Wednesday, March 30, 2011

Global Rebalancing

Concerted discussions by G20 countries to formulate a cohesive monetary policy are slowly at work. Recent comments by Bank of Canada Mark Carney on high levels of capital flows, a demand-driven commodity boom, emerging market inflation, and the transfer of such inflation to developed markets like Canada's, supposedly gave stock markets a reason to take pause earlier this week.

An interesting article by Manoj Pradhan and Alan M. Taylor of Morgan Stanley argues that the "global savings glut", where capital flows to emerging markets (EMs) return "uphill" to developed markets (DMs) in the form of asset purchases, are unlikely to continue at previous pace.
Capital flowed “uphill” from poor to rich countries — EMs saved more than they invested, the excess showing up as current account surpluses (net exports of EM goods) and financial outflows (net acquisition of DM assets). But digging deeper exposed a crucial fact: private capital still flowed “downhill” to EM economies in line with intuition, but offset by even larger “uphill” official flows, the reserves bought by EM central banks and sovereign wealth funds.


While EM reserves might still grow gradually to track EM expansion, a continued aggressive step-change to augment reserves relative to GDP seems unlikely, as current war chests are evidently large enough to cope with severe macroeconomic disasters.
Why is this important for Canadian housing? It's not a coincidence that low interest rates have been helped by increasing demand for treasuries by those abroad who have saved. If their saving patterns look to be shifting into investment, that should produce higher interest rates for government debt.

The article concludes:
...we see lasting consequences beyond those unfolding in the immediate aftermath of the financial crisis:
  • A huge rise in demand for capital in EMs with a more moderate increase in DMs. Talk of a savings glut or an investment drought may recede. The global real interest rate is likely to rise.
  • Less saving flows out of EM economies. Growth prospects are the main driver but risk premia for newly resilient EMs may fall. If investment demand is muted in DMs, and saving flat, the shift is weaker in DMs. Global imbalances moderate, reinforcing the trends after the crisis.
  • These current account shifts cannot be an “immaculate transfer” without real exchange rate adjustment. Recent real appreciation of EMs took the form of relative inflation and managed currencies (the latter creating political distractions). But EMs are likely to absorb further adjustment through nominal appreciation, given a triple whammy of cyclical reflation, growth differentials pushing nontradable inflation and oil/commodity price shocks.
Despite ongoing developed world unemployment issues, high commodity prices, and serial developed world sovereign debt crises, it's useful for us to remember the global economy will eventually start to recover in earnest and pay more attention to productive investment, and this can happen relatively quickly.

Teranet Index - January 2011

Home prices up 0.4% in January

Canadian home prices in January were up 0.4% from the previous month, according to the Teranet-National Bank National Composite House Price Index™. It was the second consecutive monthly rise, following on three consecutive monthly declines. January prices were up from the previous month in four of the six metropolitan markets surveyed: 0.9% in Vancouver, 0.5% in Toronto, 0.4% in Halifax and 0.3% in Montreal. Prices were down 0.6% in Ottawa, a fifth straight monthly decline, and 1.0% in Calgary, a fifth decline in six months. Thus the correction of late last year turned out to be short-lived for the country as a whole - three months - and longer-lasting in Ottawa and Calgary.

The 12-month gain in the composite index slowed to 3.9% in January, the seventh consecutive month of deceleration. The largest 12-month rise was 8.2% in Halifax. It remains to be seen whether this lead will last, since the small number of transactions normally recorded in Halifax in December and January could make its reading less stable. The 12-month increase was 6.4% in Montreal, 5.3% in Ottawa, 5.1% in Vancouver and 3.9% in Toronto. Only in Calgary were prices down from a year earlier, by 3.4%.

Data for February from the Canadian Real Estate Association show generally balanced conditions in major urban markets. Relative to the average, conditions in Calgary were better for buyers and conditions in Vancouver better for sellers, a finding consistent with the movement of the Teranet-National Bank indices for these markets. The Toronto market is no longer tightening. Between January 17, when the federal minister of finance announced that the maximum amortization period for an insured mortgage would be reduced to 30 years from 35 years, and March 18, the announced effective date, the resale market may have been influenced by the prospect of this change.

The Teranet–National Bank House Price Index™ is estimated by tracking observed or registered home prices over time using data collected from public land registries. All dwellings that have been sold at least twice are considered in the calculation of the index. This is known as the repeat sales method; a complete description of the method is given at

The Teranet–National Bank House Price Index™ is an independently developed representation of average home price changes in six metropolitan areas: Ottawa, Toronto, Calgary, Vancouver, Montreal and Halifax. The national composite index is the weighted average of the six metropolitan areas. The weights are based on aggregate value of dwellings as retrieved from the 2006 Statistics Canada Census. According to that census1, the aggregate value of occupied dwellings in the metropolitan areas covered by the indices was $1.168 trillion, or 53% of the Canadian aggregate value of $2.207 trillion.

All indices have a base value of 100 in June 2005. For example, an index value of 130 means that home prices have increased 30% since June 2005.


