Thursday, March 26, 2009

Merrill Lynch - Housing Report

By David Wolf of Merrill Lynch

We’ve seen a handful of more hopeful signs in the Canadian housing market of late. Demand appeared to rebound in February after an awful January, with resale activity reviving somewhat – Toronto, Calgary and Vancouver reported monthly sales increases of 54%, 51% and 94%, respectively, each well in excess of the usual seasonal bounce, suggesting a nationwide pop when those data are released later this month. And the needed supply adjustment is unfolding even faster than we’d expected – housing starts have fallen 46% over the past year, with more than a third of that drop coming just in the past two months. This decline in starts (along with project cancellations) has finally begun to bring down the bloated supply pipeline – the number of units under construction across Canada is now falling on a y/y basis for the first time since 1996.

While these are positive developments, to be sure, this looks to us far more like the ‘end of the beginning’ than the ‘beginning of the end’ of Canada’s housing bust. That is, we believe we’re transitioning from acute weakness to chronic downward grind, not imminent stabilization and recovery.

First, these sorts of near-term ‘pops’ in demand are common through sustained housing market downturns, apparently reflecting spasms of hope that the market has ‘finally fallen far enough’. Through Canada’s bust of the early 1990s, existing home sales actually troughed fairly early on in May 1990, and posted their biggest monthly gain ever in February 1991 – but prices did not put in a definitive bottom for another five years. Through the current US bust, existing home sales have in fact tried to trough twice – bouncing between September 2006 and February
2007, and again between April and September last year. But far from stabilizing, US house prices appear to have re-accelerated downward of late.

To be confident in a durable rebound in housing demand in Canada, we must be able to project a sustained improvement in consumer fundamentals, the most important of which is employment. We cannot do that – our base case projection sees the unemployment rate rising above 9% in early 2010 from its current 7.2%.

Second, the supply adjustment still looks to have a long way to go. In the US, housing under construction peaked in January 2006 at 53% above the long-term average and 27% above the late 1980s peak; three years later, the adjustment is still ongoing. In Canada, units under construction peaked just last June, and despite the adjustment since, January’s level was still 85% above the longer-term average and 46% above the late 1980s peak (see Chart 3). Moreover, two-thirds of that pipeline is multiples (largely condos), the highest proportion since 1973; those longer-lived projects will still be rolling onto the market for years to come.

Housing busts almost inevitably take a long time to play out, because supply lags badly and sellers tend to be loath to mark prices down enough to clear the market. We do not expect the current Canadian cycle to be any exception.

Teranet House Price Index - March 2009 - Monthly Report

A national downtrend, less pronounced in Montreal

Canadian home prices in January were down 2.4% from a year earlier, according to the Teranet–National Bank National Composite House Price Index™. As the chart below shows, this reading extends and deepens the home-price disinflation that began last February. It confirms that in early 2009, after more than five years of seller’s-market conditions, Canadian housing as a whole was a buyer’s market. January was also the fifth straight month in which the composite index was down from the month before, extending the first run of consecutive monthly declines since March 2007. The composite index is now down 5.5% from its peak of last August.

Of the six constituent city indices, three were down from a year earlier: Calgary (−8.2%), Vancouver (−4.2%) and Toronto (−2.4%). Two others were still up from a year earlier but by much less than last month: Ottawa (2.1%) and Halifax (1.2%). The sixth city, Montreal, also showed deceleration but maintained a respectable 12-month increase of 4.1%.

In another indication of the recent downtrend, each of the six city indices was down from its all-time high of last year (or 2007 for Calgary). However, they have not been moving in lockstep. The Calgary index was down from the month before in 14 of the last 17 months, with seven straight declines from last July through January. January was also a seventh consecutive month of decline for Vancouver. For Toronto it was the fifth, for Ottawa the third and for Halifax the second (the fourth in five months). Montreal’s index peaked in September, fell for three months in a row, then edged up 0.1% in January.

The historical data of the Teranet–National Bank House Price Index™ is available at

Calgary -11.4% from peak

Halifax -3.5% from peak

Montreal -0.4% from peak

Ottawa -3.6% from peak

Toronto -6.1% from peak

Vancouver -8.3% from peak

National Composite -5.5% from peak.

By : Marc Pinsonneault, Senior Economist Economic & Strategy Team, National Bank Financial Group

February 2009 CMHC Data

Good day,

CMHC released statistics for February 2009 last week and I have finally had a few minutes to look over them and put together some charts.

Starts were 701.

Completions were 1241.

Units under construction fell to 25,097. We still have a long way to go down here.

