Tuesday, August 19, 2008

Mohican Buys House

Yes it is true and here is how it happened.

Me, Mrs Mohican, and Baby Mohican are expecting another addition to the family soon. We don't have enough space for the new baby in our current rental unit and we were considering our options. We were looking at renting a reasonable suite or townhouse as a first option since we don't like the prospect of spending more to own than rent and we especially don't like the value of our property dropping before we even move in.

The rents for the places that would be suitable ranged from $1400 to $1700 / month and the quality range was dramatic. Suffice to say that for me and the Mrs to be happy, we would need to spend $1600 / month to rent a suitable place for a family of four in the Fraser Valley. We would also have the prospect of moving again once we found a suitable place to purchase and we didn't really like the thought of moving with two small children.

The question then came up, what could we purchase for the same amount of money? Here is the formula which you may be familiar with by now:

Fair Value = 100/(5 Year Mortgage Rate) * (Annual Rent - Taxes - Strata - Maintenance)
Fair Value = 100/5.35 * (19,200 - 3,200)
Fair Value = $299,000

So the question became, can we find something to purchase that meets that criteria? The answer, as you've probably figured out by now, is yes we did. This would have been impossible even 3 months ago as we found a brand new unit available from a developer who was trying to unload the last unit in the complex at nearly 20% off the last sale price (May 2008) and more than 20% off current listings in the development. They had several offers fall through due to others being unable to remove subjects (sale of own home) and they were very willing to consider our lowball offer. We came to an agreement at well below the Mohican Fair Market Value and the deal was done.

We are comfortable with securing a residence which costs us less per month than renting an equivalent unit. We are also cognizant of the fact that our residence will likely fall in value over the next few years, a loss that is compensated for by not having to move again and the fact we are paying less than rent to own our new home. Some solace also comes from paying $50,000 less than my neighbour did for a similar unit only three months ago. Additionally, we have a 10 year mortgage payoff plan. The plan is quite realistic so although our Loan to Value ratio is low (60%) to begin with it will decline very quickly toward zero.

I still believe that prices will likely correct 30% to 50% from peak pricing and that some areas and housing types will correct more than others. I have never been tied to the idea of buying at the perfect 'bottom of the market' so I am free to rely on my cash flow / opportunity cost metrics instead or market timing. I am comfortable buying a home for personal use using the formula above but buying an investment property is another issue. We can examine that further at a later date.

32 comments:

Van Housing Blogger said...

Let me be the first to say 'congratulations.' It is apparent to all that you did your maths, checked your gut, and are going in with eyes open.

I wish you well with your new home and soon to be larger family.

the pope said...

Congrats Mo! Glad you found the right place for the right price and wish you best of luck with the move and new addition to your family!

I'm guessing your new neighbors won't want to talk too much about the deal you got in comparison to what they paid.

arit said...

Congratulations Mohican!

We were actually discussing the same exact situation in Rob's blog two days ago.

I am glad that your metrics worked.

Good luck with your new house and let us know when is the house warming party, in bear suits.

Best regards,

arit

mohican said...

Thanks, we agreed to not tell the neighbours what we paid. I'm not a spiteful person and healthy neighbourly relations are important. We will just tell them that 'we feel we got a fair deal.'

I was actually very surprised that we were able to get 20% off peak pricing so quickly but I think these deals can be had for a buyer who is prepared to be aggressive, get their numbers met, and be prepared to walk away. The last comparable sale (my neighbour) in the 'hood was $50,000 above what we paid.

My realtor was reluctant to take us on as a client because he felt we were being 'unrealistic' and, although he was happy for us, he was shocked at the deal we got.

arit said...

It is pretty amazing still. Last week we saw brand new 4bdr Townhouses here in Richmond for 600,000. I do not know where you bougth, but HALF the price??? Half???

Something is very "fishy" here, and I suspect those 600,000 numbers will start "stinking" pretty soon....

Best regards

arit

Etienne de Cochon said...

Congratulations Mohican!

Etienne de Cochon said...
This comment has been removed by the author.
exx said...

Congrats! According to your formula, the fair value of the place I want in Port Moody should be $264,000. Currently selling for ~380K. Sigh...

jesse said...

Congratulations on the new upcoming addition to your family. Back to sleepless nights for a while I guess ;)

Your alternative of buying what you can afford and not spending extra for unnecessary features seems the next best alternative to waiting for a bottom. When #3 and #4 come along you'll have the ability to upgrade if necessary!

Your story is testament to how negotiable prices can be if you keep your eyes peeled. Don't ever be afraid to throw some offers in the dirt.

jesse said...

"let us know when is the house warming party, in bear suits."

I'm not sure mohican is technically a bear anymore. Maybe in spirit. A spirit bear?

mohican said...

Actually jesse, we got everything we wanted. We aren't big fans of granite so we were happy to see it wasn't included but the finishing is quite nice, the location is great, and it is way more space than we need (2000 sq ft) so there is lots of room to grow.

