BC Lower Mainland Real Estate liquidity drying up

Skimming the Greater Vancouver Real Estate, and the Fraser Valley Real Estate statistics packages, it is not surprising in the least to see volumes decline in the July month-to-month comparisons.

The reason is very simple – the introduction of the HST and the threat of higher interest rates. While HST has an impact on new homes sold, the threat of higher interest rates also pushed demand forward. Even though short term interest rates have a smaller impact on the longer-term fixed rates than most people think, it is likely that most financially unsophisticated people would think that rates (at least in the short run) are going up, so they must “lock” their purchases in today.

Usually the opposite thinking works better – the best time to buy real estate are when interest rates are high – since real estate is a credit-driven market, one would surmise that once credit becomes more expensive, real estate demand would drop and subsequently prices would have to lower in order for transactions to proceed.

If the 50% reduction in sales reported is sustained for the following year, you are bound to see price reductions as people that need liquidity in the short-term will be forced to reduce their asking prices. The people that are not urgently seeking liquidity are more likely to sit on their high asking prices and not have a transaction occur.

In terms of sheer valuation (costs vs. income potential/rent savings), Vancouver real estate is by far and away an expensive option. I’ve already explained some other intangible components to the valuation, but one major pillar of real estate has been its “safety” perception by the local populace. Once the “real estate is safe and/or never loses value” mantra disappears, you remove one of the intangible components of demand in the market.

I do not foresee a collapse in the market like we saw in certain USA markets, but a protracted period of time where the price level does not move and/or a slow downturn in prices is likely in the cards.

Financial Psychology – Real Estate

When seeing a post like this, which describes somebody posting a piece of paper saying “Don’t become a mortgage slave!” on a telephone poll or plastering a “Certified Bubble Pricing!” sticker on a realtor’s sign, it makes me wonder – why do they do it?

In fact, why is real estate and gasoline prices the only real conscious items where we lament the high price, as opposed to inflated equity pricing, or inflated bond pricing (i.e. low interest rates)?

It’s likely because such commodities are heavily transparent in daily life – everybody needs a roof over their head, and many people own a car and consume gasoline.

In the case of real estate, it can also be divided into two general categories for the common person – people that do not own a place, and people that do. The people that do own are very unlikely to engage in such dialog, so it can only be assumed that people that do not own real estate take the time to do such activity.

Finally, such activity highly suggests that these people would eventually want to own, if the price is acceptable (whatever it may be). It is unlikely that somebody that has zero interest in purchasing real estate would go through such an effort.

My pondering is the following – is the goal of this person to “save” other people? Or is their goal to lessen demand in the market, causing lower prices in the marketplace?

In either case, you have to question the motives since it just seems like that if real estate in Vancouver did correct by some magnitude that the people putting up the message would be buying themselves, serving as a buffer against price decreases.

I am always fascinated by this concept of “needing to own”, when ownership is better conceptualized as “renting title from the government”. The government still has control over the land usage (through zoning), and if you want to do any significant improvements to your lot, you need approval from regulatory authorities in terms of obtaining a building permit with requisite approvals. Ownership used to mean control, but control in the modern era has been whittled down by regulations. The intangible benefits to ownership appear to be selecting which colour of paint to put on the walls and the right to own a pet, and people have to pay a very heavy premium for those rights. I can see, however, how the cultural concept of ownership has inflated the value of it.

One other constraint that most people face is the inability to invest surplus capital in products other than low-interest bearing GICs – most people have been burned by other financial products, and thus view their mortgage/home equity as an optimal investment vehicle. This is part of my argument why real estate valuation is so high in Vancouver, because of historical performance, including that relative to other financial products.

China’s booming real estate market

I always have a sneaking suspicion that the Vancouver real estate market is a proxy for Chinese real estate, given the heavily ethnic Chinese population concentrations (especially in Richmond, east Vancouver, and around the Metrotown area in Burnaby).