The number of completed yet unsold units is skyrocketing and currently stands at 2391. Contrast that with one year ago at 1384. Despite the best efforts of the developer's marketing firms, new units just ain't sellin'. It could be that they are unaffordable for the average person and that there are very few greater fools left.

Monday, March 23, 2009

How much is your time worth?

I really do want to know because my time is not free given there is not enough of it. So when I look at an investment, be it real estate, stocks, or a business venture, how should I account for my time?

Let’s take a simple example of a couple looking to diversify and add some real estate to their investment portfolio. They talk it over, look at the success and failure stories, think a bit about the responsibilities, and decide to look for an investment property, planning to manage it themselves. After 2 months of searching, driving to open houses and viewings, discussing over dinner, running the numbers, many offers, negotiations, inspections, mortgage approval, negotiation, and signing, and eventual closing proceedings, they purchase a condo with prospects of a cash flow positive rental income.

After countless hours of work they now have a property to rent out. Now comes the easy bit. Rental listings, fielding calls of interest, shortlisting applicants, background checks, interviews, viewings, and the eventual contract signing and logistics of occupancy.

Now the checks roll in. They go to the bank and deposit the cheques. Then there’s the property tax payments, regular reading of strata minutes, (hopefully few) maintenance calls, possibly handling of complaints of neighbours (if they’re really unlucky), and the added complexity to their income taxes.

Then there’s handling termination of occupancy, walkthroughs, and negotiation of damage deposit refund. See paragraph 3.

Every few years there will be some semblance of major repairs. Now there are the contractor interviews, planning, negotiation, reviewing and signing of contracts, oversight, and audit of the work; if they’re lucky not much more than this. Or they can go it themselves and do the plans, buy the materials, work weekends, and hopefully not spend crazy amounts of time doing it.

When they eventually sell this property there are outlays including interviewing Realtors, signing the contract, negotiating, giving tenants notice, employing a lawyer/notary, and the eventual property transfer itself. Never mind the tangible commissions and other taxes and fees.

But still, the property, at least as the cash flow statement indicates, is profitable. But what if we simply look at this investment if we assume we are running a business? Here all costs, including the initial investigation, contract negotiations, operations, accounting, and capital outlays, all must be budgeted for as if employees are paid to perform these tasks. The costs conveniently forgotten on the cash flow statement of a small-time investor start adding up.

I hear countless stories about a property being “cash flow positive” looking at the basic cash outlays: rent coming in, mortgage, maintenance, and taxes going out. Yet if we start including other costs, assuming others were fairly paid for doing this work, all of a sudden, given one’s time has value, the “cash flow positive” investment is anything but. Often I hear the justifications for all this; “sweat equity” is a favourite of mine, putting some intangible return on time spent, but an even better one is that renovation and real estate is really a hobby, a pastime whose efforts would be done for free anyways. Right. To be fair I hear the same for other types of investments too. Investments take time to manage, though some take more time than others.

It is well worth asking how corporate investors, who cannot hide all the "other" costs of managing investments on their balance sheets, make a decent return in the first place. If or when purpose-built rentals become feasible in Vancouver again, what type of yield will be required?

Tuesday, March 17, 2009

Owner’s Equivalent Rent

A question surfacing recently on local blogs and forums has been how to properly value owner-occupied housing. The concept of “owner’s equivalent rent”, the effective rent an owner-occupier pays to carry a property, can be used to justify a property’s value. Such a concept would require setting equivalent rent based upon what other owner-occupiers pay, a slightly unsatisfying exercise for the value investor. A more palatable method would be to find equivalent investment properties and see what rents they command but this is not always easy. It begs the question: how does one ground a property’s value when there is little in the way of equivalent local rentals to do so?

A recent article in the Vancouver Sun had three local pundits involved in the real estate industry give their comments about the local real estate market. While I cannot encourage you to read it fully, I did pick up on a few items Dr. Tsur Somerville from the University of British Columbia has said about his research in how real estate markets behave with a significant portion owned by owner-occupiers.

Q: You said the investment piece is gone: Does that mean that the froth is not going to happen again? (If people aren't buying as investment properties, what would happen with price?)

Tsur Somerville: A couple of issues: No. 1, we don't actually really understand what goes on with investment real estate. When you look at research and studies, it is because home owner/occupiers are such a big piece....

Q: How big?

Tsur Somerville: Since we don't actually 100 per cent know which unit is which. But if you take the Lower Mainland and [calculate] 2.5 million people, 2.6 people per household, that's 800,000 households, 60 per cent homeownership [so] 480,000 households.

The investment piece is still very small in the overall number. It's highly concentrated in certain product types, downtown condos, certain suburban high rise buildings. Overall, it's not a big story. Going forward, we have two things we don't really understand, which is what are those people going to do?