I was short the market for one year and I decided to cover because the fundamentals made sense. I sold my 800 sq ft 15 year old condo for $200k and bought a brand new 2000 sq ft townhouse for $285k. My short position was extremely profitable in my view.

I am still bearish on the market and I am still anticipating the upcoming big price drops for the market as a whole. I fully expect that place in Port Moody that exx wants to be available at or below his price within 3 years.

jesse said...

"Actually jesse, we got everything we wanted."

I've been reading your blog since you started it and I am sure for you this is true. For some -- and no doubt many regular readers here -- there is a definite pull between need and want. There is no limit to how much you could spend on real estate, should you have the means.

mohican said...

Yes, you can spend limitless amounts of money on real estate if you have the means.

An interesting feature of the top of the market is that the biggest fads (granite, hardwood, stainless steel) demand the greatest premium and the highest margins for the builders. Builders are very effective in the extraction of extra dollars from unsuspecting and emotional buyers.

I have a co-worker who just came into my office boasting about getting bamboo flooring and granite countertops installed in place of the completely adequate materials in place already. This co-worker earns a fraction of my income but feels entitled to these features in his/her home. I find this baffling.

Radley77 said...

Congratulation Mohican! I wish you and your family the best in your new home.

I bought under eerily similar situation with a developer earlier this year. 'Twas a developer eager to sell, lowball offer, and did lots of similar calculations.

I've really enjoyed reading your blog and hope you still have the chance to update up the financial planning aspect of your blog (between diaper changes perhaps :) ).

GOod luck again in your new home!

Metaldwarf said...

Congrats Mo.

A question about your formula
What figure do you use for expected maintenance costs?

Where did you pick up the nice mortgage rate?

mohican said...

metaldwarf - I only included a minor amount for maintenance because all exterior maintenance is covered by the strata fees and the home is brand new so it needs zero upkeep for the first few years. Over time the maintenance will increase although I assume the strata, rent and taxes will also increase bringing me to the same net rent number at the end of the day. These assumptions are yet to be proven and actually may prove to be false, in which case I may have overpaid.

I could make my formula more complex and elegant to account for inflation and depreciation but I have opted for simplicity since I'm not sold on the benefits of the complexity right now.

I work for the bank so I get a good deal on my mortgage, although it isn't too far off what you could get through a good mortgage broker.

jesse said...

"Over time the maintenance will increase although I assume the strata, rent and taxes will also increase bringing me to the same net rent number at the end of the day."

Expenses will tend to outpace inflation where rent will tend to lag inflation. From what I've read, this is approximated by choosing an appropriate denominator in your calculation. If your property stays well maintained it could be the denominator you have chosen is reasonable.

VancouverGuy said...

"Rent will tend to lag inflation where costs will exceed inflation."

Not an exact quote, but the gist of what you said Jesse... Rents have historically lagged inflation, but I would not rely on historical results. Yes, everything is based on supply and demand; however, in a system where population is growing and as a result new rental housing (and replacement rental housing) is required over time, rental rates and replacement costs must trend toward a level that supports the replacement of rental housing by an investor.

Right now, I am sure no one is building rental housing, because you wouldn't make any money on it. But at some point people will have to build rental housing and replace the existing rental stock. Rental rates will have to move to a rate that makes that reasonable given a certain level of construction and land costs. That doesn't mean current construction costs necessarily, where a tight labour and materials market makes costs unreasonable.

Fundamentally, however, if incomes in BC have gone up in real terms (they have, even though wages have not), whereas rental rates have dropped in real terms, then there is room given current incomes to increase real rental rates in order to compensate for increased construction costs without just a decrease in land values. As I said, I don't mean relative to current, inflated levels, but I do mean long-term.

If there is a significant over-supply of housing because people over-built, this won't happen. So you may be right in the short-term that rent will increase at a lower rate than inflation. And, given that there should be a recession in BC, that would also support this hypothsis. But long-term, I just don't believe that rental rates can increase at less than inflation if they are essentially reliant on labour-intensive construction and interest rates as the major cost inputs unless incomes do not keep pace with inflation. That would be a completely different scenario though.

jesse said...

"So you may be right in the short-term that rent will increase at a lower rate than inflation."

I won't argue the macro arguments you are making but a same property will generally have falling rent compared to the average because it ages.

VancouverGuy said...

Yeah, I've never looked at how that works at the micro level, so you're probably right.

It's interesting, some hard assets are priced based on replacement cost, so the income stream from an old double hull barge should be equivalent to a new double hull barge all other things being equal. But I suppose the utility people derive from housing decreases with age, so there should be a pricing differential.

that guy said...

congrats mohican!

first_time_buyer said...

Hi Mohican

Congratulations on the new addition to the family and on the purchase.

With due respect, I slightly disagree with your formula, particularly when you deal with depreciating assets like condos, due to practically no land allotment with those properties. I dont know much about the land deal associated with townhomes so would restrict my comments on that.

