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.

Fraser Valley Real Estate - February 2009 Stats

The Fraser Valley Real Estate Board posted the February 2009 Statistics package and here it is on the down low.

Sales stink like the fresh manure smell that permeates the Valley many days! Sales are at levels not seen since the 1980s.

Active Listings are quite high for this time of year and seem to be rising in the normal seasonal pattern.

Since sales rose a bit from January the number of months that it would take at the current sales rate to sell all the homes for sale in the Fraser Valley dropped to 'only' 14 months. This means that if you are trying to sell a home right now, it might take a while unless you drop the price - a revolutionary idea to be sure - this whole supply / demand equilibria thing.

The benchmark price has fallen 13% in 9 months now with more price drops to come it seems.


The correlation between the supply / demand situation and price changes is strong. If prices are to increase substantially anytime soon it will take a massive rise in sales, large reduction in active listings or both for this to change.

By performing some simple seasonal analysis it seems that months of inventory will probably bottom this year at the 7-9 MOI level in either April or May. This does not indicate upward price pressure and by later in the year we could be looking at some very significant price declines. The Fraser Valley is on track to lose another 15% or so in 2009. There are potential events that could influence the market in either direction as well.

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.

You Are Still Winners Vancouver!!

REBGV released monthly housing market data for February 2009 here.

You might feel like a real loser for buying those 4 presale condos at the Woodwards building that you are really underwater on now but you can rest easy knowing that Vancouver is a 'winning city.' We are still winning the fastest real estate price decline from peak of any North American market but it really looks like we are going to have to pick up our socks if we are to maintain that lead. Come on now Vancouver, let's give Miami something to talk about.



Sales are still in the figurative toilet and we can expect them to rise for the next 2 or 3 months as the normal seasonal variations of activity in the real estate market take place.



Active listings are at super elevated levels before the spring listing rush.



The ratio of sales to active listings is low, really low.




Months of inventory is high, really high.




The tight correlation between months of inventory and price changes continues to be tight. Tighter than white on rice.

Prices are still in a downward trend.

Good luck with those Woodwards condos, I'm going fishing.

In Derrick Penner's Shoes

The Vancouver Sun published an interesting discussion between so-called real estate experts with Sun reporter Derrick Penner asking the questions.

"The Sun invited to its editorial offices a panel of experts in Polygon Homes chairman Michael Audain, top realtor Patsy Hui with Re/Max Westcoast, and Tsur Somerville, director of the centre for urban economics and real estate at the Sauder School of Business at the University of British Columbia."

Here are the questions I would have asked if I were in Derrick Penner's shoes:

1) Please tell me how you each earn a paycheque? Do you feel how you earn your money helps you have an unbiased opinion on real estate matters?

2) What makes you a real estate expert? What are your qualifications?

3) Why should the Sun's readers heed your advice? Do you actually have any advice? What is in it for our readers? What's in it for you?

4) What would you say to someone who felt that prices of homes in the Vancouver area were destined to fall another 20-30% from current levels? What would you advise people to do if that were the case?

5) Where do you feel future buyers of real estate will come from since population growth is at historically low levels and the ownership rate has risen dramatically in the past 15 years? How will prices rise if there are fewer buyers than sellers?

What would you have asked if you were in Derrick Penner's shoes?