What Dr. Somerville is commenting on is that when owner-occupiers make up a significant portion of a housing pool, it becomes more difficult to determine motivations of marginal players when existing data lump investors and owner-occupiers in one pool, especially when the “investment piece is still very small,” say, 40% of total households.

Joking aside, what I believe is implied is many people place a monetary premium on ownership and motives for buying and selling are not always strictly financial, hence the difficulty in separating true “investors” from the rest. (this blog discussed the concept of the "ownership premium" here.) The “non-investment” focus of marginal owner-occupiers therefore adds uncertainty to the behaviour of the market. He states that there is segmentation between owner-occupied and rental housing, or at least that is the perception, meaning that valuing entire neighbourhoods based upon the whims of investors not heavily involved in the market is questionable.

From a value investment perspective, to determine the net present value, we sum a property’s expected discounted net cash flows. We should also remember that undensified detached housing can justifiably carry a premium over today's rent as the property could be redeveloped in the future so as to increase its utility (as discussed here) and possibly a "gentrification" premium AKA location-location-location in some circumstances (see m-'s great post for some interesting data and analysis). Determining net present value with many equivalent properties with known rents is simple; unfortunately it is more difficult when properties have few direct comparisons. It is possible that in certain neighbourhoods the one or two rentals offering true comparables do not provide enough of a sample to truly gauge what rents would be for other properties. This can even be true for a seemingly normal property with a high finish quality where the neighbourhood's rentals are not renovated to the same degree.

Buyers are therefore left looking at comparable sales in the same geographic location to determine value, in part because neighbourhoods and even adjacent blocks can significantly vary in price. I doubt very much rental data enters into most owner-occupiers’ heads when determining a fair price yet it is an important and almost necessary clue when determining a property’s value ex speculation. Perhaps it is a stigma associated with comparing “the renters” to “the owners”; an admission a property can be rented out at all goes against the concept of “achieving” ownership, or maybe it is just making the buying decision simple: find five comparable sales, offer about that, and Bob’s your uncle. Alas, this is not my idea of value investing.

Believe it or not, even “high quality” houses are rented out. A quick search of Craigslist turns up a few “high quality” rentals, as examples (not sure if they’re “real” or not; these props will likely disappear so maybe do your own search...):

You can calculate how much these properties would be worth as net present value and compare to their rough market values. There are not too many examples of higher quality rentals, however, and we are still left with the problem that a specific neighbourhood will likely reveal few, if any, equivalent rentals for a property for sale.

Yet even from the close to nonexistent comparables, we can still make some assumptions. In the absence of direct data we can look at high quality rentals across the entire region and compare them to lower quality rentals in their respective areas. This will give a rough indication of the premium higher quality demands in the rental market. From this we can look at a larger set of “high quality” compared to “lower quality” rentals and apply a factor to determine equivalent value for a certain “higher quality” property. The concept is simply that there are many neighbourhoods that are effectively comparable, even if separated geographically.

Using comparables from other neighbourhoods is roundabout method of determining value. The uncertainty is higher and my guess is Realtors won’t like the concept one bit; after all isn’t all real estate local? But we need something, even if it’s using deductive inference, or the market is not grounded on anything but sentiment and margins.

Many neighbourhoods have a large mix of both rental and owner-occupied properties so the problem of determining value for the value investor is less severe. For some neighbourhoods, say close to UBC for example, the concept of determining value for predominantly owner-occupied properties I am sure can seem daunting. Even in the face of such high noise, using a bit of deduction, an expanded "virtual" rental market provides us with enough of a tangible signal highlighting how much "high quality" properties are currently priced above what the rents say they are worth.

Saturday, March 14, 2009

Baby Mohican 2.0

Me, my wife and son welcomed another mohican family member into the world this morning. We are excited. Mom and baby are doing well.

Understandably I won't be posting much over the next few days. I'm sure everyone will do a great job of holding down the fort.

Friday, March 13, 2009

Landcor 2008 Report - Highlights

These highlights are taken from the Landcor report on the BC real estate market in 2008. See here.

Provincial Overview - 2008 in review

2008’s residential sales count is similar to the total sales generated in 2002, dropping to 113,654 sales in 2008, compared to 115,314 in 2002. This is a 28% drop from 2007’s total sales of 158,272, and 31% down from the peak year of 164,315 sales in 2005.

Detached home and vacant land sales saw the greatest decreases in total sales this year when
compared to 2007, dropping 35% to 46,164 units and 33% to 11,749 units. Condos experienced the smallest decline in total number of units sold in 2008, down 24% to 35,097 from 2007’s total of 46,099 (the highest annual sales count on record for this property type).