The government of China released an economic report, assuming it is to be believed, that states the following:

3. Investment in fixed assets increased rapidly and that in real estate continued to accelerate. In the first quarter of this year, the investment in fixed assets of the country was 3,532.0 billion yuan, a year-on-year growth of 25.6 percent, or a drop of 3.2 percentage points as compared with the growth in the same period last year. Of this total, the investment in urban areas reached 2,979.3 billion yuan, up by 26.4 percent, or a drop of 2.2 percentage points; that in rural areas was 552.8 billion yuan, up by 21.0 percent, or a drop of 8.4 percentage points. Of the total investment in fixed assets in urban areas, that in the primary industry, the secondary industry and the tertiary industry went up by 9.7 percent, 22.4 percent and 30.0 percent respectively. The investment in eastern, central and western regions grew by 24.4 percent, 26.2 percent and 30.0 percent respectively. In the first quarter of this year, the investment in real estate development was 659.4 billion yuan, up by 35.1 percent year-on-year, or a rise of 31 percentage points.

Also in the report is the following GDP summary:

According to the preliminary estimation, the gross domestic product (GDP) of China in the first quarter of this year was 8,057.7 billion yuan, a year-on-year increase of 11.9 percent, which was 5.7 percentage points higher than that in the same period last year.

11.9 percent growth. Massive.

Since China’s GDP is around $4.72 trillion if you annualized the above number, this is a huge amount of growth in terms of absolute numbers – about $502 billion. Since the USA’s GDP is about $14.2 trillion, it would be equal to about 3.5% GDP growth in the USA.

To put this in another perspective, Canada’s GDP is about $1.4 trillion and it would be as if Canada’s economy grew by 36% for the year!

China’s economic growth is explosive, and whenever you have economies that are on fire to that extent, the boom and bust cycles will be profound.

Garth Turner on Variable/Fixed mortgages – bad advice

On Garth Turner’s “Bingo” post on March 29, 2010, he states:

But the big question I was asked today: what should you do about your mortgage?

The bankers will be on the phone to you soon ‘suggesting’ you lock in, ‘for your own protection.’ Have none of it, if you are in a cheap VRM. We know why the lenders are saying that, since they count on scores of people now rushing in to voluntarily increase their payments. Once again, they play the emotional card, consistently suggesting actions counter to the best interests of Canadians.

A prime-minus VRM is a gift. Keep it. The Bank of Canada rate would have to soar by more than 200 basis points (2%) by Christmas for you even to consider locking in. And even then you would be saving money staying variable. In fact, the typical prime minus one half borrower would be better off staying put until the prime mushroomed almost 4% above current levels. You’d still be paying less a month.

And a prime rate of 6.25% is not going to happen for two, three or perhaps four years. Any sooner and you could mop up the economy with a Swiffer.

Right now, a 5-year variable rate mortgage is prime minus 0.5%, and if you shop around, the 5-year fixed rate is 3.79%.

Prime is currently 2.25%, and should rise to 3.50% by the end of the year. Markets currently suggest the prime rate will be 4.75-5.00% at the end of 2011.

Thus, a variable rate mortgage, locked at prime minus 0.5%, should have a higher rate than a fixed rate mortgage sometime in the second half of 2011.

If prime stayed at 4.25% for the rest of the 5-year term, then a variable rate mortgage is still a cheaper option. However, the differential between the two is close enough that for most everyday people, I would still suggest a 5-year fixed rate if you can get 3.79% for it. It is highly likely over the 5-year period you will outperform the variable option, especially if the yield curve starts to invert (which will happen if the economic recovery runs out of steam).

The crystal ball becomes considerably more fuzzy if you use a 4.39% 5-year fixed rate (which is currently what is ING Direct’s posted rate). If rate increases in 2012-2014 moderate, then taking the variable rate option will be a winner. However, this is exceedingly difficult to predict.