Marc Pinsonneault
Senior Economist
Economy & Strategy Group
National Bank Financial Group

Teranet - National Bank House Price Index™ thanks the author for their special collaboration on this report.

Tuesday, March 29, 2011

Real House Prices and Price-to-Rent

Real House Prices and Price-to-Rent

Great analysis and graph of hoouse prices.

This is what Canada's house price chart will likely look like in the next few years.

Sunday, March 20, 2011

The use and reasonably foreseeable misuse of price to rent ratios

financialinsights has been posting recently on the so-called price-rent ratio indicator of housing valuations. After reading these posts and associated comments by Ben’s readers, I thought I should give an understanding, using textbook finance theories, how “typical” price-rent ratios are derived and how they relate to conventional investment measures such as price-earnings ratios. In addition I will highlight an important difference in price-rent ratios that I believe is in play today that is unusual in other conventional investments.

Pardon if this is elementary for you and if this information is not absolutely correct. I have no degree in finance, but the crux of my assertions I believe to be correct. The post is a bit long but if you’re interested in understanding what price-rent ratios really mean it hopefully provides some "insight".

Net present value

To understand the price-rent ratio, we can first go back to basic finance math and look at the “net present value” (NPV) of a stream of future cash flows. Cash in the future is normally worth less than today and such is discounted at the “discount rate”, sometimes referred to as the “cost of capital”. For example if I promise to pay you $1000 today or $1000 a year from now, you will put less value on the future $1000 because you can invest today’s $1000 and receive, say, 2% interest risk-free, so my future $1000 is only worth around $980 (1000/1.02). If you are skeptical I am capable of paying you back on time (or at all), you will further discount my $1000 by some amount. If I’m the Canadian government you probably won’t discount much beyond expected inflation, if I’m the Greek government or some Joe of the street you are probably discounting a lot. If you can recoup the money by liquidating collateral put up by the debtor, the discount rate decreases. We can sum multiple discounted cash flows from different payment periods together and get its NPV. NPV is the price an investor would be willing to pay for an investment given the risks involved.

For a property, this series of discounted cash flows is simply revenue (rents) minus expenses (maintenance, taxes, management fees, and capital replenishment) from future payment periods. The revenue and expenses have some variability and risk inherent in property – there is no real way of avoiding it. As a result property will always have a higher discount rate than risk-free. However with property, as a bonus of sorts, revenue and expenses tend to increase roughly with inflation. (Well not quite; as a building ages it depreciates and has higher ongoing maintenance expenses, while the rent will slightly lag inflation – older buildings rent for less than newer ones.) As with any investment we sum the cash flows to get NPV:

NPV = (R-E) + (R-E)(1+i)/(1+d) + (R-E)(1+i)^2/(1+d)^2 …. + (R-E)(1+i)^N/(1+d)^N

where R is the rent, E is expenses, i is the rental inflation rate (which normally but not necessarily tracks CPI), d is the discount rate, and N is the final payment period. Assuming N is large, using simple math this reduces to:

NPV = (R-E)/(d-i)

Notice the denominator d-i for a moment. Remember d is the discount rate, which includes future inflation expectations and risk. In other words, d-i is what we can call an inflation-independent measure of risk. (Again this is a bit of a lie but not much of one.) This number is also referred to as the “cap rate”.

(You may also note that E does not include financing expenses. For the purposes of this analysis, assume we use our own money. Besides, anyone we borrow from or invests with us should be doing the same calculations we are.)

The analog for cap rate in other investments is the price-earnings ratio and the principle is the same (P/E => 1/caprate). With so-called growth investments, the expenses are front-loaded and a potential boon from revenues is pushed out and often heavily discounted, meaning their price-earnings are higher. Property investment will tend to more closely match the price-earnings of utilities like gas, electricity, or water. (Property is, after all, a utility in its own right.)

Relating to price-rent

Price- rent ratio is used because it is a quick mental calculation that is easy to understand and track. It is reasonably simple to see how it relates to the NPV calculation above. Since rents and expenses do not tend to deviate much over time, they can be lumped into a single number: a rule of thumb is to assign 20% of rent to expenses.

A typical residential investment firm would demand, say, a cap rate of 8%. (Wow that seems high… Well, historically, it isn’t.) This means we get an investor’s “desired” price-rent ratio:

desired P/R = 0.8/(cap rate) = 0.8/0.08 = 10

which is a gross yield of 10%. We have a derivation of the price-rent ratio based on an investor’s cursory DCF analysis.

Misuse of price-rent

Price-rent ratio metrics are an approximation. There are some deviations that can and do exist, some substantial. We hear stories of properties with 1000:1 price-(monthly) rent in parts of Greater Vancouver. When using price-rent to value a property it’s important to take into account its highest and best use. For example, a small house surrounded by larger more affluent houses (or condominimums) is likely going to be re-developed. Its value will be based on comparing various DCF scenarios and choosing the highest one. An underdeveloped piece of land is akin to a call option. In this scenario there are definite grounds for a higher price-rent (though maybe not 1000:1!) because an owner can sell today for today’s best use.