Regionally, the Kootenays, Okanagan and BC North/Northwest markets dropped 38%, 36%
and 34% from their respective previous year sales counts to 4,950, 16,710 and 9,067 sales.
Greater Vancouver saw the smallest decline in total number of units sold, down 24% to 48,644 from 2007’s total of 63,827.

The total sales values in BC Residential real estate fell 22.5% from 2007’s total value to $48.186 billion. This puts 2008’s real estate transaction value in third place, behind 2007 and 2006, which were record breaking years for the province of BC. Despite the drastic declines experienced in the end of the third quarter and through Q4 08, average sales prices in the province are up 10% over last year, averaging $323,968, up from $294,180 in 2007. When looking at the median sales price a similar statistic emerges with 2008 up 9% over 2007, at $349,900 from $320,000 in the previous year.

Out-of-province buyers sit tight in 2008.

Down 37% from levels enjoyed in 2007, out-of-province purchases fell from 9,375 to 5,891 in 2008. The most significant decrease came from Canadian buyers in provinces other than BC, Alberta and Ontario. This buyer group had 60% less sales than in 2007, down from 1,111 to only 444. Albertans remain the most significant market of BC property purchasers from outside our borders, representing 69% of all out-of-province purchases, totalling 4,061 sales.

Alberta buyers continue to shop close to home with 33% and 30% of purchases in the Okanagan and Kootenay region in 2008. The preferred property type for Albertans remains the condominium, representing 37% of purchases (1,496 sales), followed by vacant land at 27% (1,077 sales) and detached homes at 22% (881 sales).

BC Budget assumptions: nice try

Three weeks ago the BC Budget was released. The basis for the revenue and cost projections for the budget was an average 6.2% unemployment rate in 2009, falling to 6.0% in 2010.

I previously posted on this topic here. For the assumptions in the budget, see this pdf page 87.

How are we doing so far? Well, three weeks after their projection, unemployment has now hit 6.7%--up 0.6% from January. I'll put up the graphs later, but it appears to be going hyperbolic. [UPDATE: here it is! I think my 10% by 2010 prediction is looking likely.]
In short, the $495 million dollar deficit projection has now been blown out of the water.

I'm not clairvoyant here. I just observed that housing starts were going to plummet leading to construction employment to go back to pre-bubble levels. If you do the math, you can see what will hapen to employment. But, I'm sure all we'll hear from the usual economic commentators and our government leaders is another chorus of 'hoocoodanode'.

Enough with the koolaid and the rose coloured glasses! Can we please all open up a can of reality soda and get on with what has to be done?

Wednesday, March 11, 2009


I have written about different premiums placed on housing that can lead to prices higher than the current net rents they generate would justify. The two I have discussed are the "ownership premium" that was argued to be fallacious and the "densification premium" that was argued to be reasonable. I will discuss the gentrification premium, an anticipation of increasing a property's future productivity by anticipation of an improvement in its neighbourhood's quality.

Gentrification is where a neighbourhood is generally seeing a rise in its "quality", however that is defined. From a strict point of view, gentrification is where a neighbourhood's real income rises. But it could well be a neighbourhood appears to be getting wealthier when the actual monetary wealth of its inhabitants is not, even though the "quality" of the inhabitants is indeed increasing. (Wealth can be measured in different ways!) To handle these two scenarios, and for reasons to be apparent, I will be looking at rents, not incomes, as a method of measuring gentrification.

A quick note on taxonomy. A neighbourhood that is "gentrifying" or "undergoing gentrification" is a measurement of its trend towards increased quality. A neighbourhood that is "gentrified" is a measurement of its current quality after the gentrification process. A gentrifying neighbourhood will become gentrified while a gentrified neighbourhood may or may not be gentrifying further.

Gentrifying eventually means a neighbourhood will be more desirable. This can be due to many factors including proximity to shopping, good schools, good quality building, status, etc. Gentrification can even be self-reinforcing, where a neighbourhood receives a good reputation and becomes even more desirable. Many will pay a premium of their incomes to live in a gentrified neighbourhood so rents as well as prices would tend to be higher. Incomes will tend to be higher as well as only those with higher incomes can afford the rents and prices but this is not absolutely true. It can also be that the neighbourhood contains some willing to spend more of their incomes on housing. Thus we have two dynamics: greater desirability generally means people are willing to pay more of their incomes to live there, and greater desirability attracts those with higher incomes. The ultimate arbiter of desirability comes down to rents charged -- whether someone is willing to pay more or has ample income with which to do so is not directly relevant, though it has significant implications about a neighbourhood's ability to make gentrification "stick".

