Thursday, June 25, 2009

Greater Vancouver - Inflation Adjusted House Price Index



As promised a few days back, I've put together a chart which shows quarterly Greater Vancouver benchmarked detached House Prices from 1976 to present. I have also added a simple linear trendline to the chart and the year over year change in real prices.

I really think that we have not seen the end of price decreases yet since this would be the smallest correction on record after the biggest boom on record - that would be unusual.

What do you think?

PS - I'm going away for a bit of a break so jesse and other will hold down the fort for the time being. Warm regards.

43 comments:

Noz said...

What's the price per income ratio for Vancouver as a trend?

I'd like to know if it's as ludicrous as LA, SF, or NY....and how it can be with a lower mean income average.

chadmpnp said...

One thing I have gathered from my years of investing in equities, when an asset is reverting back to the mean it doesn't just go there and turn or stall, it overshoots, every time, so I would expect the same here. Clearly I expect prices to fall more but to be honest we're not as extended as I would have expected.

barbor62 said...

A quick downturn in prices over the summer, and that chart is clearly showing lower highs and lower lows.

barbor62 said...

A quick downturn in prices over the summer, and that chart is clearly showing lower highs and lower lows.

barbor62 said...

A quick downturn in prices over the summer, and that chart is clearly showing lower highs and lower lows.

Michael said...

What if we get deflation instead of inflation? Nominal price can still fall, even if inflation adjusted prices rise or stay flat.

Also, it would be interesting if we can net out the effects of the "easy money" created over the last few decades. (I think we reached the end of easy money -- peak credit has come and gone) .... perhaps a price graph that nets out the effects of interest rates, or one that is normalized over the amount of money and credit created in the system.... such a graph would give us the "natural" rate of growth of RE.

jesse said...

"Also, it would be interesting if we can net out the effects of the "easy money" created over the last few decades."

Michael, I am not certain there is much dependency upon interest rates, though there is certainly some effect. There has been a secular trend to a lower cost of capital brought on by higher certainty of future inflation. However the correlation between interest rates and short-term movements is not that strong. Japan and the US are examples of where low rates did prevent price drops. But I'm sure Vancouver is different.

That said, when people are speculating on prices -- especially on a "sure thing" -- the financing costs and maximizing payments are a major determinant on how prices CHANGE. Funny, though, how prices haven't rocketed past 2008 highs this year given the rates are so much lower, and equally funny how the low 5 year rates from around 2002-2003 had prices significantly lower than today's.

I would argue that when financing costs correlate to short-term relative price movements, like we've seen in the past few months, that's speculation central. People are still obsessed with relative price movements. Dollars to doughnuts, they're comparing prices to -- let me guess -- other prices? The obvious question is what is supporting these prices at all?

Michael said...

Here is a rough look at what I meant.

There has be a steady decline in interest rates since the 1980s decreasing from around 15% (for a conventional 5Y mortgage) to around 4% today. I would argue that if everything else is held constant, nominal prices would have gone up roughly 3.5 times simply due to interest rates. Now, nominal price for detached homes approximately went up roughly 5x in that same period. If we remove this effect, detached houses only went up 1.5x. That's only a increase of 3%/year.

What's interesting is when u apply the same math to attached and condos... You get close to breakeven (0% for attached, slightly negative for condos).

Now that we are in a liquidity trap (rock bottom interest rates), where will prices go from here?

jesse said...

"nominal prices would have gone up roughly 3.5 times simply due to interest rates. "

The 15% and 4% mortgage rates were the extremes. Part of the reason for 15% rates was because of uncertainty about future inflation. The 4% rates, on the other hand, are factoring in deflation for the next few years. Once deflation works through the system, rates are going up. It is still uncertain how fast deflation will work through the system but it is not really a free lunch. Deflation means falling wages and is not good for income generation. Weakness in the rental market, even without the large oversupply of dwellings, is testament to this.

I don't buy for a second that a 4% cap rate is normal for residential property investment. There are too many risks and costs for anything less than 7% net yield and certainly more for denser properties with higher building capital. The fact that REITs aren't touching residential real estate in markets like Vancouver should be a sign of too many amateurs on the pitch.

