Wednesday, July 11, 2012

Financing Advantages

Something that goes somewhat unstated in the real estate discussions I read online and in print is how, in Canada, residential financing receives preferential rates over similar investments not only for owner-occupiers (aka "homeowners") but also investors ranging from the family renting out a basement suite to those who actively manage multiple properties and derive the lion's share of their income from these operations. The article that piqued my interest is one written by Martin Wolf last year:

According to a FT article last week, Lloyds’ bank has a target return on equity of 14.5 per cent. Banks like to argue that this is the level of return on equity they need to earn, in order to gain funding from the markets. Naturally, remuneration is linked to achieving such objectives. The question, however, is whether such objectives make any sense. The brief answer is: no. 
Forget banks, for the moment. What would you say if someone offered you an investment with a promised real return of close to 15 per cent? You might say: “How much can I buy?” Alternatively, you might say: “What is the catch?” Sensible people must take the latter view. If you thought that you were being offered a reliable real return at such an exalted level, you would buy as much as you could. This must be particularly true now when real returns on the bonds of relatively safe governments are close to zero. 
So what is the catch? The obvious answer has to be that the real return in question is extremely risky, because it is volatile and offers a significant chance of total wipe-out.

So yes on the surface when someone claims a double-digit return on equity on an asset that ostensibly grows at the same rate as the overall economy one must think a bit, but Wolf makes a few observations about how this can be sustainable over long periods (emphasis mine):

In truth, there are two other reasons why banks might earn 15 per cent returns on equity, apart from the fact that these highly leveraged balance sheets are risky. One is that they can earn monopoly profits. The other is that they are subsidised, principally because taxpayers provide insurance against catastrophic risk, particularly for bank creditors. The two – monopoly and subsidy – are, of course, related. Without barriers to entry, subsidies would be arbitraged away. 
In short, when banks tell us that 15 per cent (or something in that neighbourhood) is their target returns on equity, they are saying that their businesses are very risky and/or protected against competition and/or well subsidised and probably a bit of all three.

In the case of housing in Canada, both investors and owner-occupiers have access to government-underwritten financing that pushes spreads down to levels that, without a government backstop, would be higher. In terms of the added spread, I've heard estimates of the added spreads of around 100bps for prime low-ratio loans. In cases where land is leased, liability is limited, LTV ratios are high, or cash flows are risky, this spread increases.

Canada has, for a prolonged period, subsidized residential investment and home ownership through preferential lending rates. If this produces net beneficial externalities the lower spread is somewhat justified but on the other side, as Wolf highlights in his post, government subsidy is not necessarily a free lunch; rather risks can build and must eventually be borne on government balance sheets, taxing future growth.

Canada has been riding increasing real land prices for over a generation and we should be cognizant of the risk that preferential financing is incurring a large and looming liability on the government's books. With the recent run up in prices nation-wide, with prices becoming detached from their utility and consumer debt loads increasing, it is worth pondering whether that reduced spread from free market has to be given back, in whole or in part. Given recent moves by the Bank of Canada and the federal government, it appears this line of thinking is under active consideration.

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