The rents and prices of ungentrified and gentrified neigbourhoods should still line up so as to give an investor a decent return. The investor doesn't really care so much for whether a neighbourhood is gentrified. (He may care to some degree though. Perhaps a gentrified neighbourhood generally attracts a more responsible tenant meaning he can generally afford lower yields but that is likely a secondary concern and not the subject I am trying to address.)

If a neighbourhood is expected to gentrify in the future, prices can carry a premium beyond that suggested by current rents. Imagine a condo in a neighbourhood that is "the next thing". It is a quirky Bohemian neighbourhood and has lots of amenities and vibrant culture. There is an argument that over time the neighbourhood will start attracting more affluent residents or just "ordinary" residents willing to pay a premium to live there. But not yet. There are still warts around drug dealing and crime but the general consensus, vis a vis other neighbourhoods, is this neighbourhood has a bright future. If we can reasonably expect that rents will outpace inflation in the future, this condo can be sold at a premium compared to what its current rent justifies.

The gentrification premium is in many ways speculative but is based on one's reasonable expectation of future inflation-adjusted rent increases. It is not absolutely certain a neighbourhood will gentrify. It may start looking better but perhaps rents don't increase like we anticipated. Perhaps the drug problem persists or other neighbourhoods are offering competition keeping the rents down. The gentrification premium here was not justified because rents did not increase as expected and we are left with unfounded speculation.

Notice the gentrification premium is about anticipation of rent increases. A neighbourhood that is gentrified but not expected to gentrify more would not have a gentrification premium.

An important point is that gentrification can apply to a city as a whole or to its individual neighbourhoods. It is generally true that Vancouver commands a premium to live compared to other Canadian cities but only as it relates to incomes (the ability to pay) and income-to-rent ratios (the willingness to pay). In other words people are willing to pay a larger portion of their salaries towards accommodation in Vancouver than in other regions of the country and/or, possibly, only the more affluent can afford to live there. These two factors can be due to many reasons including cultural ties, climate, ambience, high paying jobs, whatever. If we think that the city's FUTURE desirability will increase and people are willing to pay MORE of their incomes towards accommodations than is currently the case, and/or that incomes are generally set to rise above inflation, Vancouver can carry an aggregate gentrification premium. The data I have seen make this thesis sketchy. Incomes and rents have tracked each other quite closely over the past 25 years and real incomes and rents are at best flat.

If an individual neighbourhood gentrifies and a city's overall rent and income trend is flat, as seems the case in Vancouver, it has important implications for the gentrification premium. Stated bluntly, the sum of all gentrification premiums must sum to zero. For every neighbourhood that is truly gentrifying, to balance the books, there must be another neighbourhood experiencing the opposite, at least in terms of rents. Keep that in mind when touring a sample of neighbourhoods.

Now it could be Vancouver is collectively becoming higher quality without income and rent increases. I applaud such efforts to increase quality, akin to a war effort in a way, and this could well lead to higher rents and incomes. However high quality is based upon producing real value such as vibrant neighbourhoods, workmanship, effective facilities and services, low crime, and sustainable and productive employment; not a quick paint job and a two week vanity party. There is, though, a justifiable premium should residents collectively make the city into something greater than it is today, as measured by income and rents sometime in the future.

Also note that gentrification and densification can go hand-in hand. Densification is generally about increasing land productivity by increasing the number of dwellings where gentrification is increasing land productivity by improving its quality. Often both occur at the same time but not necessarily.

The takeaway from the subject of gentrification is that for a property to have a gentrification premium, one must reasonably expect rents for the same property to increase more than inflation, by way of improved desirability, income growth, or both. The anticipation of the city's future greatness is what has led many to justify paying a speculative premium for Vancouver property and this premium is certainly priced in, in spades. At some point -- and who knows when -- the promise of greatness needs to be delivered.

New housing prices drop most in Western Canada: StatsCan

From CBC News.

Contractors' selling prices for new homes decreased 0.6 per cent between December and January, Statistics Canada reported Wednesday.

The agency said the largest decreases were recorded in cities in Western Canada, and the pace of decrease in January was slightly faster than the 0.1 per cent decline observed the previous month.

Prices declined 2.8 per cent in Edmonton, 2.1 per cent in Calgary, 1.1 per cent in Victoria and 0.7 per cent in Vancouver in that period. Builders in those four cities reported unfavourable market conditions.

Contractors' selling prices for new homes in New Brunswick, however, increased between December and January.

In Saint John, Fredericton and Moncton, new housing prices increased 1.4 per cent from a month earlier.

Statistics Canada said builders in New Brunswick increased their list prices or returned to their list prices, after reporting lower negotiated prices in previous months.

Meanwhile, in St. John's and Saskatoon, prices for new homes increased 0.8 per cent from a month earlier, while in Quebec City prices increased 0.6 per cent.