Either way, the lack of ultra-cheap credit will have the effect of slowing down demand in the housing market. Whether that will translate into lower prices remains to be seen. Personally, I have long since thought the housing market was irrational beyond belief, but have come to accept it could be that way for longer than my lifespan.

Ultimately, the only time that housing will become “cheap” in Vancouver is likely when people don’t want to buy houses when mortgages are so expensive that GICs start to become an attractive investment option. Just imagine living back in 1982 when you had a choice of buying some Vancouver special for $150,000 on an 18% 5-year fixed-rate mortgage or renting and putting your would-be down payment in a GIC earning 15% and not having to worry about making those $27k/year interest payments… in situations like that, the cost of capital becomes so high that renting becomes a much more viable alternative.

If we ever see those days again, where buying a house is very difficult because you have such more financially attractive (and accessible) options elsewhere, I would suspect valuations are ripe for buying. We are a long way away from this, even if mortgage credit is given out at 5%.

Vancouver Real Estate – Cultural Factors

Just reading this post out of the Vancouver Real Estate Anecdote Archive:

Vancouver has the highest percentage of young adults by government definitions (18-30) living at home in Canada. Much of this is cultural, where members in certain communities (Asian, East Indian just like Greeks and Italians in Toronto) do not leave home until they are married as renting is a huge waste of money in their eyes. When you leave at home for a couple years, it is very easy to accumulate a large DP when you have no expenses (someone making 30k living at home is much better off than someone making 60K having to rent). Factor in that 40% of the city is made up of primarily two ethnic minorities, and that people are getting married later, you have a situation where FTBS come to the table with very very large DPS that more than offset the high cost of houses. The do not need massive salaries to afford their homes…

[DP = Down payment, FTB = First Time Buyer]

I referred to the “Cultural Factor” as being a relevant determinant in terms of the expensive Vancouver real estate market.

I don’t think it is the “live at home” factor that accounts for a latent demand factor in Vancouver Real Estate valuations – looking at the demographic bulge would suggest that there are relatively less people of the domestic 18-30 year bracket that would be moving into their own dwellings, compared to the people coming in (immigration factor).

I do think that having a very heavy Chinese ethnic component in the Lower Mainland is a significant cultural demand component – I don’t think any other culture values real estate and education as highly as people having Chinese origins. Combine this with the perception of price stability (compared to the amount of money lost in the stock market) and it creates demand for an asset class that is perceived to be a “sure thing”.

My rational framework (which is not at all supposed to model real life reality) suggests Vancouver real estate is over-valued around 40%. But the famous quote, “the market’s ability to remain irrational longer than your ability to remain solvent” always applies, especially with real estate.

Canadian government firing a warning shot on real estate

Finance Minister Jim Flaherty made a statement on December 18, 2009 regarding maximum amortization periods and down payment rates. While I don’t have a copy of the statement or speech made, the National Post has a fairly good summary.

The salient detail is that the finance ministry might change the guidelines and decrease the maximum amortization period of a mortgage (currently 35 years), and increase the minimum downpayment (currently 5%). It would be likely that 30 year mortgages with 10% down payments will be the new rule.

The federal government is probably realizing that the CMHC has guaranteed a ton of debt and in the event of a Canadian real estate meltdown that it would have to pay a very heavy bill as people begin to default on underwater mortgages – this would occur when incomes do not rise to match rising interest rates. Most of the Canadian banks would get away with the financial damage, while CMHC would be paying the bill.