David said...

How is it the biggest boom? Based on your graph it ranks third. The prior two booms increased a greater percent bottom to top and within a shorter time period.

Michael said...

"The 15% and 4% mortgage rates were the extremes. Part of the reason for 15% rates was because of uncertainty about future inflation. The 4% rates, on the other hand, are factoring in deflation for the next few years.

Run the numbers from the 1980s to today, and you will find that there is a meaningful correlation between interest rates and nominal RE prices.

My points are:
1) Easy money played a large role in blowing up RE prices since the 1980s.
2) Changes in interest rates is one way to quantify this "easy money"
3) We reach the end of this "easy money" with interest rate at 0 (Liquidity trap).
4) If we follow japan, RE price will deflate and bounce around for a decade.
5) We will likely not follow Japan, because Vancouver/Canada is different.
6) What has been the "natural" appreciation rate of RE? Obviously, unemployment and e/immigration will be factors. Can we graph this?

jesse said...

"1) Easy money played a large role in blowing up RE prices since the 1980s.

Agreed but this was a one-time secular trend as you imply.

"2) Changes in interest rates is one way to quantify this 'easy money'"

I think "easy money" has more to do with lenders taking larger risks in a quest for incremental returns by lending larger and larger sums of money than they used to (AKA financial "innovation"). I would have expected mortgage spreads to have decreased (and they have) as a sign of "easy money". The bond market comprises way more than just real estate.

"4) If we follow japan, RE price will deflate and bounce around for a decade."

I'm not sure your point but Japan is an excellent example of where asset prices fell despite falling interest rates. The US is showing to be another example though accelerated compared to Japan's experience.

"5) We will likely not follow Japan, because Vancouver/Canada is different."

Japan had several problems related to demographics and monetary policy that Canada will not follow. I'm of the opinion it doesn't matter: the thing to look for is whether or not real estate is a good investment based upon cash flows to determine fair value, not by looking at past trends that may or may not include unsustainable speculation. Looking back over 100 years, real estate moves in generational cycles in some cases lasting longer than 20-25 years.

"What has been the 'natural' appreciation rate of RE?"

If you want to look at past trends, I would look at long-term trends that transcend recent monetary policy. Dr. Shiller has published his famous index graph going back over 100 years showing marked movements not just in the past 10-20 years but a history of peaks and valleys lasting decades.

Also I would separate detached from apartment appreciation as the two have different dynamics affecting their price. In areas increasing in population, detached will appreciate faster than condos because the land will eventually used more productively through rebuilding. Apartments and condos have no such luxury and as such need to make a decent risk-adjusted return right away.

Anyways, here are a few old posts that may be interesting for you:

Greater Vancouver Price / Rent Ratio

Vancouver Real Estate Bubble Uberpost

House Prices Always Rise (over the long term)

JimTan said...

Interesting! That's Freako offering his opinions in 2007 too!

jesse said...

"What has been the 'natural' appreciation rate of RE?"

Another way to look at this is to track "natural" appreciation over, say, 100 years and figure out what a "small" 1% P.A. gain above income growth compounds into.

Michael said...

A simple regression (from 1990 to 2009Q1) of just using the 5-year mortgage rate predicts Royal Lepage housing prices with an adjusted R square value of 0.44. It has a similar adjusted R square value for Teranet's data.

Conclusion: Interest rates play a significant role in housing prices, as it explains roughly 40% of the changes in housing prices since the 1990s.

In viewing the residual graph of this model (ie. if interest rates effects were removed from prices) the period that it did not explain prices very well is after 2005Q1. Why? I reran the regression from 1990 to 2004Q4, and re-plotted the residual graph through 2009Q1. According to this plot, interest rates explained prices very well until about 2003, when the Olympics were awarded to Vancouver!

This made sense. Olympics meant lower unemployment and higher migration into the province. So, I went ahead and quickly ran regressions with the umemployment rate and provincial & international migration numbers. Unemployment rates alone produced an adjusted R square value of 0.59. Interest rates and unemployment rates together gave an adjusted R square value of 0.72, and finally all 4 factors gave 0.85. One can further optimize the model (like adjusting the lag time for each of the 4 factors), but for a simple model, it's pretty darn good!

