Category: Real Estate

Misconceptions on Canadian mortgages

There have been quite a few media articles about how the recent rule changes has kneecapped the Canadian real estate market. It should be pointed out that these rule changes were strictly in the context of having CMHC (a federal crown corporation, so if they fail, then the public picks up the bill) insure such mortgages.

It does not include private lenders or insurers (such as Genworth (TSX: MIC)). So private lenders and insurers are free to make bone-headed decisions, such as providing zero-down financing and prime minus 1% rates to 450-rated credits if they deem it to be in their best interests.

Since the major chartered banks are really only interested in arbitraging their mortgage portfolio risk by getting CMHC to pick up the downside, they have been much more reluctant to give mortgages outside of the 25-year amortization, 5% down payment guidelines. The two major private lenders in the Canadian market are Equitable Group (TSX: ETC) and Home Capital Group (TSX: HCG) which have to make their own decisions with respect to giving out mortgages.

The share prices of both of these companies should be leading indicators with respect to the Canadian real estate market as a whole. The analogies in the USA, such as Novastar Financial, have long since gone insolvent for well-documented reasons. The semi-equivalent of CMHC, Freddic Mac and Fannie Mae are still publicly traded, but will not likely be returning capital to shareholders ever unless if the US government decides to make their obligations disappear.

I would be cautious of the Canadian private lenders without trying to thoroughly examining their loan portfolios. Doing this is not an easy job, even on the inside. They are producing disproportionately large earnings per share strictly through the usage of leverage, which in itself is not a bad thing, but you don’t know how secure those assets are. In the case of Equitable, one sees a company that has about $10 billion in mortgages outstanding, about $5.3 billion of it has been securitized (wrapping them up in happy packages, insuring them, and then selling to market) – the only problem of the securitized assets is that your net interest margins on them are piddling low – 0.49% in the last quarter, compared to the very relevant 2% more you get with the non-securitized assets.

ETC’s book value per common share is $27.46 (at June 30, 2012) and is currently trading at $31.49, so there is a premium assigned to their operations.

As long as interest rates remain low, Canadian real estate should remain flat

Interesting articles on the Globe and Mail (link 1, link 2) from TD and Scotia regarding house prices.

I tend to agree with the general projections that prices will probably compress around 10-15% in the medium term, but there will not be a precipitous crash in the real estate market.

I will give one strong condition to this, however: interest rates must remain at suppressed levels.

Note the following chart (of Vancouver real estate prices):

A parenthetical note is that this chart should be using a logarithmic y-axis as a linear graph distorts relative price movement at higher levels – this is why you never see stock charts scaled on a linear fashion.

Vancouver detached properties are still ridiculously overpriced (and will be a likely exception to the 10-15% rule simply due to the abatement of the well-known foreign capital influx), but I will bring your attention to the chart between 1994 and 2001, where minimal growth was seen in prices in all relevant markets.

It is likely that we’ll see such meandering for the next few years, providing that interest rates remain low.

Real estate has an embedded cash conversion feature – you can rent it out for cash. The value of this rent is higher during low interest rate periods (simply because you can’t sell the real estate asset and invest that cash into risk-free bonds) and lower during high interest rate periods. On a more retail level, if you are spending $2,500 per month to rent a home in Richmond, BC, you will need to earn $30,000 in after-tax dollars to pay for that rental. This is about $35,000 pre-tax after income taxes and statutory deductions. Add in regular living expenses and the like, and a $30,000 after-tax commitment translates into about $42,000 pre-tax earnings for that rental expense (assuming a 30% marginal rate for the middle income bracket in BC).

The equivalent of that $42,000 pre-tax expense is about $1.4 million at a 3% return, $1.05 million at 4%, or $840,000 at 5%. Your risk-free rate on a 10-year Canadian government bond presently is 1.9%.

Note this calculation does not factor in carrying costs (taxes, maintenance, etc.), but is designed to illustrate changes in theoretical valuation between certain interest rates.

In context of equivalent yields and real estate values, one can easily rationalize how in the rest of the country except for some very heated markets (Richmond, Point Grey in Vancouver, etc.) that valuations are where they should be, given the interest rate environment.

People concerned about a change in interest rates that don’t want to go through the hassle of selling their properties have a very simple financial option to hedge themselves against interest rate risk: sell treasury bond futures.

Mortgage rates in Canada

It is making the airwaves that the Bank of Montreal is offering a 5-year fixed rate mortgage at a 2.99% APR rate. There are slightly less favourable conditions attached to such a mortgage (lower prepayments throughout the mortgage), but otherwise this is the lowest 5-year fixed rate ever offered.

With the risk-free 5-year government bond rate at 1.3%, the bank is still making money from the loan. I’m guessing the only people qualifying for such a mortgage would be those that have very good credit ratings and those purchasing homes with reasonable leverage (e.g. 25% down payment or above).

Interestingly enough, since most financial institutions have raised rates on their variable rate mortgages – (last year there were offerings that went as low as prime minus 0.9%, or 2.1% with existing interest rates, while today you will be lucky to receive prime minus 0.25%), it makes the fixed rate offer a significantly superior option. Although I do not believe short term rates are going anywhere in 2012, it is difficult to fathom that short term rates will still remain at the levels they are through the duration of a five year term.

