Canadian Real Estate - A Crack in the Tree

by Tom Bradley, Steadyhand Investment Funds

The Full Article

“It’s like if the tree in the backyard has a crack in it, you worry it’s vulnerable to a storm. But if no storm happens, it goes on and on, and maybe eventually strengthens through growth. If the right storm comes along and knocks it onto your neighbour’s house you’ve got a problem.”

This analogy for the Canadian residential real estate market is from our Bank Governor, Stephen Poloz. It prompted me to pull together a number of observations that were building up in my real estate file. In the attached piece (it’s too long for a blog), I point out that:

• Being too early is tantamount to being wrong.
• Real estate is a cyclical asset, cycles have a symmetry to them and therefore, extremely good cycles don’t end with a little pause or modest slowdown.
• There’s a strong consensus that interest rates will stay low and house prices will stay high.
• Fundamental measures are on balance negative. The most important ones are extremely negative.
• Foreign buying, inter-generational transfer and the loonie are wild cards in the analysis.
• Canadians are focused on the ‘Income Statement’ impact of buying a home (i.e. carrying cost), but are overlooking the ‘balance sheet’ impact.
• We’ve been in an ideal environment for rising real estate prices. It’s been a ‘virtuous circle’. If a few of the variables turn, a downward spiral is equally possible.
• A few other items that will make real estate bulls mad.

In true Steadyhand fashion, I’m not suggesting you make a big asset shift by selling your home and moving the family into a rental. But I am suggesting that it’s time for added caution. If possible, you should to be subtracting from this asset class, not adding.

Copyright © Steadyhand Investment Funds

Buy vs Rent Pet Peeve

News out of the US is showing prices are falling again but, on a positive inflationary note, rents look poised to rise, meaning the price-rent ratio is looking rather average. The combination of these two factors has caused the blogosphere to dust of the old rent-vs-buy calculators and show that, wonder of wonders, buying might not be such a bad financial move after all, in certain conditions, though there are still some doubters.

According to Ben Rabidoux's analysis of the data, Canada is still a ways off on this front. (Courtesy theeconomicanalyst)

There are a bunch of calculators out there, one of the more famous ones is the New York Times calculator that includes opportunity costs and other fees often glossed over by conventional buy-vs-rent calculators I've seen around. The calculator is well done, showing the number of years until owning will exceed renting from a strict financial perspective. In New York, of course, only around 55% of residents own, so there is some indication the consumer surplus (or ownership premium) is close to zero. As an investor at heart, with no ownership premium to speak of, I would recommend a more numbers-focused approach I outlined here that looks at real estate as an investment without financing costs (i.e. looking at the business case) first, then worrying about the financing later. But anyways.

I'm all for calculators -- I use one bought 20 years ago to do my day job -- but in the case of using one to calculate buy-vs-rent, one of the major pet peeves of mine is ignoring the "low probability high severity" risks in the calculations. Owning an expensive, complex and unique capital asset carries risks that are difficult to quantify on a spreadsheet. I put these low probability high severity risks into two categories: expense risk, and revenue risk.

Expense Risk

Since, for most, investing in property concentrates one's capital into a handful of assets, there is risk of some large un-hedged event occurring. For example water damage, plumbing, or other structural flaws may not be covered under insurance and many tens of thousands of dollars may need to be spent to correct them. These events will be rare but do happen from time to time.

Revenue Risk

Yes, people do get sick, die, lose their jobs, or get divorced. "It" will happen to other people until it doesn't, but we know statistically "it" will. Some of these events can be hedged against through insurance while others cannot. (Ask your spouse about buying divorce insurance if you like sleeping on the couch.) These risks are of course not unique to home owners and they can be mitigated by moving in case the expenses are too onerous. Owners face the challenge of not only moving but also selling, and this could be during a bout of market weakness; that is, the additional risk for owners is not being able to "ride out the dip" if prices fall.

Liquidity Risk

There are also risks with future "liquidity events". Housing market recessions are often accompanied by illiquid marketplaces where houses take significantly longer to sell than in normal times. If the above risks occur and cash is needed, or the house needs to be sold due to relocation or other life events, it may not be possible without selling at a steep discount. 

What can be done

Many of these items, as mentioned, can be hedged through insurance or, in the case of larger operations, diversification of holdings (which is what insurance companies do... normally). Diversification is not practical for a homeowner so he or she must absorb some of these difficult-to-hedge risks. Governments realise this to a degree, which is why they attempt to make housing more affordable for owner-occupiers through various (and often catastrophic) schemes like preferential mortgage rates, tax treatments, et cetera.

So after considering the factors in even the best buy-vs-rent calculators, there are risks that they do not account for. The nature of the risks means they are not meted out evenly and are difficult to quantify; how does one put a number on the probability of prolonged illness? The nature of low probability risks and their inability to be easily quantified means they are often simply ignored, even if they're real and potentially severe. That's a big mistake, in my opinion.

The ignoring of low probability risks is akin to a "reverse lottery". Since few will experience the fallout due to these risks, it will appear that the majority of people will have come out ahead by owning, which is true, but not necessarily in aggregate. If we sum all experiences, including the many "winners" and the few "losers", the buy-vs-rent gap narrows and may even turn negative.

The best method of mitigating low-probability high-severity risks is to demand a discount in home ownership over renting and diversify your investments. This may mean buying less primary residence and more other assets. The online calculators can only provide part of the information required to make a proper financial buy-vs-rent decision and should be used with caution.

San Diego Affordable Again

I have found Rich Toscano's posts over at Prof. Piggington's interesting over the years. Rich had correctly called the San Diego bubble -- the first major US market to experience price weakness -- and has been tracking its distress all the way down.