Anyway, according to this model, housing prices started to overshoot in 2007. At the peak, it overshot by roughly 16%. As of of Q1 2009, it is still around 16% over valued, due to a decline in the unemployment rate. This explains why prices dropped even though interest rates went down.

If you want, I can email some graphs, so you can post for others to view and comment......

Michael said...

*correction to typo*
due to an increase in the unemployment rate. This explains why prices dropped even though interest rates went down

van_coffee said...

Michael -

When you did your regression, was the dependant variable you used the House Price Index or a benchmark price or did you use the rate of change in the house price index or benchmark price as the dependant variable?

Paul said...
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Paul said...

Hey Mohican,

Do you think the bottom is in for Vancouver real estate? Not being there all I can do is go on what I am hearing which is pretty bullish! I am surprised to say the least.

I have set up a new blog for PEI real estate stats etc. I hope you can drop by and check it out!

http://paul-charlottetown.blogspot.com/

Paul

chadmpnp said...

Paul, there's no reason to pump your blog on here when you clearly haven't read anything on this site.

chadmpnp said...

Michael, how can we see your charts?

van_coffee said...

chapmpnp,

You are clearly a complete tool and you do not do your due diligenec because you are not aware that:

#1 - Paul started the greatest daily stats site for real estate in Vancouver;

#2 - Paul knows Mohican quite well;

#3 - Paul moved to PEI from Vancouver.

Chad -

Go stick your fist up your a**

Cheers,

VC

jesse said...

"Conclusion: Interest rates play a significant role in housing prices, as it explains roughly 40% of the changes in housing prices since the 1990s."

I think you show correlation, though an Rsq of 0.44 is not that high. Rates have dropped and prices have risen so you will find a correlation almost by definition. It does not explain price rises per se though we can suppose.

Your supposition is that a lower cost of capital is a fully causal link (or whatever the stats term is) to prices. I agree that to a degree lower rates would tend to increase asset values. What I am saying is that I don't think you can attribute the full 40% change in price to the drop in mortgage rates.

The reason I say this is because many are looking at rates longer than 5 or even 10 years when making a decision to invest (or own). The property will be in service for decades and as such the asset price should account for varying interest rates over that entire period.

Another question to ask is, while there may be a natural price appreciation, is there a natural rental yield as well? If real prices are flat, what would this yield be vis a vis other similar investments?

JimTan said...

"Anyway, according to this model, housing prices started to overshoot in 2007."

Ah so, this is consistent with the current bounce off 2006 levels. Very interesting.

Can you run some interest rate and employment inputs? That might give us some scenarios to work with!

Very good.

Michael said...

RE: R-Square Value
0.44 Rsq value may be on the low side, but BETA values of stocks have Rsq values much lower.

RE: causality of interest rates
While I agree that the lower cost of capital may not have a full casual link to housing prices, you have to agree that it is a major factor for economic activity, as it is used by governments to "modulate" economic activity. Central banks adjust the bank rate according to the CPI, but we all know that the CPI is an unreliable indicator of inflation. For example, it does not monitor the amount of "hot money" flowing to speculate on assets like RE, stocks, commodities (like what's happening in China now, but I digress) causing inflation most of which not measured by the CPI. CPI is flawed in many other ways; it is suffice to say that it is unreliable if not flawed. Because of this, central banks' feedback is muddy and I would argue that they tend to overshoot allowing economies/markets to bubble up. The good news is that their hands are almost tied now, with rates at near 0. Lastly, for the same reason, I would not spend too much time looking at any inflation adjusted graphs.

RE: long, mid or short term rates
I would agree that some investors look at long term rates for their RE investments, so maybe there is a better correlation to longer term mortgage rates or LT bond rates. Unfortunately I don't have that data to run. However, I did run a regression on a 1-year mortgage rate and separately on the bank rate, and I found that the 1-year rate has a better adjusted RSq (closer to 0.50) but the bank rate is much worst (closer to 0.30). Does this tells us that the average buyer of RE tend to look at the 1-year rate?

