Monday, February 23, 2009

A Deception so Great

" We are never deceived; we deceive ourselves."
- Johann Wolfgang Von Goethe

An old adage is that if two people tell you you’re drunk, you’re drunk. After repeated conversations with friends, co-workers, and family, I can safely say that I am nicely and completely hosed. Most of my social circle does not believe as I do Vancouver house prices are going to drop at least 40% from their peaks in 2008. From this, being a humble sort, it would be incredibly arrogant of me to think them collectively wrong.

Here I offer the wildly arrogant possibility that maybe -- just maybe -- “they” are wrong.

Vancouver is a city obsessed with real estate. Many cultures immigrating here cherish it above little else; prices have risen significantly in inflation-adjusted terms for a generation; the majority of homeowners have huge swaths of equity tied up in property. It is hard to make the case for why the real estate party is closing down for a long time. I have tried, of course, citing low immigration, low median incomes, flat rents, huge looming inventory, dependency upon construction employment, a global recession, negative savings rates, significant similarities to US markets now crashing hard, arguments with which real estate “bears” are familiar. All my arguments, it is rebutted, are short term phenomena which will pass in a few short years and Vancouver will continue with its price appreciation as it has done since it was founded.

I believe Vancouver is in a bubble. Not a house price bubble (though we are), but a bubble of collective dissonance when it comes to how to value real estate. The 800 pound gorilla in the room is the simple question: why are properties worth what they are?

There are several ways to answer the question. The first most obvious answer is simply that properties are worth what someone else is willing to pay. Fine, but that doesn’t get to the heart of “why”. Why is that someone else willing to pay? Who cares, we say. Who are we to second guess motives of buyers? Maybe there is a new batch of rich buyers who care not whether an investment produces a reasonable income stream, maybe population growth is forcing land prices up, or maybe future income growth will more than compensate for the prices we pay today.

Maybe so but the analysis of the data suggests we should care a great deal why others are willing to pay and not just stop at our whimsical assumptions about what Vancouver is. Rich immigrants? Not too many. Population growth? Not that high. Income and rent growth? In real terms, try the opposite. Running out of land? The number of residential projects under construction is near all-time highs. It is clear to me that the image of Vancouver being a playground of the rich with high immigration, rising wages, and a limited land supply is for the most part illusory.

If we go back to the question, why is property worth what it is, using the actual data, the results are all the more concerning for real estate bulls.

There is a strong case that Vancouver real estate, like other cities around the world, has been riding a generational bubble. It has fostered a “can’t lose” attitude, where stomach-churning drops are assumed to quickly recover to new highs. In the past 25 years Vancouver has spent relatively short periods in the price valleys with relatively long periods of over-valuation. This is classic speculation with a twist. The length of speculation and perpetual volatility has perversely led to survivorship bias and, due to the relatively slow movement of property markets, deification of successful real estate investors embedded in local social circles. The speculation has not been the flash in the pan we all connote with other booms but a slow and seemingly secular trend to permanently high prices. It has fostered an air of invincibility around real estate investing, still heavily present today. How about those stories we hear of flippers losing their shirts on presale assignments? They are merely unfortunate and limited casualties in the machinations of the city’s real estate juggernaut. It has been a mistake to count out the Vancouver real estate owner, say the successful surviving real estate gurus.

We are now in the throes of another wave of high volatility with a decided trend downwards. At first glance it looks the perfect storm: oversupply, low sales, high prices, a global recession, and tighter lending, all point to prices falling more. Even with these insurmountable odds speculators will still be playing in the market, ever aware of Vancouver’s amazing ability to rebound from previous crashes. I hear it constantly: prices have dipped and will stabilise in 2010, the recession will be over by the end of the year, in-migration of rich families will eat up the excess inventory quickly, et cetera. Almost certainly there will be people buying this spring anticipating new highs within a decade. The same will happen in 2010, 2011, 2012, and on, all the way down and up again. This does not mean these buyers would support prices from falling but it does mean there are still bulls in any active market (by definition, in fact).

I have heard several comments from those bearish on local real estate that prices supported by rents and incomes will happen in but a few years, amounting to a truly meteoric, though not unprecedented, fall from grace. I am not so sure. The mood of Vancouver is so tilted towards the sanctity of real estate investing I find it only convenient to think a handful of years of a bear market changes this thinking. If anything I see years of pain to change how people value real estate, likely more than five or even ten: the “stickiness” of prices we hear so much about. This does not preclude significant price drops in the next few years -- I personally think it likely -- but to really get to a point where affordability is restored could take much longer.

So why is real estate priced as it is? What would we say after a crash and the subsequent fallout? I can hear it now: real estate, in its essence, is but a utility, providing a service for a fee like a car. Affordable, not unaffordable, housing supports income and economic growth. Property is only worth what income it produces. Dare to dream, drunk jesse.

The past generation has done well from real estate investing and I believe its perpetual success has fostered a deception -- a cognitive dissonance -- about what real estate really is and how it is valued. The deception is so complete it is terrific. While high prices may continue, there is a real and plausible possibility of a slow and painful trudge towards lower prices for a long time.


AndrewJ said...

I think there is a possibility that this is the last hurrah. It might take a number of years to beat it out of us but we'll get there. I'm hoping sometime in the next 2 years housing will be priced at a clearly affordable point. The waters are a little muddy right now with the economic crisis forcing me to reassess my risk. They're taunting us with low interest rates and so far it seems to be providing a little bit of support to the market judging by Paul's recent numbers. I don't think it will be quite enough to stop this year from being bad but it might ease (or should I say prolong) the pain a bit.