As a bit of an epilogue to San Diego's terrific bubble experience, Toscano has summarized the city's housing market conditions in his latest post Shambling Towards Affordability: Year-End 2010 Edition.

Why is Toscano such a great read? He has continually concentrated on the true "fundamentals" of real estate investing, including:

• price to income ratios
• price to rent ratios
• construction and real estate sector employment
• loan arrears
• rent and wage growth
• months of inventory
  

Save a handful of bloggers like CalculatedRisk and others, understanding what truly drives house prices in the long term seems oddly absent from discussion. Toscano has presented both relevant fundamental data as well as poignant analysis of them. Some of Toscano's important contributions have been:

• Even through the severe recession, he quickly understood rental growth continued to track CPI inflation even as wages and house prices were dropping and inventory was high.
• Prices per square foot closely tracked the Case-Shiller house price index, allowing a 3 month sneak-preview into apples-to-apples price movements. (The CS-HPI is released with a 3 month delay.)
• Construction and real estate-related employment distress portended a significant increase in foreclosure activity.
• Higher quality houses tend to be more "downwards sticky" compared to lower quality stock; likewise detached property prices fell slower than condos and apartments.

The biggest takeaway from Toscano's work is that, in San Diego -- a city with a growing population, a reasonably diverse economy, and desirable climate -- fundamentals eventually mattered. As 2010 drew to a close, San Diego's house price bubble has been summarily bookended with prices approaching fundamental values again, a process that took 5 years from their peak in 2005.

San Diego and Toscano ftw.

How Real Estate Investors Invest Part 2

In the previous post in this series I outlined the basic inputs and calculations used by certain investors when determining the investment value of a particular property. In this installment we go through a simple example for a purpose-built rental building. A massive thanks to Rachelle over at Landlord Rescue for allowing me to publish a simple spreadsheet containing the calculations of an actual property in the Toronto area. (Toronto was used instead of Vancouver to avoid investors in Vancouver real estate from soiling themselves.)

link to spreadsheet (Note there is a bug with google spreadsheets; Click refresh if you get an annoying popup window and avoid dragging your mouse over the "anyone with the link" link. Should be fixed soon I hope.)

This is an actual real-life building in the GTA. We have the following inputs:

Purchase Price = $528,800
Closing Costs = $1,000
Deferred Maintenance (Renovations) = $0

Revenue
Rent = 5 units totaling $3725/month

Expenses
Taxes = $4759/yr
Insurance + Utilities* = $4974/yr
Property management** = 8% of revenue
Building maintenance = 10% of revenue
Vacancy allowance = 5% of revenue
TOTAL = $1668/month

* Rent includes utilities
** Property management fees can be a few % higher in Vancouver

Calculations
NOI = Revenue-Expenses = $2057
Cap rate = NOI/Purchase Price = 4.7%
GRM = Purchase Price/Revenue = 11.82 (price/monthly rent = 142)

Financing
Here the investor is putting 30% down and assuming a 5% mortgage interest rate. With these numbers the mortgage payments just cover the NOI and is cash flow neutral, which is the goal of this particular investor.

Discussion
Here we see the investor requires 30% down and 5% mortgage rate to make this property cash flow neutral. Also note the investor does not consider capital appreciation when determining the investment's value; it's all about the cash flow at what they consider to be a sustainable financing rate.

We can see right away the impact of lower mortgage rates on these investors' criteria for a cash flow positive property. They have no earnings, at least initially, save debt repayments. In time, the investor assumes, the rents will increase with inflation and start producing positive cash flow.

After some years there will be some added expenses as the building starts aging. This is partly, but not completely, accounted for in the 10% gross rent maintenance allowance. Significant overhauls may be necessary from time to time and this is accounted for through depreciation allowances, usually a few % of the purchase price on a geometric schedule. Though the spreadsheet does not explicitly cover this, one can expect in time some of the free cash flow to be diverted to capital replacement.

Also for consideration is the 5% assumed mortgage rate. Certainly in today's climate mortgage rates could easily stay at or below this level for some time. I have no doubt some investors are using even lower rates (even variable rates!) when calculating their monthly cash flow. Food for thought, though, that rates this low are borderline deflationary. It is unclear if the projected rental increases will be as large as anticipated if rates remain low.

With this in mind, there is a box at the bottom of the spreadsheet for calculating purchase price for a given cap rate. That is (at least in theory), an investment with revenues that generally track inflation should not vary their present value when inflation changes, therefore the cap rate will stay constant. What cap rate would be considered acceptable? Well the "acceptable" number used by this investor is 7% for that particular property, putting an acceptable purchase price in the area of $308,600. Food for thought.

So there you have it. A real-life example of a cursory analysis of a potential real estate investment. Certainly there is a ton more to consider when evaluating a particular property's investment viability but, following this investor's philosophy for what it's worth, having these numbers work on a particular property (at whatever values one considers acceptable) should warrant some additional investigation. Otherwise, it's probably best to spend one's efforts elsewhere.

How Real Estate Investors Invest

This blog often deals with subjects that border on the abstract when it comes to the nuts and bolts of real estate investing. I recently viewed a spreadsheet used by a full-time real estate investor, one also used by many of this investor's acquaintances in the same line of work. This post is devoted to me explaining what factors they are using in their spreadsheet to calculate returns.

I will be focusing on a spreadsheet for the so-called "buy and hold" strategy -- buy, rent out, and hold indefinitely. We do not assume the property will be sold any time soon but, of course, capital appreciation comes in to calculating total return. So lets get into it.