RE: "natural rates". Building this model made me realize that perhaps there is no such thing. There may be secular trends, cyclical trends, and one time events that influence prices. Population growth could be a secular trend. The annual season, and monetary/fiscal policies could be cyclical. And the Olympics could be an one time event. I guess I was wrong to even ask about it initially...

What drives Vancouver RE? The model provides some insights but like you said it is hard to determine causality. Vancouver is different, as we all know, because I bet that a large portion of our economic activity is related to RE. Your comment about causality clued me to think that employment (or the lack of employment) does not only drive housing prices, but these two can feed on themselves to build the bubble that we are in today. And certainly the Olympics adds fuel to the fire.


Here are some more results from the model. Take it with a grain of salt, as models like this changes over time, we don't fully understand the causality of the factors or it's not linear, and there may be other factors (like income, inventory) that I don't have data for or didn't think of.

1) 1% change in Unemployment rate roughly changes housing prices by 10%
2) 1% change in 5-year mortage rate, changes housing prices by 8%
3) every 1000 interprovincial migrants into BC causes housing prices to go up by 1.8%, and
4) every 1000 international migrants causes housing prices to increase by 1.7%
5) Unemployment is the most significant contributor (pvalue=2.8E-19), then 5-year mortgage rate (5.9E-13), Provincial Migration (8.0E-7) and least significant is International migration (1.6E-2).

You can view the model here:
http://docs.google.com/Presentation?id=dghbwhpz_80dkj9zdg7
It also has a forecast, but not necessarily a good one. (low mortgage rates and high unemployment) Feedback/comments please.


Jimtan: While prices did overshoot starting in 2007, the model does not predict the bounce off 2006 prices, as the model's prices decay as much as the actual decay of housing prices. As mentioned by end of 2009 Q1, we are still 16% "overshot".

Van_Coffee: I used the LOG of average prices (Royal Lepage survey of bungalow and 2 stories). Having said this, I also run the regression on Teranet's Index and the adjusted Rsq is similar but with different coefficients.

JimTan said...

"Jimtan: While prices did overshoot starting in 2007, the model does not predict the bounce off 2006 prices, as the model's prices decay as much as the actual decay of housing prices. As mentioned by end of 2009 Q1, we are still 16% "overshot"."

I think that there were some deals in 2nd Quarter about 5-10% lower. So, your valuation would be almost neutral at the bottom this spring.

nero911 said...

I find it interesting that people can believe RE prices have reached a trough and will recover from here.

This is as good as it's going to get folks.

There are two things that are going to happen in the next 5-10 years, Inflation or Deflation.

If Inflation - interest rates will be jacked up so high you'd think you were wearing bell bottoms again. RE prices will drop and defaults will rise.

If Deflation - asset prices will drop. Consumers will save, and spend less. Money gets sucked out of the system.

There's no rocket science here folks. The party that went on in the last 25+ years, was a period of record wealth creation, due to dropping interest rates, greater debt (credit), globalization (cheaper goods), political stability - all that is over.

There is literally a tsunami of bad economic data, demographic data, fiscal data, and environmental data that show the next 10+ years (if we are lucky, if not, will be longer) will be absolutely no picnic.

People who are looking months ahead are missing the forest for the trees. Take a look at history. Every generation or so we have a huge financial shift. It happened in the 1930s, 1970s, and today. Paradigm shifts do happen.

On the local front:
I recently moved to Surrey and all I see are new townhouse and detached developments. They are nuts.

The reality is that anyone buying real estate (or buying and holding any other asset for that matter) is going to face much less ROI than they think (and I'm talking over the next 10+ years).

van_coffee said...

Nero -
Now that's a Wall of Worry !

Cheers, VC

JimTan said...

"There are two things that are going to happen in the next 5-10 years, Inflation or Deflation."

Wow! Nero, you must have a crystal ball. I wouldn't dare forecast 5 years ahead.

BTW, make up your mind. Deflation or inflation?

jesse said...