Statistics Canada said the new housing price index decreased by 0.8 per cent in January compared with the same month in 2008. The drop was the first year-over-year decrease in Canada since January 1997.

Year-over-year declines were recorded on the Prairies, with a 10.4 per cent decrease in Edmonton, a 6.5 per cent decrease in Calgary and a 2.7 per cent decrease in Saskatoon.
In B.C., Victoria reported a year-over year decline of 4.2 per cent, while Vancouver posted a 3.2 per cent decline.

Monday, March 09, 2009

Vancouver Housing Starts Falling into the Abyss

The highlight: Vancouver CMA housing starts off 71% from last February, Abbotsford CMA housing starts off 84%, Chilliwack CMA housing starts off 80%. Sheesh!

Canada Mortgage and Housing Corporation
Mar 09, 2009 08:15 ET

Canada Mortgage and Housing Corporation: Metro Vancouver Housing Starts Low in February

VANCOUVER, BRITISH COLUMBIA--(Marketwire - March 9, 2009) - Preliminary figures from the Canada Mortgage and Housing Corporation (CMHC) indicate housing starts in February were close to three quarters lower than the level recorded in February last year. There were 701 homes started this month in the Vancouver Census Metropolitan Area (CMA) compared to 2,446 home starts in February 2008."

February 2008 was an unusually strong month for housing starts, which makes the year over year decline more noticeable," said Richard Sam, Market Analyst with CMHC. "

However, low starts data for the first two months of 2009 are an indication that developers are pulling back until some of the supply of new and resale homes on the market are absorbed. In turn, home buyers will benefit from current buyer's conditions that exist in the resale market. CMHC is forecasting that housing starts will decline by more than one-third in 2009," added Sam.

Moving further into the Fraser Valley, housing starts remain low for the fifth consecutive month in the Abbotsford CMA. Very similar to the housing market in the Vancouver CMA, many projects are on hold.Provincial home starts declined to 12,300 units, seasonally adjusted at annual rates (SAAR) from 14,100 units in January 2009. At the national level, housing starts moved lower in February to 134,600 units (SAAR) from 153,500 units (SAAR) in January.

To view the map and tables accompanying this press release please click on the following link:

Saturday, March 07, 2009


You will probably hear the word “densification” thrown around on this and other local blogs from time to time. What it is, basically, is the anticipation that a piece of land will be subdivided or “densified” so as to put more dwellings in the same area. This has the effect of increasing the land’s productivity -- more rent from the same amount of land -- and more importantly has implications on how to value the land itself.

To understand densification we can look at two extreme examples, a highrise condo complex and a detached property right beside it. In the condo’s case, its units produce a certain utility, captured by the rents collected, and have certain costs, captured by the maintenance and other carrying costs. Since it is unlikely the condo will be torn down in the next (say) 50 years, we can sum the net cash flows, discount at the cost of capital, and we get the property’s net asset value.

Next the detached property. Since it is in a neighbourhood that has higher average density it is possible to sell the property to a developer who will build a dwelling of density commensurate to the neighbourhood’s density. The owner of the property, however, can choose not to sell the property and instead rent it out. From a net asset value perspective, what a property is worth is choosing a use that maximises total return. In this case it is possible the owner could maximise his profit by selling right away to a developer. It may also be possible he can wait a few years and hope the price of land increases above inflation and sell then. In the meantime he must live with lower returns from rents which will be (hopefully) compensated by higher capital gains as the land increases in value.

Undensified properties in an area that is undergoing population growth therefore need a bit more analysis when determining value. When we sum cash flows from rents we must consider all possible uses of the land, including renovations, reconstruction, or leaving it as-is. The maximum of all possible outcomes will set the price.

But how about properties where densification is a ways off? We can take somewhere like Vancouver as an interesting example of this. Many neighbourhoods in Vancouver have been densifying for the past 20 years. Witness the addition of dual suites in the past 5-10 years where before it was common only to have one and 20 years before this suites were not necessarily the norm at all. It is conceivable that in 10-20 years from now houses will become multiplexes, as they are in certain parts of the city already. We can do some quick back-of-the-envelope math to figure out what to expect. From this we can determine a “densification premium” to put on a piece of land expected to be densified.

Let’s take a 2000sqft bungalow that can rent for $1600 on today’s market. There are several options available for this property. We can rent it out as-is for a net profit of around $15K per year. We can tear it down and build a denser property, say a Vancouver Special with two basement suites that could rent for $3000 total, netting $30K per year. But the structure costs $250K to build and would forgo one year’s rent in the process. Another alternative is to wait for ten years and subdivide into a duplex, perhaps the construction costs $300K (in today’s dollars) and could be rented for $5000 total, netting $48K per year.