(Note, I do not have permission to share this spreadsheet directly, however I will summarise how its calculations are performed as well as what inputs are used.)

Purchase Price

The first input into the spreadsheet is purchase price. We add into this closing costs and taxes, as well as any renovations that need to be performed before occupancy:

Total Price = Purchase Price + Closing Costs + Renovations

Revenue (Rent)

The major source of revenue for a property is rent. Here we use the anticipated annual rent from the property. There may be additional income sources, including: parking, vending, storage, interest income (e.g. on capital reserve), laundry, et cetera.

Operating Expenses

Operating expenses are the ongoing costs of maintaining the property. These would include property taxes, insurance, vacancy loss, advertising, repairs, management, strata fees, etc.

A big operating expense that is often overlooked by much of the analysis I see online is the so-called "capital cost allowance" which is effectively building up a reserve for capital replacement. This is, in the extreme, building up a reserve for building replacement but also includes large or small renovations that inevitably occur as the building ages.

Calculations

After determining our purchase price and costs, revenues, and operating expenses, we can calculate a few common values used by investors to determine their return. These are listed below:

Net Operating Income (NOI) = Revenue - Operating Expenses
Cap Rate = NOI/(Purchase Price) *
Gross Rent Multiiple (GRM) = (Purchase Price)/Revenue

* Note one can substitute Purchase Price with Total Price.

None of these calculations take into account financing. They are straight calculations on the investment's operations. They are also based on current, not future, operations; rent or operating expense increases are not calculated. GRM is analogous to the "price to rent ratio" that local commenters like to refer to. (A price to monthly rent ratio R would be equal to GRM*12.)

Debt Service and Financing

Financing is simply where the money to purchase the property comes from. It is either from the investor directly or through borrowing from a lending institution. Total debt servicing is an expense. Debt servicing costs are highly dependent on the interest rate. For longer term calculations, this interest rate may need to be modified to account for higher or lower rolled over financing costs.

Closing costs is the amount of cash required to complete the purchase, equal to Total Cost - Debt. A typical amount for closing costs would be, say, 25% of Total Cost, though other ratios are of course possible.

Capital Appreciation

Like most property, there will be some capital appreciation, usually expressed as an expected average percentage gain year-over-year.

Calculations after Financing and Appreciation

In a nutshell, a total return is comprised of: cash generation, debt repayment, and appreciation. After 1 year:

Cash on Cash Return (COC) = NOI/(Closing Costs)
Equity = (Purchase Price)*(1+Appreciation) + Cash - Debt
Return on Equity (ROE) = NOI/(Equity)
Total Return on Investment = Equity/Closing Costs - 1

NOI is annualised.

Stuff Not Done

As mentioned, there are things that are not calculated. Rental and expense increases, as well as debt repayment schedules are not calculated. There is a good reasons for this, in this particular case. The philosophy is that if the return after the first year is not positive, it generates no income for the investor. This is not sustainable without a large pool of cash to finance the shortfall -- these particular investors want to produce income.

Summary

Above are some of the formulas used by full-time residential property investors to calculate an investment's return. You can plug any property you see for sale on the market into these formulas into and come up with some typical figures, then play around with the financing costs and appreciation (both these have high sensitivity when it comes to calculating return). I'll go through a simple example next time.

These investors own property locally and are actively looking to invest in property in the current market. If you want to know who is looking to buy, it helps to understand what calculations and analysis they perform to determine a property's value and under what conditions they would buy.

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.

Gentrification

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.

Densification

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.

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.

The Argument Against Value Analysis in Vancouver

Much has been made by me and other long-time commenters on this blog about what housing prices would be in the absence of a bubble, the market's so-called fundamental value. Yet Vancouver's housing market has rarely (not never) been at a "fundamental" valuation in the past generation. Does value investing have a place in Vancouver real estate if prices rarely agree with the theory? I will outline the case for why not and offer some commentary.

Here I have attempted to paraphrase many of this blog's comments into this post. The information is not new, only presented. I do hope that readers, if they have time, read some of the comments here and in the archives for more insights into the fascinating subject of real estate in Vancouver, the "most bubbly city in the world".

The simple way of determining fundamental value is to look at an asset's current and expected future cash flows, discount them at your cost of capital, and sum them up. mohican uses a simple formula that I crudely derived here. There are other simpler and more complex methods of course and there is always disagreement over assumptions. With Vancouver specifically the last time properties were valued at what I consider to be fundamental valuation was around 2000 and before that in the mid '80s. Others will say 2000 was never at fundamental valuation, a local minimum that never quite reached the trigger point for them to consider it a good value investment.

The question is, if fundamental valuations have not been present since, say, the mid '80s, do they still have merit? The argument for why fundamental analysis is flawed for Vancouver real estate goes as follows. Real estate consists of cash flows from rents and capital appreciation. The Vancouver market has had many boom-bust cycles in its past. Even if an investor buys when prices are above fundamental value (not necessarily at the peak, mind), a subsequent boom cycle will allow the investor to exit with a decent overall return. Booms and busts are inherent to Vancouver's psyche. Given enough time, typically 7-10 years, you will always be able to cash out positive, the caveat being of course you avoid buying near or at the peak. Fundamental valuation is therefore rarely, if ever, achieved because investors anticipate future bubbles to compensate for poor rental yields.

In a nutshell, that is the argument. And before commenters rip it apart I will say that many people over the past generation have made decent real (or paper…) returns in this fashion. Most I have had discussions with do not engage in "pure" speculation (i.e. flipping) but actually rely mostly on rents for their return; "mostly" because for the return to really make sense they require some form of capital appreciation above inflation. The speculative component (i.e. prices above fundamentals) is apparently omnipresent within a typical investor's time frame.