"we all know that the CPI is an unreliable indicator of inflation."

I think you will find that renters have found the CPI to be a very good measure of inflation.

jesse said...

"you have to agree that it is a major factor for economic activity, as it is used by governments to 'modulate' economic activity."

The Bank of Canada has control over some rates but the stuff at the long end of the curve is pretty much up to market forces. Generally the market self-regulates by raising rates in booming times due to increased competition for a finite pool of capital. If you think inflation was high it's strange that AAA bond yields weren't into the double digits earlier in the decade.

The US had massive asset price inflation and now has massive asset price deflation. Bond markets trudged along through this mess. I would infer from that the bond market doesn't put all its stock in asset price changes when determining yields, in which inflation expectations are embedded.

"Vancouver is different, as we all know, because I bet that a large portion of our economic activity is related to RE."

Vancouver is different because it is not something else. The high level of real estate and construction employment is not in and of itself reason for a viable economy. I use the analogy of an economy too heavily dependent upon construction is like trying to cool your house by opening the refrigerator door.

Michael said...

"Generally the market self-regulates by raising rates in booming times due to increased competition for a finite pool of capital. If you think inflation was high it's strange that AAA bond yields weren't into the double digits earlier in the decade."

This is true to a degree, but I think the market is still heavily influence by the headline CPI numbers. In the US, CPI was altered in the Clinton's year, making inflation more favorable. Also, how can you remove energy and food? Just because they are volatile doesn't mean you should not be included. Finally, there's probably a lot of cheap money created in the last decade flooding the bond market (and all other asset markets), due to financial innovations (securitization of mortgages, more leverage from banks and hedge funds etc), the Yen carry trade, and lastly China (and other Asian creditor nations) needing to keep their "low" currency pegs against the USD. Currency markets made sure all this money went everywhere including Canada..... And most of this going away, if it hasn't already. The bond market knows this, but yet rates are low. Why? Like you said it, risky assets are deflating. The money is flowing into save havens like long government bonds, etc. I think we are in a period of dis-inflation (or right out deflation) especially compared to the last couple of decades.

"I use the analogy of an economy too heavily dependent upon construction is like trying to cool your house by opening the refrigerator door."

I agree, going forward I think Vancouver's economy is sc***wed. I don't foresee any other sector to pick up the slack. Maybe just more of the same medicine that got all of us into this mess, more stimulus. Let's kick the can another time? At some point, demand for stuff will recover, but our taxes will have gone up a lot....

david said...

Jim,

I am pretty sure when nero said "There are two things that are going to happen in the next 5-10 years, Inflation or Deflation." he meant there are 2 things that could happen, since they both cant really happen at the same time.

I also think it is a pretty fair assumption. Rates cant be kept this low for long periods of time without inflation taking place at some time. But deflation is also possible because if no one wants or can get the cheap credit then we could have deflation.

You must agree that things cannot keep going the way they are right now for a long period of time. Interest rates cant stay this low forever because eventually this will cause inflation and the BOC will raise interest rates to combat this. When interest rates go up housing will become less affordable and prices will fall. The only way for this to not happen is if interest rates creep VERY slowly up for the next 5ish years. Even if they creep 0.25% a year someone with a 5 year mortgage will have a 1.25% interest rate change and see payments increase about $200 a month. That is manageable, but 5 year rates are already up almost 1% from their lows a couple months ago.

Most of these things are assumptions, but they are assumptions based on history. Dont go writing off someone's opinion by saying they must have a crystal ball.

Does this mean you don't look at stats and history in order to try to make predictions about the future? (real estate only goes up in the long term is a phrase constantly spouted by realtors).

Just out of curiosity, what do you think will happen with interest rates and prices in the next few years based on some data? You seem to put down other peoples ideas but dont put fourth any of your own.

JimTan said...

“I am pretty sure when nero said "There are two things that are going to happen in the next 5-10 years, Inflation or Deflation." he meant there are 2 things that could happen, since they both cant really happen at the same time.”

David,

Why don't you let Nero speak for himself. He knows what he meant.