This is yet another function of the low interest rate environment where people are encouraged to financially leverage on cheap credit. At 3%, why not spend the extra $100,000 on those granite counters? That’s only $250/month extra…

The argument that low interest rates increase asset prices is a simple mathematical argument, but the real estate market in the USA, where interest rates are equivalently low for long-duration mortgages, is proving that rates alone are not a sufficient explanation for asset values.

Links and after-tax calculations

I will preface this post by thanking Mark Goodfield at the Blunt Bean Counter for mentioning this site. I am quite happy to link to high-quality writers of Canadian finance that use their real names, and Mark has been on my very small list of site authors on the right-hand side underneath the “Canadian Finance” header.

In particular, I found his off-topic post about golfing at Pebble Beach to be highly entertaining. Since I am one of the world’s worst golfers, I can only live through the experience through other people and I note in sympathy of him having to be stuck in a foursome with an incapable golfer at Spanish Bay.

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My topic on taxation deals with the statement of before-tax and after-tax amounts. Taxation must be factored into all financial calculations (despite how much we dislike paying them), but most people intuitively think in terms of before-tax rather than after-tax amounts.

Here is an example: If you were given a choice of having $100,000 cash in a non-registered account or $120,000 in an RRSP account, which would you take?

Most people would take the $120,000 RRSP account.

However, the answer is not so clear. For example, if you decided to take the RRSP account and pulled it all out in one year, assuming no other income and a BC residence in 2011, you would be left with $86,425 in after-tax money to deal with.

If you split your withdrawals into two $60,000 batches, assuming the 2011 rates apply for 2012, you would still be left with $96,366 after-tax. Structured over three years would leave you with $102,043.

That said, if your goal is to invest the capital and generate income over a long period of time, it is far superior to do it through an RRSP than a non-registered account, where in the latter your returns will be whittled away by having to pay the CRA each year. With the RRSP, you would have a larger capital base to deal with and also the advantage of tax deferral.

However, if your primary method is to increase your wealth through capital gains, there are multiple scenarios where doing it through a non-registered account is superior to an RRSP – especially if your holding periods on your assets are of very long duration. For example, if you chose well and invested in something that returned 10% a year for 20 years (note this is exceptionally difficult to do!), spontaneously liquidated at the end of 20 years, you would have $566,733 at the end of the day. In the RRSP account, after withdrawal, you would have $473,639 after-tax.

Also note that if the investment is determined to be grossly over-valued at a point in time, that the penalty of “spontaneous liquidation” in an RRSP is zero, while the tax liability in a non-registered account increases as the value of the investment increases – there is a significant penalty for realizing a capital gain and an investor has to factor this into their calculations (which I did on this post). I find it personally very frustrating to hold onto investments that have appreciated beyond what I consider to be its fair value, but “prevented” from doing so because of the capital gains taxes that would be incurred as a result.

Financial modelling of the RRSP vs. non-registered scenario as I outlined above is not a trivial issue to answer. The specific variables involved include (but certainly are not limited to):
a. When you need money out of your RRSP (a function of age and personal situation with respect to financial needs);
b. Your tax situation for the next X years (including how the government will change rates over that period of time, how much other income you will generate during that time);
c. Your method of investment (as it impacts how taxes are applied, expectations of future returns).

One other component of before-tax and after-tax calculations concerns the implied rent in a rent-vs-own scenario in a real estate purchase. For an individual, a rent payment comes from after-tax funds, which means that if your rent payment is $10,000/year, the before-tax income required to generate such a rent payment, using a 30% marginal rate, would be $14,286 before-tax.

Assuming a GIC returns 10%, one would intuitively think that they would be indifferent if they invested $100,000 in a residential property vs. the GIC (note this excludes all other costs, such as maintenance, insurance, property taxes, etc.) since the “return on investment” is $10,000/year. However, either the GIC rate must be translated into the 7% after-tax figure ($10,000*10%*(1-0.3)), or the after-tax rental amount must be translated into the $14,286 pre-tax figure ($10,000/(1-0.3)).

It is important when doing these financial calculations that all figures are translated into either before-tax or after-tax numbers, otherwise there will be significant errors in comparative calculations.

Fixed rate mortgage rates will drop

Attached is a 1-year chart of the 5-year government benchmark bond yield:

5-Year Canadian Government Bond Yield

With a yield of 1.41%, this is the lowest the 5-year yield has been for decades. The lowest reached during the last economic crisis (January 14, 2009) was 1.54%.

The quick implication is that the 5-year fixed mortgage rate will likely drop. Although we are completely bathed in the midst of a European financial crisis (causing collateral damage domestically, just as the US economic crisis caused damage in Canada), banks are apparently solvent.

What will be an interesting question is whether this recent crush in the markets will cause a decrease in real estate prices or whether prices will continue to remain strong, especially in the Vancouver area. Real estate, gold, and government treasuries are three asset classes that have managed to hold value, while everything else has been dumped. If real estate prices are compressing then banks may tighten credit requirements (e.g. higher down payment, higher rate, etc.)