Thursday, February 05, 2009

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.


markoz said...

It has been a longstanding frustration of mine that Vancouver has (almost) always been "over-valued" in MY perception. The point is that if enough people perceive there to be value at inflated prices then those prices become the value. Most people I know just accept as a given that a soon-to-be-leaky, tiny condo is worth $500,000. They may not like it, but they certainly don't question it. No one ever looks at Arizona where they sell new (small) SFH for less than $150,000 and stops to wonder why it is that a similar house in Vancouver would command anywhere from $750,000 and up. Sure it's nicer to live here, but THAT much nicer? No one ever questions ANYTHING to do with real estate in Vancouver it seems (or at least they didn't).

If I say prices are too high people tell me to start with a condo and work my way up. This illustrates perfectly the lack of critical thinking that helps keep prices up. If you can't afford a down payment on a $750,000 house and you buy a condo in the burbs for $350,000 with 10% down and wait for house price appreciation to increase the equity in your condo so you can afford the down on the house, look what happens. Assuming prices go up 50% in 5 years your $35,000 in equity will be $205,000. Yay! Now I can buy that house! But the house went up 50% too. Now it costs $1.125M. Even with your $205,000 down you will still owe almost $800,000. More than the entire cost of the house 5 years ago!

Of course if the price of your condo declines over 5 years you will have virtually no equity to invest in a house.

People think this sort of behaviour is the path to riches and it makes me tear my hair out. The problem is there are more of them than there are of us.

van_coffee said...

Markoz -
Not sure if you realize this, but your last point is the most relevant by far:

I quote:

"there are more of them than there are of us"

This is exactly the point. So much future demand has been sucked away because so many people jumped on this bandwagon - people like to feel good, so they do what their friends and family do. People are generally followers.

With the lack of credit available and the huge number of units coming on stream, it is only a matter of time....

It isn't going to be fast, but it is going to be ugly.


AndrewJ said...

I think that the winding down of the baby boom generation may mean we never have another big boom cycle here. Not so much their hubris but more the lack of population in their prime earning years to support such things.

Counter balancing that is that people tend to over the long term make fairly rational choices. Now I've lived in Vancouver all my life and never experienced a winter elsewhere in Canada (most placed I've been to seemed fine in the summer) but I've heard it really does kinda suck. Does some of Vancouver's premium involve being the warmest place in the country to live? It's not enough to justify the big boom we've had but it's enough for something maybe.

jesse said...

"Does some of Vancouver's premium involve being the warmest place in the country to live?"

No. Warm weather would normally command higher rents as well. Warm weather does not justify a bad investment.

Viking said...

First let me state that I was not born in Vancouver and currently do not live there. I did live in Vancouver for 15 years and spent 4 years in Toronto. I have also travelled extensively in Canada (on business) and throughout the world.

I believe Vancouver is a special city, if one can handle rain. It is small, beautiful and offers a multitude of leisure activities. Does it have issues? Absolutely. However, its issues are no worse than other medium and large sized cities.

Is real estate expensive? Yup! Is it a bubble? Likely. Will people who bought in the past few years suffer dramatic declines in the value of their real estate? Likely.

Looking at the history of real estate prices in Vancouver they are VERY cyclical (the joys of a resource based economy). I would expect the magnitude of the fall in prices to somewhat reflect the rise that we have seen since 2000 (i.e. a big on the upside and also big on the downside).

How far down real estate prices fall will depend on many unknown factors, most importantly what happens to employment levels in the coming years. It certainly does not look good.

Patient buyers will, as per usual, be given a great opportunity to buy a nice home at a reasonable price at some point in the next few years. If the global economy enters a depression (worst case scenario) we will be given once in a lifetime buying opportunity. Unfortunately, most people at that time will be:
1.) so pessimistic (swearing off buying real estate)
2.) unemployed
3.) broke (net worth having been wiped out)
Bottom line they will not see the opportunity or will be unable to take advantage of it. At that point in time I believe Vancouver real estate will offer good long term value.

W Buffett's number one rule: don't lose what you have (i.e. capital preservation). His number two rule is: don't forget rule number one. Those with capital to invest should be offered up some very fat pitches in a few years time!

Whybuywhenucanrent? said...

We can see 34 years of house values here on the Sauder chart

But can we go back before 1975 anywhere?

I'm thinking 4.5x average annual income is the typical bottoming point for Vancouver Real Estate. I'd like too see the 1955 - 1975 data to see if that is the case.

If so, Van RE will fall 67% off it's winter 2008 peak.


patriotz said...

Is real estate expensive? Yup! Is it a bubble? Likely.

Likely? Price/income and price/rent still among the highest in the word, even after a 15% price decline.

Will people who bought in the past few years suffer dramatic declines in the value of their real estate? Likely.

The fastest price declines in North America are a fact, not "likely".

Get real.

Declan said...

"the Japanese property market remained rational longer than speculators could remain solvent."