Why the housing slump isn't over yet - By Charles Zentay at thinkinvest.blogspot.com
Bold is mine.
For years, I bored my friends with talk that housing was in for a downturn. No one believed me, and people urged me to buy in before I was shut out of the market. Despite the obvious slowdown in housing, I continue to sing the same tune. I've been doing a lot of reading this weekend about the housing market, and I've concluded that we still have a long way to go before housing reaches bottom. I have been on this soapbox since early-2005 and although the market has not changed in Vancouver yet I still maintain that the market is headed for a drastic downturn. The longer we go without a correction the bigger the correction will be.
Why? The main reason is that in spite of all the whining and moaning about the housing slowdown, prices haven't come down that much (maybe 10%) and affordability is still very low by historical standards.
Here are some other reasons to be wary of housing:
- There is a ton supply out there (supply is at a record, and 2x its normal rate over the last several years). It has just skyrocketed and it is not going down. This is becoming true in our local markets just as it was in the United States.
- Affordability for new home buyers is still at lows.- More people own houses than ever before (meaning fewer buyers out there). Vancouver has THE WORST affordability in North America.
- The Fed will have trouble lowering interest rates in the face of $85 oil and a Euro of 1.42. Can you say INFLATION?
- Credit standards are tightening, meaning fewer mortgages and therefore fewer buyers. This is also true in the Vancouver market although to a lesser extent.
- A large amount of ARMs are still resetting, with a tremendous amount due to reset in the second half of 2008. ARM resets are leading to more foreclosures, and therefore even more supply. British Columbia has the highest product adoption of variable rate mortgages in Canada, with many mortgagees having a negative amortization now.
- Homebuilders are under enormous pressure with debt coming due and therefore will be willing to dramatically lower their prices. Vancouver has a tremendous amount of new home supply coming available in the next 12 - 24 months and demand that is drying up. Developers will cut prices when they realize that nobody is buying.
- The economy seems to be softening, with economists raising the chances of a recession. If you think that the Vancouver economy can sustain itself and is immune to external shocks you are deeply deluded. The high CDN$ is hurting exports (lumber, manufactured goods, technology, etc), film-making (Hollywood north anyone), and tourism (the supposed golden egg of 2010).
- Cap Rates (the income from rents) are still very low, making housing an unattractive investment. Duh! Real estate is about the worst investment possible right now - if you don't believe me get a calculator, paper and pencil and DO THE MATH.
- All of the above is leading to a change in the mentality towards housing. It is going from something people want to own to something to be wary of. This change in attitude towards housing can take a long time to set in and have a tremendously negative effect on pricing. Apparently Vancouverites are still in lala-land when it comes to this psychology shift but it will come swift and sure.
Frankly, the only bright spot I see in housing is that the weak dollar is leading to more foreign buying of U.S. real estate (in places like New York), but the effect of this buying is minimal compared to the other negatives. I just don't see other positives.I think owners are stubborn and resistant to lower prices. Therefore, the market is not correcting itself quickly. The slowdown is likely to last several years.
Until Cap Rates are higher than Mortgages Rates (meaning it actually pays to be a landlord), I think the market will continue to head down. Unfortunately, we're not even close to having attractive Cap Rates. I wouldn't be surprised if a major homebuilder declares bankruptcy in the next 6-12 months. I also wouldn't be surprised if homebuilders and banks start to move to more aggressively clear inventory, which will lead to big price declines. Look for this to happen in our area in 18-24 months.
20 comments:
I think the dollar will be interesting to watch. For example, what does the Canadian Govt do when the economy starts to tank in the following areas:
1. Retail: people buying in the US, online, etc.
2. Exporting: obvious.
3. Tourism, Television & Film.
The high dollar can potentially kill these things, but the demand for oil and raw materials outside of North America could easily keep our dollar at a high level.. What's the central bank's option here? The middle class is getting beat, unemployment goes way up, but the corporations and shareholders in our oil patch and mines, etc continue to profit.
"Developers will cut prices when they realize that nobody is buying."
And do you think they will cut their production as well? If it's anything like the States the answer is "not as much as you might think."
Builders are in a very difficult position in slow markets. It costs serious money to downscale operations: your best employees leave, your equipment is idle and will sieze if not in use, and your spec land is effectively worthless. It is usually better on the surface to carefully manage contraction unless you have no other choice. The irony is their reluctance to cut deep and hard exacerbates inventories and delays a rebound.
"Real estate is about the worst investment possible right now - if you don't believe me get a calculator, paper and pencil and DO THE MATH."
I can, with two brash (and IMO flawed) assumptions, prove to you why real estate is the best investment going. The assumptions are that
1) prices increase at an average of 5% per year from this point onwards.
2) You will always have a job and enough money to cover shortfalls in carrying costs.
As long as I can argue with someone and convince them both 1 and 2 are true, I can always show that investing in residential real estate has better returns than investing in stocks. The simple reason is that you are leveraging an asset that "must" increase in value.
I went through real estate ROI calculations a few years ago and the numbers were so strikingly high compared to yields in the stock market that I had to check my math. The math was right but the subtleties lie in the assumptions you make and how much you discount based upon risk.
I went through real estate ROI calculations a few years ago and the numbers were so strikingly high compared to yields in the stock market that I had to check my math.
Stock market yields cannot be directly compared with RE yields. Traded companies often use their incomes to fund internal growth, whereas 100% of RE income is included in the "yield" calculations.
