The Home-Investment Duality

Similar refrains echo through my ears comparing real-estate-related articles in Vancouver to those cities with real estate booms in full swing in the US not seven years ago. Nonetheless after an uncharacteristic emotional outburst I had on Twitter regarding the mainstream media's failure to put forward with what I think a reasonable bearish argument for why Vancouver prices are too high, I was somewhat pleased to see the Vancouver Sun at the hands of Harvey Enchin dealing with the "home as an investment" mantra bearish RE bloggers have been highlighting for years now. A few excerpts from the Sun article:

Vancouver homeowners can be forgiven for thinking they've won the lottery.  

House prices have nearly tripled in the past decade and those who successfully timed the market have earned chortling rights. Long-term owners who bought their homes in 1987 for $200,000 could sell them today for $900,000 or more; a gain in the order of $700,000 or 350 per cent! 

But view those numbers like an investor would and a different picture emerges.

The article goes on to highlight a few issues with what property investors look at, including:

• Inflation adjustment
• Opportunity cost on downpayment
• Pointing to past bouts of house price volatility
• Changing asset liquidity
• Sales costs
• Capital gains tax exemption for owner-occupiers
• Financing costs

All valid points, though the summary at the end is interesting:

The notion that one's home is an investment vehicle rather than a consumption good is a relatively recent concept and it's not one that sits comfortably with many homeowners. People buy houses to settle down, start a family, raise children and become part of a community. It's where we conduct the business of living our lives. A house is more than a store of wealth, one homeowner opined, it is a store of memories.

Indeed that is what home ownership offers 70% of Canadian households. There is still, however, the 30% who rent, much of the stock owned by investors, so it seems that home ownership (not "one's home") as an investment is not a "relatively recent concept". Nonetheless it's interesting to see a reporter forage a bit deeper into the home versus investment train of thought and seemingly imply that some are, ahem, taking the home investment concept a bit too far without understanding the investment side too well.

So is a home an investment or just a place to live? Yes. It always has been; a house provides imputed rent, the net monetary value of the services a homeowner receives from a dwelling.

But the most important thing to garner from experiences in other countries and ours -- in all past real estate boom-bust cycles of which I'm aware -- is that investment returns, not homeowners' desires, eventually set the marginal price. I dealt with this concept here a few years ago if you want to understand the argument. In quick summary, investors receive no consumer surplus from ownership as would owner-occupiers, and will eventually set the marginal price of rental properties regardless of the surpluses placed by owner-occupiers, in part because investors make up a significant fraction of available property purchases in any given month (at least for certain property types*).

If you can get past that investors, not owner-occupiers, will set marginal prices, it then becomes incumbent upon all homeowners to understand what gives real estate its value in the long run. A simple, but reasonable, model is using discounted cash flows to estimate an investment's value, and a derivative of this model is validated by CalculatedRisk who shows price-rent ratios have reverted to their long-run average in the US. We should expect no different in Canada and Vancouver. (I outlined the model and derived its link to the price-rent ratio here, with a few caveats).

My advice, for what it's worth, is to get past this home-vs-investment mantra and look at investment returns, compare them to other similar investments available to investors, look critically at the actual risks property investments involve, and figure out why long-term returns in some US markets -- markets destroyed by 7 years of falling prices -- are finally starting to attract investor interest at price-rent ratios far lower than those broadly available in Vancouver.

(See my previous posts here and here for some cursory real estate investment calculations I've seen used by smaller-time real estate investors. In a future post I'll concentrate on the qualitative aspects of real estate investment risks, and how these risks are akin to a reverse lottery. For a sneak-peak at some of these risks and more important a view into how a property manager with years of experience views the current market and general issues surrounding residential property management (based in the GTA but still mostly relevant for Vancouver), I recommend reading Rachelle's wonderful posts over at LandlordRescue.)

* It is true that certain property types are heavily owner-occupied so the price-rent ratio and the concept of marginal investor pricing isn't valid for these dwellings, at least directly. However for the purposes of analysing property as an investment, leave these property types aside for a moment and consider markets with a more healthy mix of owner-occupiers and investors, say condominiums. If it turns out condos are heavily overpriced it is probable, though not certain, that property types with a high owner-occupier percentage will track condos towards lower prices.