Sunday, May 10, 2009

What Mortgage Rates are Saying

Looking at the latest posted mortgage rates, a 5 year fixed rate mortgage is between 4% and 5.25%. If you are a long-time reader, you remember the back-of-the-envelope NPV formula used by mohican (I derived it here), used to calculate a “fair” value for a property, given the net rental income and the 5 year mortgage rate:


If the mortgage rates are approaching 4%, does that mean that many of today’s prices are fairly valued? Is this formula valid in today's environment?

What low long term rates are saying, translated into mortgage rates, is that the market does not expect inflation to be a concern for the next while. That means two things for real estate investors: incomes and rents are unlikely to increase in aggregate and could even fall in the short term. The above NPV calculation, if derived from discounted cash flows, accounts for rental inflation by offsetting the denominator against inflation. We are left with a denominator that should contain the discount rate minus inflation. With mortgage rates low, what are banks saying, and should we really be using the 5 year rate in the denominator?


Arwen said...

Hm. I don't see that calculation working yet in Vancouver. Am I looking at the wrong properties? (Or perhaps am pickier about what is a sustainable rent? ... There's a lot sitting open on Craigslist.)

I came to the bubble blogs because of a fundamental confusion about how incomes were relating to prices. In the end, that's where I'll look for comfort as to value, with the understanding that Vancouver will probably always have a higher multiple than Ottawa or even Toronto - but fair "rent" is a moving target I'm not convinced I can gauge. Rents have a fair amount of upward pressure due to low vacancy and rental conversion.

Alan said...

I am leaning toward rents having downward pressure, as rising unemployment drives people into their parents basements. There was an article in the Sun a few months ago mentioning that rents in Richmond are going down.

Anyway, I have heard that over the past few years, Vancouver landlords -on average- have not even raised rents to match inflation.

investah said...

While higher int rates usually follow growing inflation, occaisionally (like now)it's the other way around. Central banks have already blown their entire bundle to combat the recession and to break the logjamb in the credit markets. All this money supply has created monetary inflation that will put pressure on int rates way before any sign of price and wage inflation. 10 year US treasuries have already gone from 2.5% in Feb to the current 3.2%.

Keep up the good work, Mohican. Although Chipmans site appears to be attracting some more sensible posters lately, yours is by far the most credible, while RET seems to be the place for clowns and financial neanderthals.

mohican said...

I don't see too much that is 'fairly valued' when honestly assessing the costs associated with ownership. There is likely places in the Abbotsford, Chilliwack, Mission, and Maple Ridge areas that are under 'fair value' but I don't think there is anywhere else closer in that is worth even looking at yet until we get further price declines.

The pressure on rents is downward and the pressure on rates is upward to that should be factored into the equation at this stage.

If I were looking at buying today, I would be very concerned about rates going up and locking in my rate for as long as possible (10 yrs) and aiming to have all or most of the mortgage paid off by the end of that term so that the risk of rates rising could be mitigated.

Arwen said...

I should say I agree that rents have a downward pressure now - they have had a fair amount of upward pressure in my area for awhile, and I'm watching them come down, but I suppose what I mean is I don't know how to judge where the trend is going in rents and where it will bottom. Which is why I end up retreating to the Case-Shiller historicals and to incomes.

I have even less sense regarding the possible risk of hyperinflation vs. inflation vs. deflation, although I've been reading arguments in both directions on American blogs.

Anyone here into predictions? How soon and how high?

Tony Danza said...


The problem with the predictions I've been reading is that none of our economic luminaries and decision makers have been through a financial crisis like this before. All we have to compare the current crisis to is the Great Depression and there is still debate about how we got out of it.

At this point I'm in the deflation camp since that's what happened during the last recession of this magnitude (GD 1). I am also very skeptical of the ability of our politicians to lead us out of something they never even saw coming in the first place.

I guess all you can do is diversify your holdings considering the worst case scenarios, hyperinflation and deflation.

david said...

I gotta say that all this talk of hyper inflation and deflation leaves me scratching my head. Both could happen, after all, they are making money cheap to borrow, which creates more supply. This supports the inflation theory. But at the same time people are losing their jobs and spending less, which means assets will probably drop in value because less people can afford them. Maybe the two theories will cancel each other out and nothing will really change much. But I would say that in 5 or so years the inflation will kick in as there is more money kicking around than there was before this mess started.

And as for that calculation, you could always use a 10 year rate, i think i have seen them posted as low as 5.25%.

Alan said...

re: money supply and inflation.

I was under the impression that with the bursting of the credit bubble and the collapse of the shadow banking system, there is actually less money supply around now then there has been for most of the decade, in spite of various governments best efforts at printing more of the stuff.

Besides, I am not convinced that there is a cause and effect relationship between the two. I know that it is the textbook theory of inflation, but I don't know that anyone has actually demonstrated the causation.

I am also scratching my head on the subject, I don't know what is going to happen, nor why. I am, however, getting some Real Return Bonds just in case.

patriotz said...

with the understanding that Vancouver will probably always have a higher multiple than Ottawa or even Toronto...


Why would RE investors in Vancouver permanently accept a lower yield than elsewhere?

Because they are expecting capital gains to make up for it? What do we call that?

Arwen said...

Patriotz - actually, it was my understanding that we (traditionally) have higher *rents* as percentage of income than Ottawa or Toronto, rental housing taking 40% of income where in other places in Canada it can be much lower. So investors aren't accepting a lower yield so much as it's just expensive to live here.

Of course, now I don't remember where I saw that info. Oh, VHB! How I miss your charts!


I'm assuming in part because of the usual suspects trotted out (climate, immigration, land ), but I think also because we just are crazy about housing out here. I was looking at historical boom/busts in Vancouver and even way back when the West End was still forest, some of the Mole Hill houses were built as part of a speculative boom.

Anyway. Given the fact that condos are relatively new to the market, leak, have no land value, and are EVERYWHERE, I wouldn't be surprised if we had rents come down quite a bit over the next decade.

Deliverator said... spite of various governments best efforts at printing more of the stuff.

Besides, I am not convinced that there is a cause and effect relationship between the two. I know that it is the textbook theory of inflation, but I don't know that anyone has actually demonstrated the causation.
Really?!? You've never heard of Weimar Germany? Zimbabwe? Argentina? French Revolution Assignats?

Supply and demand applies to currencies every bit as much as it applies to everything else.