Obviously, both deflation and inflation can't happen at the same time. The point I am making is that Nero is not working from a model. He is merely expressing an opinion based on ideology. Things have to go very wrong!

He's giving himself a five (or ten) year safety margin. Eventually, he will be right?

Ideology/bias is worthless for decision making in real-world markets. That's because critical decisions have yet to be made. The future is still unformed.

Those of us who do have to make investment decision operate within an actionable time horizon. That is, we reach conclusions that must be useful within a reasonable period of time. Those conclusions must be specific and finite.

Nero has to be specific (inflation or deflation) if he has a time horizon.

david said...

Jim,

I think a broad time horizon is completly reasonable for the current situation when it comes to real estate. Basically I believe at some point interest rates will rise and prices will drop. When this happens is not really that important to me.

For the time being I can rent a place that I like but could not afford to buy a simmilar place at my current salary. As long as I continue working and saving more money for a down payment then I am not really that concerned when a place I like becomes affordable, just that it happens.

Nero was saying that lower home prices will result if we have inflation OR deflation. I would agree that all it is going to take is time for a place I like to become affordable for me, how much time is very tough to tell though.

I realise that not everyone is in my situation and need to make a decision soon due to a new family or something like that, but as far as I am concerned, I can wait years for prices to drop, so exact times are not that important to me.

Deliverator said...

Those of us who do have to make investment decision operate within an actionable time horizon.

What exactly is an 'actionable time horizon' for you?

Are you saying that if you're looking at buying real estate, which almost always comes with borrowing money over a very long time, say, 20 years or more, you only want to know what is going to happen in the next 2 or 3 years?

Really?

Deliverator said...
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Deliverator said...

Nice model, Michael.

It would be nice to have access (even if only read-only) to the spreadsheet that produced the graph.
Also, it would be nice if the left hand scale were normalized to the Vancouver benchmark price, so people could more easily envision what may develop.

If I read it correctly, your model predicts a ~40% drop in RE prices by 2011, assuming ~10% unemployment and ~7% 5-year mortgage rates?

How volatile is your model? What would happen in your model if the unemployment situation unfolded that same way, but mortgage rates remained low due to continuing deflation, say ~5% for a 5-year rate?

Michael said...

"If I read it correctly, your model predicts a ~40% drop in RE prices by 2011, assuming ~10% unemployment and ~7% 5-year mortgage rates?"

Not quite..... Prices are negatively correlated to the 5-year rate, so that forecast has the 5-year rate (based on BoC's average of all 5-year mortgages) going to 2.5%, and unemployment going to 9.1% by end of 2011. eg. I am already calling for continued deflation with higher unemployment.

As I said before:
1) 1% increase in the unemployment rate roughly decreases housing prices by 10%
2) 1% increase in 5-year mortage rate, decreases housing prices by 8%
3) every 1000 interprovincial migrants into BC causes housing prices to go up by 1.8%, and
4) every 1000 international migrants causes housing prices to increase by 1.7%
5) Unemployment is the most significant contributor (pvalue=2.8E-19), then 5-year mortgage rate (5.9E-13), Provincial Migration (8.0E-7) and least significant is International migration (1.6E-2).


3 more cases (I threw in stagflation into the mix too):
http://docs.google.com/Presentation?id=dghbwhpz_87rrf55q5h

NOTES:
a) I changed the Y-axis to normal prices
b) Unemployment was 6.1% in 2009Q1
c) BoC's average 5-Y mortgage rate was 5% in 2009Q1

Michael said...
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Michael said...

So if we get 1990s' level unemployment (>9%) with same 2009Q1 5-Y mortgage rate (5%), we should see prices deflate back to 2003 levels... according to the model.

mohican said...

Looks good Michael.

Would you like to do a guest post explaining your model and post the three scenarios?

Just email langley_financial_planning at yahoo dot ca with your google account and I can invite you to do a post.

JimTan said...

“So if we get 1990s' level unemployment (>9%) with same 2009Q1 5-Y mortgage rate (5%), we should see prices deflate back to 2003 levels... according to the model.”

Michael,

Let's bookmark this forecast. Interesting to see whether it works out by December.