The Vancouver price graph is indeed "biased" above fundamental value. So the argument goes, as I can make it out, you may have to wait a long long time for true fundamental valuations to return. If this is true, that Vancouver has a propensity for speculation, prices may never retreat to fundamentals in one's lifetime. In fact this is effectively the argument I hear on local blogs and amongst my acquaintances and family. Really they are saying that Vancouver is full of greater fools who will inevitably compensate us for poor cash flows or that their still fruitless but eternal hope of real income growth will manifest itself. And maybe they are right.

Of course speculation is a zero sum game and many we know have done well in the past generation in their real estate investments, "others" not so much. Here though I lob a few words of caution into the hubris.

First the assumption that Vancouver will experience another boom-bust cycle in most investors' time horizons is just that -- an assumption. There are precedents in other cities, most notably Tokyo, where prices have fallen for twenty years and counting. The market there had the ability to absorb a significant amount of investors with speculative components to their business cases and not lead to a subsequent boom; in other words a lot of speculators got burned waiting for the recovery that was not. Indeed the Japanese property market remained rational longer than speculators could remain solvent. Not to say this will not happen in Vancouver, but convincing yourself it won't is a high stakes assumption nonetheless.

Second is that oversupply this time around may all but guarantee a return to fundamentals. There are just not enough people for the number of units being built and, worse, we have seen Vancouver's population "spread out" from past decades. That is, the ratio of occupied bedrooms to the total number of bedrooms has been decreasing for the past decade due to what I believe to be both a demographic shift, and historically low and lasting unemployment (due in significant part to the construction boom as it happens). What is to stop this trend from reversing when average wages are falling? If you think mohican's graph of CMHC units under construction is scary, wait until under-productive dwellings are brought back to more full productivity as people tighten their belts.

Third the past generation has seen a perpetual reduction in mortgage rates and mortgage qualification thresholds from their highs in the early '80s. This in turn has improved affordability for existing owners and pushed up prices for future ones who can still miraculously tap credit lines. That trend is unlikely to continue much further. If mortgage rates increase, it will be decidedly bad for affordability. If mortgage approvals are stricter, fewer can qualify to buy at all. And prices will suffer.

It comes down to one thing, that Vancouver real estate has had a lengthy CV of booms and busts with a distinct bias above what would be justified by fundamentals. As an investor, you may well be relying on Vancouver's house price volatility to ensure your overall returns are satisfactory. Food for thought, though, that THIS time, it may indeed be different, though not in a good way for your future savings. On the flipside, for families looking to buy a personal residence only at fundamental value, there is some chance you could be waiting a long time, though perhaps not.

Sauder Housing Predictions

In a previous post I outlined basic theory behind net present value (NPV) calculations as it pertains to real estate and related it to a working paper (PDF) published by Dr. Somerville and Kitson Swann at the Sauder School of Business at UBC. I have read a few online discussions popping up recently regarding this paper, brought on I am sure in part by Dr. Somerville’s many recent quotations in the local media.

The paper claims that Vancouver’s house prices would need to drop 11%, from a benchmark of $754,500, to return to “equilibrium”: $680,000. If we look into the methodology used in the paper, the cost of capital elements such as tax, depreciation, and maintenance are determined by a percentage of current house value. This is fine however, should the house value change, we must re-adjust the figures as I will now do.

The cost of capital was calculated to be, as percentages of the original price: maintenance and insurance 0.5%, depreciation 1.07%, and tax 0.5%. All of course are fixed costs that will not vary significantly with changes in land value so nominally these values are $3773, $8073, and $3773 respectively. Note the $8073 number for depreciation is way too high and should be around $2500-3000 but for now let’s leave it as is.

The REBGV just released their statistics showing the new benchmark price in Vancouver is about $696,000 so let’s re-calculate the cost of capital, assuming as before a 5.4% annual capital appreciation (which I will deal with in a bit). The new percentages are: maintenance and insurance 0.54%, depreciation 1.16%, and taxes 0.54%. The new equilibrium cost of capital is 4.27%.

Uh oh. Now we need to re-calculate a new equilibrium price with the new cost of capital. Plugging in the numbers we get a new “equilibrium” value of $652,000. That is a drop of -13.5% from the paper’s benchmark price and a further -6.3% from today’s market price. If we perpetually plug in the new “equilibrium” prices into the formula, as we now must given prices are dropping fast, the new “equilibrium” converges at $602,000. Put another way, the true “equilibrium” price, given the property’s nominal costs and expected capital appreciation, is -13.5% below today’s benchmark price and -20% below the number used in Somerville et al’s paper.

It unfortunately does not stop there. I must take exception with the purported 5.4% annual appreciation numbers cited as the long term expected average appreciation in Vancouver. While this may have been true in the past there are at least three good reasons to believe this level of appreciation is far too optimistic.

The first way that prices appreciate is by rising incomes however Vancouver’s real incomes are flat. This means that in terms of long-term affordability, dwelling prices cannot increase much faster than incomes are rising, roughly at the rate of inflation. There is little in the short term to believe that incomes will be rising faster than inflation; in aggregate with falling employment and a looming recession the opposite is far more likely to happen in the medium term.

The second way prices appreciate is by densification; that is, the anticipation of using a piece of land to produce higher future incomes. Here there is a good argument that some property prices can appreciate faster than incomes are rising if they have not fully densified yet. However some quick deduction can show that there is a limit as to how fast average densification can occur: the population growth rate (around 1.2% in Vancouver area). From a practical perspective the actual densification will occur less because new land (farmland and forest) is being turned into residential dwellings, easing the maximum densification potential.