In the end I think we need to get to a stable point that's somewhat connected to the rent a property earns. All attempts to stop this from happening are a waste of time and money. It's the same thing with the states. It just has to go down. Take your lumps.

If you ever watched How I Met your Mother it's like the slap bet. Barney chooses 5 slaps at some random time in the future over 10 slaps right now. If you watch the show it becomes clear why 10 slaps right away are better than 5 random slaps in the future (see the Slapsgiving episode).

patriotz said...

Dumb money is going up in smoke all over the world, and you can't hold up RE prices as bloated as Vancouver's without an awful lot of dumb money. In today's conditions money either gets smart fast or it's gone.

It's going to take well over two years for the US and other major players even to start to turn their economies around, and that's way too long for BC's RE party to keep going. The income and capital just aren't going to be there.

Clarke said...

While cognitive dissonance is a powerful phenomenon, it cannot cancel out a lack of buyers, a ton of supply, and less than stellar macroeconomic conditions. 40% seems reasonable to me.

Anonymous said...

The past generation has done well from real estate investing

I know it's heresy, but I hope that we have a generation where homes aren't investments: they're places in communities of citizens not speculators.

Enjoy the site.

Warren said...

The same people I talk to who don't think property values can drop 40% don't even think it has dropped at all yet(!) They realize the market is "soft" and so they assume prices are flat, but not falling. Clearly delusional.

Van Housing Blogger said...

People in California thought it would never happen there. How has the psychology held up in Cali? I don't know the answer, but if you want to know what the psych in Vancouver will be like in two years, look at California now.

pricedoutfornow said...

"generational housing bubble" I agree! How many times have you heard your parents/relatives say "I bought this house in 1977 for $20k and look, now it's worth $500k! You'd better buy now! RE only goes up!" But I wonder if that will be true for our generation (us in our 20s-30s) Will we be saying the same lines to our OWN children? Just because something has been true in the past doesn't mean it will remain true for the future. What happens when prices go down for a long period of time, will RE ever be regarded as a "bad" thing to buy?

jesse said...

"if you want to know what the psych in Vancouver will be like in two years, look at California now."

Sales data from San Diego suggests many low-end properties are moving at around 40% off from the peak with sales volumes almost double those a year ago. Looking at the price to income and price to rent ratios, there is still some way to go. I see a slower and more gradual race to the bottom in the next 3-4 years. After that who knows but a possibility is prices staying flat for a while until the speculative poop is completely beaten from the goose.

mohican said...

Great post jesse.

We are talking about very long investment cycles here. The investment cycle from 1982 to 2009 witnessed falling inflation and falling interest rates. Where will the growth in property prices come from without the tailwinds of lower and lower interest rates?

Additionally, household formation was a strong factor in perpetuating the rise in real estate prices because of the demographics involved. What happens when we get household dissolution / downsizing on a large scale via the retiring / dying baby boom gen.

These sort of long term trends can fool an entire generation into thinking it is a permanent condition. Cognitive dissonance indeed.

markoz said...

Here's an article from "the Guardian". She says property speculation is hardwired in the British brain. Ours too, I guess. Anyway she suggests capital gains tax on primary residences to curb speculation. Needless to say, that is regarded as rabid socialism over in the UK.

chan.philphil said...

Not so fast...

Here is an article from (see here) and a series out from (see here) talking about reality of the house price drop and the bias opinions of economists from the real estate associates.

It also talk about the new housing future market by Teranet.

After reading the article and seeing how an economist from the real estate association unwilling to admit the possibility of general price drop in Canda. (I'm not even talking about sharp drop in price.) I'm convince there is more pain to come. Because there is so much misinformation out there.

Skye said...

These kind of philosophical posts are interesting to me, in that it revolves around group psychology. I agree with your assumptions and conclusions. Ultimately though, the deciding factor will be jobs. Rose coloured glasses are fine until you can't make your payments. If the job market here implodes, there will be no choice but to change our views on what an "acceptable" debt load is. If we don't lose a large number of jobs, the mass hysteria will continue, and I will leave this silly little city sooner rather than later.

patriotz said...

Anyway she suggests capital gains tax on primary residences to curb speculation. Needless to say, that is regarded as rabid socialism over in the UK.

Really an extra capital gains tax on non-primary residences would be good enough, as it would destroy speculation at the margin. Like in Germany. But not even the NDP has the balls to advocate such a thing here.

Equally effective is to restrict mortgage financing, especially in markets where prices are out of line with rents. Also as in Germany.

macho slob said...

Good points about demographics and higher rates curbing future demand.

Agree that jobs could be a huge factor. It's not just actual job losses, but the lingering fear of possible job loss could suffice to scare off potential buyers.

Appreciate all the historical stats, but with the economy deteriorating at such a scary pace, I would be reluctant to use the last few years as yardstick to predict the future.

jesse said...

"I would be reluctant to use the last few years as yardstick to predict the future."

It may well be prices will deteriorate quickly. Think though how far prices must fall to be "affordable" again. On an interesting and somewhat related note, it looks like the US is getting a mild case of Japanitis.

buff_butler said...

I'm not sure if these have been done but this is definilty the best blog for these ideas.

1. Analysis of the housing market by graphing the [rental yield]/[price] back to 1975 with UBC data. Esentially treating it as a common share where [rental yield] = [dividend] for value analysis. You get a curve similar to a sin wave. You can then use the results to calculate a buying price based on the idea the prices will drop as bad as the other recessions.

2. Tax information regarding rentals?