The Argument Against Value Analysis in Vancouver

Much has been made by me and other long-time commenters on this blog about what housing prices would be in the absence of a bubble, the market's so-called fundamental value. Yet Vancouver's housing market has rarely (not never) been at a "fundamental" valuation in the past generation. Does value investing have a place in Vancouver real estate if prices rarely agree with the theory? I will outline the case for why not and offer some commentary.

Here I have attempted to paraphrase many of this blog's comments into this post. The information is not new, only presented. I do hope that readers, if they have time, read some of the comments here and in the archives for more insights into the fascinating subject of real estate in Vancouver, the "most bubbly city in the world".

The simple way of determining fundamental value is to look at an asset's current and expected future cash flows, discount them at your cost of capital, and sum them up. mohican uses a simple formula that I crudely derived here. There are other simpler and more complex methods of course and there is always disagreement over assumptions. With Vancouver specifically the last time properties were valued at what I consider to be fundamental valuation was around 2000 and before that in the mid '80s. Others will say 2000 was never at fundamental valuation, a local minimum that never quite reached the trigger point for them to consider it a good value investment.

The question is, if fundamental valuations have not been present since, say, the mid '80s, do they still have merit? The argument for why fundamental analysis is flawed for Vancouver real estate goes as follows. Real estate consists of cash flows from rents and capital appreciation. The Vancouver market has had many boom-bust cycles in its past. Even if an investor buys when prices are above fundamental value (not necessarily at the peak, mind), a subsequent boom cycle will allow the investor to exit with a decent overall return. Booms and busts are inherent to Vancouver's psyche. Given enough time, typically 7-10 years, you will always be able to cash out positive, the caveat being of course you avoid buying near or at the peak. Fundamental valuation is therefore rarely, if ever, achieved because investors anticipate future bubbles to compensate for poor rental yields.

In a nutshell, that is the argument. And before commenters rip it apart I will say that many people over the past generation have made decent real (or paper…) returns in this fashion. Most I have had discussions with do not engage in "pure" speculation (i.e. flipping) but actually rely mostly on rents for their return; "mostly" because for the return to really make sense they require some form of capital appreciation above inflation. The speculative component (i.e. prices above fundamentals) is apparently omnipresent within a typical investor's time frame.

The Vancouver price graph is indeed "biased" above fundamental value. So the argument goes, as I can make it out, you may have to wait a long long time for true fundamental valuations to return. If this is true, that Vancouver has a propensity for speculation, prices may never retreat to fundamentals in one's lifetime. In fact this is effectively the argument I hear on local blogs and amongst my acquaintances and family. Really they are saying that Vancouver is full of greater fools who will inevitably compensate us for poor cash flows or that their still fruitless but eternal hope of real income growth will manifest itself. And maybe they are right.

Of course speculation is a zero sum game and many we know have done well in the past generation in their real estate investments, "others" not so much. Here though I lob a few words of caution into the hubris.

First the assumption that Vancouver will experience another boom-bust cycle in most investors' time horizons is just that -- an assumption. There are precedents in other cities, most notably Tokyo, where prices have fallen for twenty years and counting. The market there had the ability to absorb a significant amount of investors with speculative components to their business cases and not lead to a subsequent boom; in other words a lot of speculators got burned waiting for the recovery that was not. Indeed the Japanese property market remained rational longer than speculators could remain solvent. Not to say this will not happen in Vancouver, but convincing yourself it won't is a high stakes assumption nonetheless.

Second is that oversupply this time around may all but guarantee a return to fundamentals. There are just not enough people for the number of units being built and, worse, we have seen Vancouver's population "spread out" from past decades. That is, the ratio of occupied bedrooms to the total number of bedrooms has been decreasing for the past decade due to what I believe to be both a demographic shift, and historically low and lasting unemployment (due in significant part to the construction boom as it happens). What is to stop this trend from reversing when average wages are falling? If you think mohican's graph of CMHC units under construction is scary, wait until under-productive dwellings are brought back to more full productivity as people tighten their belts.

Third the past generation has seen a perpetual reduction in mortgage rates and mortgage qualification thresholds from their highs in the early '80s. This in turn has improved affordability for existing owners and pushed up prices for future ones who can still miraculously tap credit lines. That trend is unlikely to continue much further. If mortgage rates increase, it will be decidedly bad for affordability. If mortgage approvals are stricter, fewer can qualify to buy at all. And prices will suffer.

It comes down to one thing, that Vancouver real estate has had a lengthy CV of booms and busts with a distinct bias above what would be justified by fundamentals. As an investor, you may well be relying on Vancouver's house price volatility to ensure your overall returns are satisfactory. Food for thought, though, that THIS time, it may indeed be different, though not in a good way for your future savings. On the flipside, for families looking to buy a personal residence only at fundamental value, there is some chance you could be waiting a long time, though perhaps not.