An Argument for Permanently Higher Prices

The BC housing blogging scene is filled with posts both bullish and bearish on future prices. This particular blog has been, since its formation a few years ago, predominately bearish on the general BC real estate investment climate. In the interest of mixing things up I thought I'd present what I consider to be a valid argument for a permanent shift in higher prices in the Vancouver area.

First a little theory. A value analysis of real estate relies on determining a property's net asset value, the sum of its future discounted cash flows. I derived the formula here in 2008. To recap, a property's value is its net operating income (NOI) divided by the capitalization (cap) rate. The important thing to note about the cap rate is that it is, in theory, inflation-independent. The cap rate in essence is a measure of the inflation-adjusted cost of capital plus some risk factor.

Risks owning a property would include property damage, lost income due to a poor choice of tenants, demographic changes, et cetera. In the past few years the cap rate has noticeably decreased. The obvious reason for this is speculation however it is, every once and a while, worth investigating if part of the increase is indeed a secular shift towards lower cap rates. How could this happen.

Since a property's value is effectively inflation-independent we should investigate other possible ways higher prices can be justified. One possibility is that mortgage rates are permanently lower, effectively meaning the expected returns from other investments of similar risk have also decreased. This is deflation and, ultimately, will leave cap rates unaffected. We are starting to see the potential beginnings of falling rents in Vancouver. Many parts of the US are experiencing rental deflation, something unheard of since recording began after World War 2.

We can also look at the other risk factors associated with home ownership, namely suite damage, building quality, and poor tenants. It could be argued that building quality has recently increased due to technical innovations, effectively reducing the depreciation rate. From what I have seen this is unlikely as the drive for cheaper materials eats up any quality gain. In addition, during times when land prices are high, there will be a push to skim the edges of the building codes in the name of increased margins. I would be surprised if most new structures have a depreciation rate any better than properties built 30 years ago.

What if tenants are less risky? Here we may have something. Vancouver's demographics have changed in the past 20 years. Could it be that new residents to Vancouver are inherently more reliable tenants than those previous? There is some evidence to support this view. In Taiwan, China, India, and Hong Kong cap rates are a few % lower than the historical average in North America. Why is this? It could well be speculation but it could also be culturally there is less risk in renting. (It could also partly be more favourable tax regimes.) In addition a lower unemployment rate could mean a more stable (and one assumes a higher quality) tenant base than in previous years.

In summary Vancouver has low cap rates compared to the rest of the country. From what I see amongst friends and family there is a dangerous air of speculation on the city's future price appreciation. However we should not discount the possibility that renting property is becoming, on average, a less risky proposition due to a more stable tenant base. This is, if only in part, a valid reason for permanently higher prices.