Thus the 100/(interest) should be changed to 100/(int + depreciation rate) to get a fair value. To be fair you can multiply the remainder part with (1+ rent_inflation/100) to counter for rent and tax inflation.

Let me know if I missed anything.

jesse said...

ftb, mohican's calculation is based on summing a series of discounted cash flows to determine present value. The land itself has no other value than being available to produce these cash flows.

Depreciation is built into this by incurring larger expenses for replacement structure or renovations in the future. If the townhouse has a usable life of, say, 60 years, that means the replacement dwelling cost will be discounted 60 years into the future and included in the cash flow. Likewise, roof and siding replacements are discounted 15 years (or whatever) and rents are increased with inflation (plus or minus).

The formula is an approximation and is tweaked to work by modifying the denominator to account for inflation, depreciation (which can be faster or slower depending upon the tenant and dwelling type), and risk.

In terms of this formula as it pertains to SFH or equivalent, I am not certain it works with the same denominator, the reason being at some point in the future the land could densify and incur larger cash flows. An owner of this property forgoes cash flows as an option play (as freako once described it) -- the potential cash flows should be used to determine fair value. IMO this gets tricky in some types of dwellings where densification is a long ways off (if ever) but the market thinks it a possibility for whatever reason (take neighborhood in North Van as an example). In these situations you will likely forego cash flows for many decades in the hope that the "potential" that may never materialise can be paid for by the next owner.

VancouverGuy said...

Jesse is right that Mohican's methodology is merely a simplification. We have no idea what the future assumptions are for maintenance, or taxes, or really anything, because he just applied a cap rate to the current income of the property.

If a condo lasts 50 years (those big concrete structures should last a fair while, right?), then the terminal value assumption isn't very important at all anyways. So whether or not you have a residual interest in something after fifty years shouldn't impact your calculation very much (so long as you think it can last that long).

As I've noted before, I think using a cap rate equivalent to the mortgage rate is a bit too low, but not because you have a depreciating asset. My equity should be at more than a few hundred basis point premium to my cost of debt if I have the majority of my wealth tied up in an undiversified, highly-levered asset with significant location and structural risk.

mohican said...

Well put vancouverguy. I have simplified a lot with my formula and I recognize the shortcomings of it and I don't think we can add a lot of value to the formula's use by incorporating an elaborate set of assumptions about various things which may or may not prove correct. In fact I'm nearly certain the assumptions would all prove wrong over time.

Additionally, I am not exactly ecstatic about tying up so much money in an undiversified, illiquid, leveraged asset but from a monthly cash flow perspective for my family it makes sense to buy. Remember, I'm not comparing my purchase to the 'best alternative use of my funds' since I'm only comparing it to rent with my cost of capital and basic expenses the only hurdles to overcome.

In order for the metrics to work for an investment property I would add some additional hurdles because we are now comparing the investment to other investments. 500 basis points over the bank of canada target rate would be my starting point for an investment property.

To put it another way here is how my personal situation works out approximately:

My opportunity cost (loss of interest on downpayment) = $325 / month
My interest costs (mortgage interest in first month) = $825
My monthly strata fees, taxes, and maintenance = $300
My total monthly costs of purchasing = $1450

My alternative cost = $1600 / month in rent. In fact there are units in my new complex that rent for $1700 / month but I don't think that is sustainable.

I 'save' $150 / month by purchasing. Additionally, every dollar I pay down on my mortgage instantly starts 'saving' me 5.35% after tax.

jesse said...

"My equity should be at more than a few hundred basis point premium to my cost of debt"

Yup. In mohican's case, if he maintains his property well and is blessed with good neighbours, his cap rate can be reduced somewhat compared to the average.

J.Son said...

Congratulations Mohican! I'm guessing the very soft FV market had something to do with the deal you got ;) Good on you for agreeing to purchase at a price you have determined is fair, rather than what the market is currently dictating.

mk-kids said...

Congrats Mohican! $142 per square foot seems almost reasonable...

wallylee said...

Wow, congrats!
You bought a brand new 2000sf townhouse in FV for $285K??
Which part of FV is this.
That sounds too good to be true.
I would have expected that kind of pricing sometime next year, but this early in the game is phenomenal.

So much for the Last of the Mohicans tale.
Looks like the Mohicans will have a bright future.

condohype said...

Mohican, I love the way you went about your decision. You looked at your situation, you looked at the numbers, and you made a call based on what makes sense for you. This is how people should make financial decisions. It pains me to think about all the good people who bought because of the hype, never bothering to do the basic math to find out if their "investment" makes any sense. Congratulations to you and your family.

investah said...

Congrats Mohican on finding a comfortable solution to your needs....and congrats to the developer on getting out before further losses....what could be better than a win/win sit.

solipsist said...

Congratulations on both barrels of your good news mohican!

You did your math. If you don't pay any attention to prices for the next couple of years, you won't regret it, I'm sure.

Mrs. solipsist and I are putting off solipsist 2.0 until things tank a bit in Vancouver, and we will buy then (and hopefully, get preggers again).

Or, maybe move to the Valley...