The third, and the most striking, way prices appreciate is through a waning of inflation expectations that has resulted in perpetually lower mortgage rates over the past generation and this has, through a perpetually decreasing cost of capital, caused unusually high capital appreciation. We are at a point where inflation expectations are unlikely to decrease much more. The best scenario is for mortgage rates to stay flat; the worst is for them to increase.

Taken all three together, the maximum nominal appreciation I would expect from Vancouver detached housing going forward is around 2.5-3% annually. Condos, due to the fact there is little possibility of densifying further, will likely appreciate at inflation, say, 2%.

Coming full circle, using my newly expected capital appreciation estimates, we can further adjust the cost of capital up by 2.4% and re-calculate “equilibrium” value. Astonishingly the new price drops to $270,000. Note this is too low, mostly because the depreciation number used in the paper is too aggressive. Using a more realistic annual building depreciation of $2500 we can re-calculate “equilibrium” at approximately $400,000. You can make other assumptions – perhaps a lower mortgage rate – and arrive at equilibrium a bit higher, however it will be difficult to justify anything but a significantly reduced outlook for the long-term appreciation of property prices compared to Somerville et al’s estimates.

Edit: Commenters here and in other places in the local RE blogosphere have raised questions about depreciation as a line item in a DCF (discounted cash flows) calculation. While I agree depreciation is not a cash flow, in this case depreciation represents an expected decrease in future cash flows below headline estimates. In terms of the formula's framework, for what it is, depreciation does account for decreased future cash flows but is not explicit enough to really know what Somerville is modelling. Read the comments for an alternate approach.

Also the "densification premium" awarded to detached properties is further reduced when one accounts for capital costs associated with making land more productive. More bad news.

Value Investing in the Current Environment

From here.

Jeremy Grantham is the Chairman of the Board of Grantham Mayo Van Otterloo, who manages approximately $120-billion in assets, well known among institutional investors but relatively unknown to retail investors. Here are some highlights from both parts of Grantham’s October 2008 newsletter “Reaping the Whirlwind,” and ”Silver Linings and Lessons Learned.”

Part 1, “Reaping the Whirlwind,” published 2 weeks ago:
“At under 1,000 on the S&P 500, US stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10 prices, but even more so. History warns, though, that new lows are more likely than not.
“Fixed income has wide areas of very attractive, aberrant pricing.
“The dollar and the yen look okay for now, but the pound does not.
“Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!
“Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows.
“As for us in asset allocation, we have made our choice: hesitant and careful buying at these prices and lower. Good luck with your decisions.”
You can read ”Reaping the Whirlwind,” in its entirety by clicking here where Grantham has published his views on the fallout from the financial crisis and the investment opportunities he sees.

Part 2, ”Silver Linings and Lessons Learned”, published early this week:
“When asked by Barron’s on October 13 if we would learn anything from this ongoing crisis, I answered, ‘We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term. That would be the historical precedent.’
“That is unfortunately likely to be the case. But over the next several years at least, there are many silver linings and valuable lessons to be learned.
“Chief among the many benefits of this crisis are unprecedented opportunities for investing in some fixed income areas where some spreads are so wide as to reflect severe market dysfunctionality.
“As of October 18, we also have moderately cheap US and global equities for the first time in 20 years. Probably quite soon, global equities too will offer exceptional opportunities after the additional pain that is likely to occur in the next year.
“We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the S&P as a probable low.
“The world faces unavoidable declines in economic activity and profit margins, so this overrun is unlikely to be much less painful than average, although you never know your luck.”
You can read ”Silver Linings and Lessons Learned,” in its entirety by clicking here where Grantham has published his comments on lessons learned from the credit crisis, as well as his proposed strategy.

Source: Jeremy Grantham, GMO, October 2008

Charts

I found this great chart over at Calculated Risk and thought I'd post it here for discussion.

Here is a chart of the TSX as well. As of market close on October 27, the TSX was down 43.3% from its June 18th peak. In terms of speed of the crash, the TSX kicks butt on the S&P500 with a 43% fall in only 20 weeks.

The Dimensions of Stock Returns

Abbreviated from here.
By Truman A. Clark

An ongoing objective of financial research is to explain the behavior of stock returns. Factors are sought that explain both differences among the returns of individual stocks in any given time period and the variation of stock returns through time. If a factor does both, it is said to explain the common variation of returns. In addition, if a factor is related to non-diversifiable risk and possesses explanatory power independent of other factors, the factor is considered a "dimension" of stock returns.

Fama and French (1992) found that two factors related to company size and book-to-market ratio (BtM) together explain much of the common variation of stock returns and that these factors are related to risk. Small cap stocks have higher average returns than large cap stocks, and high BtM (or "value") stocks have higher average returns than low BtM (or "growth") stocks. Based on Fama and French's findings, size and BtM are dimensions of stock returns.

Fama and French also investigated a market factor. A market factor is needed to distinguish stocks from fixed income securities, and it is important in explaining the variation of stock returns through time. But, among stocks in a given time period, differences in their sensitivities to the market factor are unrelated to differences in their average returns, so the market factor is not a dimension of stock returns.

The Fama/French results have important implications for domestic equity portfolio design. Large capitalization growth stocks constitute large portions of traditional "market-like portfolios" based on indexes such as the S&P 500, the Russell 3000 and the Wilshire 5000. Domestic equity portfolios with greater commitments to small cap stocks and value stocks offer higher average returns than conventional market-like portfolios.

Size and BtM also are dimensions of international and emerging markets stock returns. This confirms Fama and French's interpretation of size and BtM effects as rewards for bearing risk that cannot be eliminated by diversification.

Risk and Return
Controlling for differences in BtM by comparing large cap value to small cap value and comparing large cap growth to small cap growth, small cap stocks had higher average returns than large cap stocks. Controlling for differences in size by comparing large cap growth to large cap value and comparing small cap growth to small cap value, value stocks had higher average returns than growth stocks. The higher average returns of small cap and value stocks represent rewards for bearing risk.

If standard deviation were a complete measure of risk, average returns would increase as standard deviations increase. Controlling for differences in BtM, a direct relation between average returns and standard deviations is found when large cap stocks are compared to small cap stocks. But, controlling for differences in size, a discrepancy appears. Small growth stocks had a lower average return and a higher standard deviation than small value stocks. Since greater standard deviations are not consistently associated with higher average returns, standard deviation is not a reliable measure of risk.

Size, Book-to-Market and Earnings
Seeking a risk-based explanation for the relations of size and BtM to average returns, Fama and French (1995) investigated the behavior of the earnings of stocks grouped by size and BtM. Measuring profitability by the ratio of annual earnings to book value of equity, Figure 2 illustrates the evolution of profitability over long periods before and after stocks are classified by size and BtM. BtM is associated with persistent differences in profitability. On average, low BTM stocks are more profitable than high BtM stocks of similar size for at least five years before and after portfolio formation. Low BtM indicates sustained high earnings that are characteristic of firms that are growing and financially robust. High BtM indicates protracted low earnings that are typical of firms experiencing financial distress.

Expected Returns and the Cost of Capital
Financial markets channel funds from suppliers of capital to users of capital. Expected returns are the rewards investors anticipate for supplying capital. Investors require a higher rate of return (or risk premium) for bearing greater risk. Risk is something that investors collectively shun and that cannot be eliminated by diversification.

The cost of capital is the price users of capital must pay to obtain financing. Competition forces users of capital to bid higher prices to obtain funding for more risky ventures.

In equilibrium, the expected rate of return and the cost of capital are determined jointly as the price at which the demand for and supply of capital are equal. In financial markets that function efficiently, investors only receive risk premiums for bearing risk. As risk increases, the expected rate of return and the cost of capital increase.

High BtM and small size often indicate companies that are experiencing some degree of financial distress. On average, they have higher costs of capital because they tend to be riskier than companies with low BtM and large market capitalization. The higher average returns of small stocks and value stocks reflect compensation for exposure to non-diversifiable risk factors.

The Three-Factor Model
The findings of Fama and French suggest that much of the variation in stock returns is explained by three systematic risk factors.

· The market factor measured by the returns of stocks minus the returns of Treasury bills.
· The size factor measured by the returns of small stocks minus the returns of big stocks.
· The value factor measured by the returns of high-BtM stocks minus the returns of low-BtM stocks.

Portfolio Engineering
Many investors commit high proportions of their domestic equity holdings to portfolios resembling the S&P 500, Russell 3000 or other market-like proxies. Large cap growth stocks are the dominant holdings of the S&P 500 and the Russell 3000. As a result, market-like proxies are poor portfolio structures for investors seeking exposure to the size and/or value factors. Investors can get such exposure by increasing their relative holdings of small cap and/or value stocks.

The potential increases in expected returns due to these tilts can be estimated with the three-factor model. For purposes of illustration, it is assumed that the expected risk premiums are six percent per year for the market factor and three percent per year for both the size and value factors.

Words of Caution
Structured portfolios offer the prospect of higher long-term returns than market-like portfolios, but the expected risk premiums are not sure things. Factor premiums vary widely and randomly. For the 1927-2001 period, the standard deviations of the annual premiums were approximately 21% per year for the market factor, 14% for the size factor and 14% for the value factor. Owing to their high variability, it may take decades before rewards for bearing increased size and value risk are realized.

Cumulative premiums for each factor are computed by adding successive monthly premiums for the period January 1927 through December 2001. Although the cumulative premiums tend to rise over long periods of time, each moves erratically with lengthy episodes of downward drift. The market premium declined from December 1967 to July 1982—a period of more than 14 years. The size premium declined from December 1983 to December 2001—a period of 18 years (and still counting). The value premium declined from December 1987 to December 2000—a period of 13 years.

Structured portfolios are not appropriate for all investors. Structured portfolios have higher expected returns because they are riskier than market-like portfolios. Over periods of less than 20 years, structured portfolios often will have lower returns than market-like portfolios. It is only over periods of 20 years or more that it becomes more probable that structured portfolios will outperform market-like portfolios. Investors with short horizons or aversion to risk should stick with market-like portfolios. Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk.

International and Emerging Markets Equities
Size and value effects are not confined to US equity markets. The MSCI EAFE Index represents a portfolio of international stocks from developed countries similar to the S&P 500. EAFE is composed predominantly of large cap growth stocks. During 1975-2001, international small cap stocks had a higher average return than EAFE indicating a size effect, and international large cap value stocks had a higher average return than EAFE indicating a value effect.Based on the limited amount of data available, size and value effects also appear in emerging markets. The IFC Investables Total Return Index represents a portfolio of tradable stocks in emerging markets countries that non-resident investors are permitted to own. During 1989-2001, emerging markets small cap stocks and value stocks had higher average returns than the IFC index.

The international findings are consistent with Fama and French's interpretation of the size and value effects as rewards for bearing non-diversifiable risk. If size and value effects were related to risk factors unique to the US, forming globally diversified portfolios could eliminate them. Instead, the existence of similar size and value effects in both domestic and international stock returns demonstrates that these effects are global phenomena reflecting exposures to ubiquitous sources of risk.

Implications for Global Equity Allocation
EAFE is the international equivalent of the S&P 500. EAFE returns, expressed in US dollars, are determined jointly by stock returns computed in local currencies and foreign-exchange gains or losses against the dollar. Because the two indexes contain stocks with similar size and value characteristics, it is reasonable to assume that the costs of capital of EAFE and the S&P 500 are approximately equal. If it is also assumed that currencies have zero expected returns, EAFE should have about the same expected gross rate of return as the S&P 500.

Concluding Comments
The identification of size and value factors by Fama and French has important implications for equity portfolio design. Relative to traditional market-like portfolios, portfolios with greater exposures to the size and value factors offer higher expected long-term rates of return.
Structured portfolios can be designed that provide targeted sensitivities to the size and value factors. International and emerging markets equity returns also exhibit size and value effects.
Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk. For the right investors, structured portfolios are promising alternatives to old-fashioned market-like portfolios.

Shareholder Letter from Bill Miller

The following is a letter to shareholders of Legg Mason Value Trust: Second Quarter 2008

Dear Shareholder,

A group of us were standing around a few weeks ago when Warren Buffett wandered over. Chris Davis had dubbed us the Value Support Group, as we all adhered to that approach to investing. we were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were all losing clients and assets over and above our losses in the market. It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value.

Mason Hawkins said, "Warren, I'm an optimist. I think this whole thing can turn quickly, and surprise people. Are you an optimist?" "I'm a realist, Mason," the sage replied. Warren went on to say he was optimistic long term, and backed that up in a talk the next morning on the remarkable history of growth, innovation, and wealth creation the U.S. had produced over the past 200-plus years. He also offered a sober assessment of the current challenges we face, and said it would take some time to work through them.

He then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains. That is a point Charlie Ellis elaborated on in his fine book, Investment Policy, a few years back. As a matter of logic,
it is irrefragable. As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more. Or more accurately, our clients may not be able to. We are value investors because we are persuaded of the logic of buying shares of businesses when others want to sell them, and we understand that
lower prices today mean higher future rates of return, and high prices today mean lower future rates of return.

The best time to buy our funds or to open an account with us has always been when we've had dismal performance, and the worst time has always been after a long run of excess returns. Yet we (and everyone else) get the most inflows and the most interest AFTER we've done well, and the most redemptions and client terminations AFTER we've done poorly. It will always be so, because that is the way people behave.

John Rogers, the founder of Ariel Investments, came in to see us last week. John has been an outstanding investor for 25 years or so, but like almost all value types, is going through one of his toughest periods now. His assets are down, similar to the experience we've had. He said it was the most difficult market he'd seen, a judgment I would have given to the 1989-1990 market, up until the frenzy erupted over Fannie Mae and Freddie Mac, which sent financials to what looks like a capitulation low on July 15th. I am now in John's camp. A point he made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it's in the papers, it's in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn't need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).

I am reminded of what John Maynard Keynes, himself a great investor, said once about investing, "It is the one sphere of life and activity where victory, security, and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is when I should sell it." It has been explained to me that it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. "Don't you even read the papers?" was a common comment.

While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it. Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 Crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?

Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy and Chesapeake Energy in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005? If you had bought Tesoro Petroleum or Valero Petroleum when their prices broke late last fall -- remember the Golden Age of Refining story that took Tesoro from under $4 to over $60? -- you would be looking at losses in this year greater than if you had bought Citibank or Merrill Lynch. I do think some things are obvious: it is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the American consumer will spend sufficiently to keep the economy moving forward long term. It is obvious that the U.S. economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.

Sir John Templeton died a few weeks ago, full of riches and honors, as he so deserved to be. The legendary value investor got his grubstake by famously buying shares of companies selling for $1 a share or less when war began in 1939. He didn't know then that the war in Europe would spread to engulf the world, nor how long it would last, nor how low prices would ultimately go. He always said he tried to buy at the point of maximum pessimism, but he never knew when that was. He was, though, a long-term optimist, as is Mr. Buffett, as am I.

Bill Miller
July 27, 2008

Is it time to buy stocks yet?

The major stock indices around the world have all come down a great deal in the past year and may be offering better investment opportunities now than 1 year ago.

I can't say whether stock prices will go up or down but as a student of market history I am interested in what the past can teach us. Have a look at this chart which tracks the Price to Earnings ratio of the 500 largest companies in the United States from 1950 to 2008. The index levels are significantly lower now and accordingly the P/E ratio is also lower now.


The US markets were down another 10% during June and more so far during July. Worry about the economy and the financial system is on every news channel and there are very few bright spots. Corporate earnings are expected to be under pressure over the next 12 to 24 months as it is likely that the US is in recession and the hangover from falling house prices bites into corporate profits. This will affect the 'E' part of the P/E ratio for the next while. Stock prices are also forward looking and are already pricing in the prospect of lower profits.

Personally, I have a long time horizon and I'm always buying as part of a systematic investment plan but I'm much happier buying today than 1 year ago.

Bill Miller's Comments

This commentary is from Legg-Mason's fund manager - Bill Miller who has the reputation of being the manager with the longest track record of beating the performance of the S&P 500 with the performance of the Legg-Mason Value Trust fund - sold in Canada through CI Investments as the CI Value Trust Fund.

This commentary will be short and to the point:

We had a bad 2007, which followed a bad 2006. Over this two-year span, we underperformed the S&P 500 by around 2000 basis points, our worst showing since the two-year period 1989 and 1990, where we underperformed by 2500 basis points.

In the 25 years since we started the Value Equity mandate in 1982, we have had six calendar years of underperformance. Despite that 19-6 record against the market, all the losses are painful. They are also unavoidable and unpredictable. It would be great if we could figure out how to never underperform.

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About the only advantage of being old in this business is that you have seen a lot of markets, and sometimes market patterns recur that you believe you have seen before. It is not an accident that our last period of poor performance was 1989 and 1990. The past two years are a lot like 1989 and 1990, and I think there is a reasonable probability the next few years will look like what followed those years.

The late 1980s saw a merger boom similar to what we have experienced the past few years and a housing boom as well. In 1989, though, the merger boom came to a halt with the failure of the buyout of United Airlines to be completed. The buyout boom had been fueled by financial innovation. Then it was so-called junk bonds, which had been purchased by many savings and loans in an attempt to earn higher returns. Now it is subprime loans repackaged into structured financial products.

The Fed had been tightening credit to guard against rising inflation, which began to impact housing. By 1990, housing was in freefall, the savings and loans were going bankrupt (as the mortgage companies did in 2007), financial stocks were collapsing, oil prices were soaring in 1990 due to a war in the Middle East, the economy tipped over into recession, and the government had to create the Resolution Trust Corporation to stop the hemorrhaging in the real estate finance markets.

Eerily similar to today, the situation began to stabilize when Citibank got financing from investors from the Middle East. Although the overall market was down only 3% in 1990, we got trounced, falling almost 17%, the result of our large holdings in financials and other stocks dubbed “early cycle,” and which tend to perform poorly as the economy is slowing or when it sinks into recession.

If it were possible to forecast with any degree of accuracy, one might be able to descry a slowing economy from an examination of economic data and perhaps adjust portfolios accordingly. But unfortunately, as I have often remarked, if it’s in the newspapers, it’s in the price. The process works the other way: stocks are a leading indicator, so first they go down and then the data comes in.

In 2007, financial stocks began to decline in early February, before the market corrected in March. They then rallied into May, began a slow decline that culminated in an intermediate bottom in August when the Fed lowered the discount rate, rallied into early October, and then began the precipitous fall that appears to have made a bottom around the third week of January. The decline in financials reflected the freezing up of credit markets that began in August and which still persists, and was followed by a steep drop in consumer stocks in November that also may have seen their worst days now that the Fed has begun to aggressively cut rates. All of this was accompanied by the decline in the housing stocks, which fell almost continuously throughout 2007, ending with a loss of almost 60% on average.

The financial panic got going in earnest as we entered 2008; with global markets all dropping in the double digits or close to it as of this writing. The so-called decoupling thesis, which maintained that non-US and emerging markets and economies would be unaffected by a US slowdown, while not dead (yet), is severely wounded.

The monetary and fiscal authorities have now begun to move with alacrity, with the Fed cutting the funds rate to 3.0% (with likely more to come), and the administration and Congress coming up with a fiscal stimulus package estimated at around $150 billion dollars. Will it be successful? Yes. More precisely, if these measures aren’t enough to free up credit and stimulate spending sufficient to set the economy on a growth path, then additional measures will be taken until that is accomplished. The important point is that the monetary and fiscal policy makers are focused and engaged, and will do what is necessary to stabilize the markets and restore confidence.

This does not mean that the recovery will be swift, or seamless, or without additional trauma. But there will be a recovery, and I think the market abounds with good value. Those values may get even better if the markets get more gloomy, but they are good enough now for us to be fully invested.

I think the market is in for a period of what the Greeks refer to as enantiodromia, the tendency of things to swing to the other side. This is not a forecast, but rather a reflection on valuation.

All of the poorest performing parts of the market, housing, financials, and the consumer sector—with the exception of consumer staples—are at valuation levels last seen in late 1990 and early 1991, an exceptionally propitious time to have bought them. The rest of the market is not expensive, but valuations cannot compare to those in these depressed sectors.

Bonds, on the other hand, specifically government bonds, which have performed so wonderfully as the traditional safe haven during times of turmoil, are very expensive. (In bond land, the only values are in the so called spread product, and there are some quite good values there.) The 10-year Treasury trades at almost 30x earnings1, compared to about 14 times for the S&P 500. The two-year Treasury yields under 2%, and is thus valued at over 50x earnings!

The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it was in favor of Treasuries 20 years ago. Just prior to the Crash of 1987, stocks yielded about 2% (same as today), but traded at over 20x earnings. The 10-year Treasury yielded over 10%, vs. 3.6% today. The two-year Treasury now has a lower yield than the S&P 500, and that is before share repurchases, meaning you can get a greater yield in an index fund than you can in the two-year, and a free long term call option on growth. Even more compelling are financials, where you can get dividend yields about double that of Treasuries, which only adds to their allure, with them trading at price-to-book value ratios last seen at the last big bottom in financials.

I think enantiodromia has already begun. What took us into this malaise will be what takes us out. Housing stocks peaked in the summer of 2005 and were the first group to start down. Now housing stocks are one of the few areas in the market that are up for the year. They were among the best performing groups in 1991, and could repeat that this year. Financials appear to have bottomed, and the consumer space will get relief from lower interest rates.

Oil prices have come down, and oil and oil service stocks are underperforming in the early going. Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position portfolios for the 95% of the time the economy is growing, not the un-forecastable 5% when it is not. I believe equity valuations in general are attractive now, and I believe they are compelling in those areas of the market that have performed poorly over the past few years. Traders and those with short attention spans may still be fearful, but long-term investors should be well rewarded by taking advantage of the opportunities in today’s stock market.