So which one to pick? Doing a quick net asset value calculation, option A is $270K, option B is 320K and option C is $290K. From these assumptions I would be better to rebuild the property right away and start generating revenue quickly.

The point is not the accuracy of the calculations, only that a property’s potential return can be more than what its current structure can produce. It doesn’t necessarily mean all properties should be torn down but it does mean their values will be higher than what a straight rental income equation suggests. This is the densification premium.

Premiums for densification and speculation are often confused. A densification premium is really about summing cash flows assuming the property is held in perpetuity and redeveloped as necessary to maximise return. Speculative premiums, those we have seen in many US cities and those likely present in Vancouver, are not really densification premiums at all if the net cash flows do not reasonably justify the prices.

Another point is that while future development and densification is a certainty, the existing properties must be carried by someone until they are ready for redevelopment. This means that families and investors must occupy the properties until such time as it makes sense to start densifying and have the incomes or equity to do so. It also means if densification is a ways off it has little to no impact on the property’s value. Many assuming a property will be redeveloped in the next 20 years may be extrapolating a bit too aggressively depending upon where the property is located.

A final and obvious corollary to all this is that a densification premium is on the land itself, not the structure. The potential uses of the land determine its value. The current capital asset located on the land has value as well of course. Note land values can be negative if there is no way to make a profit by owning it. In certain parts of the US, notably Detroit, this is effectively happening.

Densification premiums along with speculative premiums are already priced into the local market and then some. If we experience a full-on market crash the price bottoms for detached housing will still justifiably include some semblance of densification premiums. Condos will not be so lucky, not because they cannot be densified further but because the reconstruction costs are considerable compared to the increased density. (Construction costs do not necessarily scale linearly with density.)

What should we take away from the densification premium concept is that many properties carry a justifiable premium (or discount!) over what is justified by their current rents. This is an important point when determining value in a market downturn and estimating a property’s inherent value from an investment perspective.

Thursday, March 05, 2009

Fraser Valley Real Estate - February 2009 Stats

The Fraser Valley Real Estate Board posted the February 2009 Statistics package and here it is on the down low.

Sales stink like the fresh manure smell that permeates the Valley many days! Sales are at levels not seen since the 1980s.

Active Listings are quite high for this time of year and seem to be rising in the normal seasonal pattern.

Since sales rose a bit from January the number of months that it would take at the current sales rate to sell all the homes for sale in the Fraser Valley dropped to 'only' 14 months. This means that if you are trying to sell a home right now, it might take a while unless you drop the price - a revolutionary idea to be sure - this whole supply / demand equilibria thing.

The benchmark price has fallen 13% in 9 months now with more price drops to come it seems.

The correlation between the supply / demand situation and price changes is strong. If prices are to increase substantially anytime soon it will take a massive rise in sales, large reduction in active listings or both for this to change.
By performing some simple seasonal analysis it seems that months of inventory will probably bottom this year at the 7-9 MOI level in either April or May. This does not indicate upward price pressure and by later in the year we could be looking at some very significant price declines. The Fraser Valley is on track to lose another 15% or so in 2009. There are potential events that could influence the market in either direction as well.

Wednesday, March 04, 2009

The Rental Shortage

The Tyee has had an interesting series of articles on the housing market of late and the latest in their installment is The Path to New Rental Homes: One Broker's View by guest poster David Goodman. I encourage you to read the post as it highlights some of the technicalities surrounding building rental housing in the Vancouver area. Certainly it seems, on the surface, to be a bit of a quagmire.

First he starts off by setting the scene:

During my 26 years in apartment sales, I've heard on at least 50 separate occasions developers commenting that "even if the land is thrown in for free, we cannot make the numbers work on a new rental building." As a result, the Vancouver vacancy rates stands at 0.5 per cent, the age of the average purpose-build rental is 50 years plus, and local developers attempting to produce new rental housing are likely to lose money.
So developers cannot "make the numbers work"? Sounds reasonable. But I don't really get it. The vacancy rate is low, apparently signaling low supply. I would expect rents to increase to compensate for the low vacancy rate. I wonder why rental rates aren't increasing -- maybe the vacancy rate isn't as low as he is citing? He continues:

Things changed considerably in the early 1970s when the strata condominium was introduced to the market. This new concept provided buyers, including tenants, the opportunity to purchase and own their own suite rather than pay rent. Prices paid for condominiums were soon much higher than rental apartments. As a result, land quickly increased in value to reflect the fact that building condominiums was significantly more profitable than building rental apartments. Accordingly, except for very few special situations, the construction of purpose-built rental properties ceased. This situation has not changed much since the 1970s.
Ahh now we get to it. The reason purpose built apartments have not been built is because building condos is more profitable. It certainly seems that, given the horrid price to rent ratio in the city, any developer would be batshit crazy to build something with cash flows unlikely to cover debt repayments and other carrying costs (except with a large downpayment of course! haha).