You should be comparing P/E, but that may be hard because GAAP earnings aren't necessarily accurate. Second, stocks prices contain lots of forward looking expectations that may not be contained in current income or yield figures. That could also be true for real estate, but to a much lesser degree.
High-end rentals are growing averaging 20% vacancy available immediately. These are units that were rented all summer. Many are in the $8000.00/month range. How long does an investor eat the empty suite? 90 % of September expiries were not able to be re leased. Count them yourself and watch October expiries! http://preview.tinyurl.com/35ycry
...although the market has not changed in Vancouver... There is a ton supply out there...
Are you talking about Fraser Valley or Vancouver itself? I don't have numbers to support my thesis just personal experience going to open houses almost every weekend in Vancouver West area (condos). The prices now are higher than 6 months ago (I'm talking about selling price, not listing), for units in the same building. As simple as that. For example, just this weekend I visited a unit on the 7th floor for $320K. 4 motnhs ago the same floor plan on the 22nd floor sold for $308K.
jesse,
I know its a wild idea for Vancouver these days, but maybe the builders could build economic infrastructure.
strataman,
I love how some of those ads say "no pets". If someone was going to rent a condo from me for $11K/month, they can have a horse in there for all I care.
"Stock market yields cannot be directly compared with RE yields."
I was thinking more of yield to "maturity", including cap gains. Should have said return, not yield.
More precisely, net total return.
Historically, net total return for RE has been a bit better than for fixed income. This is to be expected, because the earnings from RE (net rental income) are very predictable. The higher the risk of an asset class (i.e. the higher the variability of its income), the higher the total return must be in the long run (to attract investment).
Stocks have performed way better than RE in the long run. And please spare me comparisons of leveraged RE versus unleveraged stocks - that's totally bogus.
"And please spare me comparisons of leveraged RE versus unleveraged stocks - that's totally bogus."
I don't think it's bogus from a practical perspective. Given the normal options available to someone, taking out a mortgage from a bank is simple. Taking out a margin account is pretty simple too but the interest rates are higher compared to a mortgage. Also the tax system allows writeoffs for maintenance and depreciation.
mohican's point about RE being a bad investment in today's market is valid as long as you look at risk properly. His quip about pulling out the calculator and doing the math is only right with the proper accounting of this risk. In a market with lower prices and growing population, RE is not a horrible investment.
I don't think it's bogus from a practical perspective. Given the normal options available to someone, taking out a mortgage from a bank is simple.
No, it is bogus. Clearly the people lending money at a fixed rate are not morons. There is no free lunch. Housing returns above the cost of borrowing for one simple reason: higher risk.
If we want to compare historic returns of various asset classes we should look at risk adjusted returns. Sharpe ratios in other words.
This is to be expected, because the earnings from RE (net rental income) are very predictable
Yup, the only complication (as mentioned earlier) is low density, whose value can fluctuate quite a bit based on small changes in expectations. For high density, however, it is a non-brainer.
In a market with lower prices and growing population, RE is not a horrible investment.
I don't think anybody is saying that it is. Also, I think it is a very very bad idea to generalize about asset classes. Market efficiency will make mincemeat out of generalizations - in the long run.
"No, it is bogus. Clearly the people lending money at a fixed rate are not morons. There is no free lunch."
No they are not morons. I know many people who, by putting 25% down on an investment property, will have annualized returns above 15% when they sell the property (in the next 6-12 months anyways). That said, they manage the property closely and likely do not pay themselves for the overhead in maintaining the property. Banks don't invest in RE as much because they actually need to pay properly for maintenance and would see the proper accounting of risk on aggregate. The individual investor will probably not account for time spent properly and due to hubris or ignorance think many risks do not apply to him. Hence 15% YOY.
My original point is that it is easy to show someone math to make real estate investing look great, even at current prices, and in my mind is partly why the local market is staying high.
The individual investor will probably not account for time spent properly and due to hubris or ignorance think many risks do not apply to him. Hence 15% YOY.
Not sure I follow. Are you saying that they make more money because they are oblivious to risk? Risk is not a fictitious boogeyman. You will not be rewarded for being ignorant of it.
As for the 15% with 4-1 leverage, what time horizon do you have on that?
Second, looking forward, with the awful yields, these guys will get subpar returns even if houses manage to scrape out nominal gains over the next few years.
"Are you saying that they make more money because they are oblivious to risk?"
No I'm saying serendipity has been kind to some I know. Others will jump in based upon these people's advice and/or bragging.
"As for the 15% with 4-1 leverage, what time horizon do you have on that?"
10 year, 5% YOY appreciation. 40K down on 160K, assume carrying costs equal rent. Sell for 260K minus 5% fees nets about 180K (with some of the principal paid off). 16%.
And yes, pretty much 0 chance of repeating that in the next 10 years.
It's surprising that so few people out there are aware of the very risky situation we're in right now. This economic boom is hanging on a very thin thread. Most people I know are loving the high dollar. Sure, being able to get a deal on an iPod Touch in Bellingham is great for now. But it won't be long before the hangover from falling exports starts to kick us in the pocketbook. Film industry and tourism industry too. Economies are made of boom and bust, and the bust is about to bite us. Hard.
I know many people who, by putting 25% down on an investment property, will have annualized returns above 15% when they sell the property (in the next 6-12 months anyways).
Not "when they sell the property... etc" but "if they sell the property RIGHT NOW". A lot can happen in 12 months. Like from March 1981 to March 1982. Or the last 12 months in Florida, CA Central Valley, etc.
You've just said that now is a good time to sell RE. Which means it's a bad time to buy, right?
"The investor of today does not profit from yesterday's growth".
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