A piece of land expected to be redeveloped (or simply to have its revenue outpace inflation due to significant income growth) at some point in the future, but is not occurring today, is akin to a growth investment, where the market is assuming future cash flows will increase significantly some point in the future. This may or may not be rational and the premiums placed on these properties are speculative.

An important consideration for residential real estate, unlike other investments, is that it is not just investors who are active in the market. Owner-occupiers who prefer to own will be willing and able to pay a premium over rental value for a property, a so-called consumer surplus. In the case where owner-occupiers are heavily active in a market an investor either tags along for the ride, hoping to sell at a higher price in lieu of a low cap rate, or simply sits on the sidelines or invests in better returns elsewhere. Canada’s ownership rate has increased from 64% at the turn of the century to close to 70% today. If one believes the newly-minted Canadian owners place a premium on ownership, this will tend to have driven marginal prices higher. At some point, however, there are no more marginal owner-occupiers buying and we’re left with the “sidelines” investors requiring rental value without the premium.

In some markets there are few comparables that are rented. In this case, price-rent ratios are not useful due to poor data quality. A proxy of price-income ratios is used to infer “imputed rent” of a property. Country-wide this makes sense since, well, 70% of occupied properties are not rented! Nonetheless it is a proxy for what an investor would demand.

A final important point is how the role of financing would adjust price-rent ratios. I will not pass any opinion on this, only to state that, obviously, lower costs of capital have effect at the margins but it is far from clear to me permanently lower costs of capital would mean a secular shift to permanently higher price-rent ratios.

In summary the price-rent ratio can be construed as being derived from simple financial calculations of discounted cash flows. Since rational investors will eventually act as marginal buyers, the price-rent ratio serves as an indicator of where prices will revert before such investors will support prices. In the right circumstances it’s the purest indication we have of what gives housing value in the long run.

Sunday, March 13, 2011

Vancouver Housing-Related Statistics

This post is intended to summarise data sources that can be used to analyse the metropolitan Vancouver housing market. Many of these data sources can be used for other housing markets too. Unfortunately there is no one good source of data, however the Sauder School of Business has summarised much of the key historical data.

House Prices

Real Estate Board of Greater Vancouver House Price Index
jesse's REBGV tracking spreadsheet
Fraser Vally Real Estate Board House Price Index
Teranet National Bank House Price Index
Sauder data

Inventory and Sales

REBGV Press Releases
FVREB Press Releases and statistics
AgentWill's statistics (tracks a sub-area of the Vancouver CMA)
jesse's REBGV tracking spreadsheet


CMHC reports "Rental Market Reports — Major Centres"
Sauder data


Statscan labour force survey
BC Stats labour and income
Sauder data


GVRD city median incomes
City of Vancouver income map (2000)
City of Vancouver local area statistics
BC Stats taxfiler income tables
BC Stats labour and income


BC Stats Migration
BC Stats Population Highlights
BC Stats Population Estimates
GVRD key facts
City of Vancouver statistics
Metro Vancouver housing data book

Housing and Construction

CMHC reports "Monthly Housing Statistics"
GVRD data
City of Vancouver statistics (from Census data)


Citizenship and Immigration Canada statistics

Interest and Mortgage Rates

Sauder data
Bank of Canada data
Government of Canada 5 year bond quote

Economic Accounts
BC Stats

Economic Reports

BC Stats economic statistics
RBC Housing Trends and Affordability
TD economic reports


CMHC statistics
GVRD key facts
GVRD census bulletins
City of Vancouver statistics
Sauder Centre for Urban Economics and Real Estate data
BC Stats
Statistics Canada

Wednesday, March 02, 2011

Bifurcation of the BC Real Estate Market

No, bifurcation isn't a an intestinal disorder although it could cause some consternation (not constipation) among some observers who expect uniform behaviour across various real estate markets.

Based on market behaviour since the 'flash crash' of 2008/2009, we could draw a clear line between the urban market of Greater Vancouver and the rest of the province. The City of Vancouver and its immediate suburbs have witnessed a frenetic pace of home buying activity and consequent price rises.

This is in a pretty marked contrast to the real estate markets of the Fraser Valley, Vancouver Island, and the rest of BC. While prices have risen substantially in the area covered by the REBGV this past year, they have fallen or remained relatively flat in many markets including the Fraser Valley, Chilliwack, Okanagan, Northern Interior, etc. thus bifurcation.


Quite simply, I think it just comes down to supply and demand. The Greater Vancouver real estate market has inelastic supply and demand that is relatively stable. When the market is hot, supply becomes even more constrained as holders of real estate hang on for further gains rather than listing. Demand is increased as potential buyers feel like they are 'getting left behind' and the ratios of supply and demand drive prices higher. This, of course, can work in reverse, which is what we witnessed during the 'flash crash' of 2008/2009 and I expect we will witness a rather severe and perhaps more prolonged version again soon.

What do you think? When might this happen?

Note: The Landcor 2010 Report paints the same picture: