Real Estate asset bubbles

David Merkel writes the following about financial asset bubbles:

If they want to get a little more complex, I would tell them this: when a boom begins, typically the assets in question are fairly valued, and are reasonably financed. There is also positive cash flow from buying the asset and financing it ordinarily. But as the boom progresses, it becomes harder to get positive cash flow from buying the asset and financing it, because the asset price has risen. At this point, a compromise is made. The buyer of the asset will use more debt and less equity, and/or, he will shorten the terms of the lending, buying a long-term asset, but financing it short-term.

Near the end of the boom, there is no positive short-term cash flow to be found, and the continuing rise in asset prices has momentum. Some economic players become willing to buy the asset in question at prices so high that they suffer negative cash flow. They must feed the asset in order to hold it.

It is at that point that bubbles typically pop, because the resources necessary to finance the bubble exceed the cash flows that the assets can generate. And so I would say to the new office studying systemic risk that they should look for situations where people are relying on capital gains in order to make money. Anytime an arbitrage goes negative, it is a red flag.

I couldn’t help but read this and think to myself: This can apply to Vancouver real estate.

When the boom begins, the assets are fairly valued – you could say the same thing about the Vancouver Real Estate market around year 2000 – your average detached home was around $375,000; townhouse $250,000; condo $190,000. Some properties you could purchase and rent out and still have a cash flow positive proposition.

And then… “Near the end of the boom, there is no positive short-term cash flow to be found, and the continuing rise in asset prices has momentum. Some economic players become willing to buy the asset in question at prices so high that they suffer negative cash flow. They must feed the asset in order to hold it.

This is exactly what is happening to real estate in Vancouver today – people buying properties are purchasing them not for cash generation purposes, but for an implicit increase in asset value, hoping to dump it off to the next sucker for a higher price. The carrying costs of property are higher than the cash flows you can derive from them.

It is just a matter of time before asset prices adjust to a value defined by financial return. Timing when this may occur is very difficult. For myself, I have under-estimated the resiliency of the marketplace – there were many times that I thought things had “peaked”. Fortunately I am not a short seller, but I do strongly believe that those that are leveraged up on Vancouver residential real estate should strongly look at their holdings and ask themselves whether they could financially handle a 20-25% decline in valuation over a two year period. Even after such a correction, property values would still be at the higher end of a rational price range.

A lot of people use real estate as a “store of value” – i.e. owning the title to land is a better proposition than holding cash, which could potentially depreciate through inflation. While you can claim diversification, I do not believe it is hedging risk of depreciation of the asset value. Contrast this with an investment in a large natural resource company that has plenty of reserves, or a low-cost leader in consumer staples, and you will likely find better stores of value there than the existing Vancouver real estate market.