Over many years, the developers of condominiums would assemble single-family lots in apartment-zoned areas or seek to rezone former industrial sites. Unfortunately, we have almost exhausted the conventional source of residential development land throughout the Lower Mainland. As a result, the cost of multi-family zoned land and the resulting new condominiums have increased much further in Vancouver compared to other parts of Canada. This is one reason why we have all heard of some prime Vancouver sites selling at over $200 per square foot gross buildable at the recent peak of the market.
The old faithful "running out of land" argument. Can we be so sure about this? Maybe it seems land supply is tight because there are so many projects under construction? The population didn't suddenly explode in the past 5 years and hit the buildable land brick wall. It is entirely possible what we are witnessing is underutilisation of existing housing and speculation. If we were truly land constrained wouldn't real rents be increasing as well? Strange how they are not.

I have learned to appreciate the important real estate concept known as "highest and best use" in considering the value of real estate.
Developers and value investors share this philosophy. But the difference is what "value" means. For the developer it's a very simple and short term calculation: build within one or two years and sell, pre-sold or on spec, to someone else, likely a speculator (in one form or another). This dude either occupies it, using the full brunt of his ownership premium, keeps it dark for a flip, or rents it out at a yield a developer wouldn't touch with a ten foot barge pole. Value investors, on the other hand, look at "highest and best use" more on what cash flow is possible. It may mean re-development but only because doing so generates higher rents to compensate for the construction costs and delay in occupancy. I have no clue the thought patterns of Mr. Goodman's current clients though I would expect, given they are the "dudes" buying the bags, it's not exclusively a value play.

Purpose-built rental housing is not being built because of more profitable alternatives to the developers, namely selling it to someone else to deal with. I laugh when I realise the rental vacancy stats Mr. Goodman cites don't include small time landlords to whom his developer acquaintances sell. I am sure regulation plays some part but give me a break -- even if we remove every shred of red tape surrounding rental units it still wouldn't make sense UNTIL THE RENTS CAN COVER THE THE CARRYING COSTS.

It is laudable Mr. Goodman's suggests to streamline the ability to build purpose-built rental housing again but to think doing so will suddenly swing developers into the rental camp again is a bit too "rich" for me, at least until land values drop or rents increase to where it makes financial sense. I encourage him to keep priming the pump for such an eventuality.

Tuesday, March 03, 2009

You Are Still Winners Vancouver!!

REBGV released monthly housing market data for February 2009 here.

You might feel like a real loser for buying those 4 presale condos at the Woodwards building that you are really underwater on now but you can rest easy knowing that Vancouver is a 'winning city.' We are still winning the fastest real estate price decline from peak of any North American market but it really looks like we are going to have to pick up our socks if we are to maintain that lead. Come on now Vancouver, let's give Miami something to talk about.

Sales are still in the figurative toilet and we can expect them to rise for the next 2 or 3 months as the normal seasonal variations of activity in the real estate market take place.

Active listings are at super elevated levels before the spring listing rush.

The ratio of sales to active listings is low, really low.

Months of inventory is high, really high.

The tight correlation between months of inventory and price changes continues to be tight. Tighter than white on rice.

Prices are still in a downward trend.

Good luck with those Woodwards condos, I'm going fishing.

Sunday, March 01, 2009

In Derrick Penner's Shoes

The Vancouver Sun published an interesting discussion between so-called real estate experts with Sun reporter Derrick Penner asking the questions.

"The Sun invited to its editorial offices a panel of experts in Polygon Homes chairman Michael Audain, top realtor Patsy Hui with Re/Max Westcoast, and Tsur Somerville, director of the centre for urban economics and real estate at the Sauder School of Business at the University of British Columbia."

Here are the questions I would have asked if I were in Derrick Penner's shoes:

1) Please tell me how you each earn a paycheque? Do you feel how you earn your money helps you have an unbiased opinion on real estate matters?

2) What makes you a real estate expert? What are your qualifications?

3) Why should the Sun's readers heed your advice? Do you actually have any advice? What is in it for our readers? What's in it for you?

4) What would you say to someone who felt that prices of homes in the Vancouver area were destined to fall another 20-30% from current levels? What would you advise people to do if that were the case?

5) Where do you feel future buyers of real estate will come from since population growth is at historically low levels and the ownership rate has risen dramatically in the past 15 years? How will prices rise if there are fewer buyers than sellers?

What would you have asked if you were in Derrick Penner's shoes?