000 which would be my highest price offer today if I were actively looking.

Some comments about the comments:
1) I may be budgeting too little for maintenance but I may revisit that later.
2) I am not fairly considering opportunity cost in my calculations. I assume opportunity cost is the 5 year mortgage rate. Perhaps it would be better to use the 10 year rate or the 5 year posted rate.

vancouverguy - I like the way you think - looking at it in terms of alternatives is compelling. A comparison to the P/E ratio of stable corporations would be a better measure of opportunity cost. The point made about diversification is one of my biggest concerns with any potential real estate purchase and one that I don't feel I'm adequately compensated for in potential return right now.

macho slob - the 5-10 minute thing is something that my wife and I have decided for lifestyle reasons not to save money. Frankly we could afford to drive to the store every day but it is a big waste of time and we enjoy going on evening walks as a family to pick up our groceries. It is also better for our health and the environment.

jesse said...

vancouverguy, your method seems technically correct but most people looking to buy versus rent will not have your level of sophistication when it comes to making the decision. I like mohican's simple model for that reason, if nothing else to give some number, maybe not perfect, by which someone will not make an extremely poor financial choice.

I think your logic for what is a fair return on RE is good. Are you suggesting augmenting mohican's model or leaving it the way it is?

VancouverGuy said...

I have my own excel model that I use to determine the fundamental value of real estate. Because I am a financial modeller by trade, I like to model everything out and examine the cashflows and sensitivities (and I have a lot of context for returns for different types of businesses). The real question then is what is a reasonable rate of return, and is the marginal purchaser an investor or an owner. Because of the tax implications (you are foregoing after-tax rent expenses), the relative returns are better for an owner, but the return requirements should be lower for an investor because theoretically they will be diversified. I'm not sure that most owners really examine the diversification impact... which I personally think is a huge oversight.

So what is a reasonable rate of return for a REIT? According to Canadian Capitalist, returns from 1978 to 2003 were 12.0% where inflation was 4.5%.

http://www.canadiancapitalist.com/2007/07/25/reits-risks-and-returns

http://www.westegg.com/inflation/infl.cgi

So that would say a kind of 10% rate of return for an investor would be reasonable in today's inflation environment. Your return requirement should be higher if you are undiversified of course, but then you can adjust it downward to get the equivalent return for your tax advantage.

I think on a diversified basis that's probably reasonable. A slight premium to regulated utilities... just below the targeted return for highly-levered infra investments...

My original thoughts were always that the minimum required return should be 8% and something like 10-12% would be preferable.

condohype said...

I like this discussion about financial modeling and the need to consider diversification when investing. A lot of new buyers may have made different choices if they bothered to consider the opportunity cost of their real estate buy. The idea that real estate is the only way to build value is nonsense. The hype machine has been very successful in describing renting as "throwing money away" when, in fact, it opens up opportunities for diversified and, dare I say it, better performing investments.

patriotz said...

Paying money for rent is no more "throwing away" money than paying for any other needed or desired service.

Paying more in financing costs than the rental value of a property is throwing money away. It's like borrowing money at 6% to buy a GIC yielding 3%.

Warren said...

mohican,

No doubt timing can be difficult. I'm also sure you are not making this decision alone. If your spouse is pushing to own because of your family, that can be a big pressure. Once buying becomes cheaper/equal to renting on a monthly basis, your main argument against buying is gone. Although signs say that prices may drop further, now you are in the position where in fact you are "throwing money away" by renting and the decision becomes a lot harder.

However if its the perfect place for you, why not? By your comments it appears the price is already down 20% or so from "peak", and you're looking at buying it after another 10% off. That's not at all unreasonable. I think many of the areas I'm looking into would require real consideration if I knew I could get in at around 30% less that the peak price.

jesse said...

"Once buying becomes cheaper/equal to renting on a monthly basis, your main argument against buying is gone."

You can see the return required for a rational and diversified investor to make money in real estate. Prices have to come down a lot more for owning to be TRULY cheaper than renting. Back of the envelope doesn't cut it with such a complex purchase.