CMHC does collect a one-time insurance premium, according to this schedule:

Loan-to-Value Premium on Total Loan Premium on Increase to Loan Amount for Portability and Refinance
Standard Premium Self-Employed without third Party Income Validation Standard Premium Self-Employed without third Party Income Validation
Up to and including 65% 0.50% 0.80% 0.50% 1.50%
Up to and including 75% 0.65% 1.00% 2.25% 2.60%
Up to and including 80% 1.00% 1.64% 2.75% 3.85%
Up to and including 85% 1.75% 2.90% 3.50% 5.50%
Up to and including 90% 2.00% 4.75% 4.25% 7.00%
Up to and including 95% 2.75% 6.00% 4.25%* *
90.01% to 95% —
Non-Traditional Down Payment
2.90% N/A * N/A
Extended Amortization Surcharges
Greater than 25 years, up to and including 30 years: 0.20%
Greater than 30 years, up to and including 35 years: 0.40%

So let’s pretend you buy some Yaletown condominium for $400,000 and decide to pay 5% down and a 35-year amortization.  Your insurance premium, with a verifiable income, is 3.15%, or about $12,000 for the right to have your bank protected in the event of you defaulting on the $380,000 mortgage.

If the rules change to 10% down and 30-year amortization, the CMHC premium goes down to 2.2%, or about $7,900 on a $360,000 mortgage.  Strictly looking at the premiums, it would suggest that changing to a 10%/30-year system would reduce defaults by 30%.

The problem deals with correlation – if one mortgage defaults, it is more likely that others will in a cascading line (mainly because CMHC will have to sell the property in order to recover as much of the defaulted loan as possible, depressing the market, and likely causing other strategic defaults).  It doesn’t matter what caused the default, but my prime hypothesis is when people go and get their 2% floating rate mortgages, when the Bank of Canada starts to raise rates in the middle of 2010, people will be facing double interest payments when they haven’t properly budgeted for it.

There is also the batch of people that got low 5-year fixed rate mortgages facing renewal – right now 5-year fixed rates are still at relatively low rates (3.8%) but the party will end.

The finance ministry is just trying to make sure the party ends slowly (by people paying off their high-leverage loans over a long period of time), instead of the cops coming in and storming the house (if people can’t pay the interest on their high-leverage loans and cause a cascading default).  Jim Flaherty probably knows this is a financial time bomb that can potentially go off if the wrong circumstances hits the economy, and is taking preventative medicine to do so.

CMHC mortgage bonds currently trade like fixed income government securities.  You can see a chart of mortgage bonds outstanding on this chart.

What makes Vancouver Real estate so expensive?

What makes Vancouver real estate so special? It is very difficult to isolate to a single variable, but geography, immigration, culture, historical performance, and interest rates are all contributing to a very high degree of real estate price inflation, much higher than conventional rational analysis would suggest. I will address these elements separately.

A rational framework for real estate pricing: A rational price would be a discounted cash flow model of rental revenues, subtracting carrying costs (property taxes, insurance, maintenance, cost of capital) and adding in an amount for the ‘ownership premium’. Just browsing through MLS, I came up with the following example:

Richmond-House

Working out the math, we have $15,600/year in rent collection, subtracting roughly $2,500 in property taxes, $800 insurance, $1,200 in maintenance, factoring in zero for cost of capital, assuming a 4% “return on investment”, and adding in a very generous 50% “ownership premium” leaves us with a “rational” valuation of $416,250. Asking price: $838,000, so our model was off by about half. The rational real estate valuation model is clearly broken and should be thrown out – it fails to adequately model what we see presently in Vancouver.

Just like the stock market, real estate in Vancouver is governed (at least for now) by a different model other than discounted cash flows. Let’s look at the variables I outlined in the first paragraph.

Geography: The Greater Vancouver area is surrounded by mountains to the north, water to the west, the United States to the south; all three directions cannot be expanded upon. The only direction available for further land development is east, which is constrained primarily to Surrey and western Langley due to the commute times to where the job centres are located. In addition, another constraint to the land supply is the Agricultural Land Reserve (ALR), which protects a substantial amount of land south of the Fraser River. I will attach a map below showing the extend of the ALR’s boundaries:

GVRD-with-ALR

We see that most of the potential new residential development within an hour’s drive of Vancouver and Burnaby can only be located in Surrey, west Langley Township and west Maple Ridge. Otherwise residential development has to concentrate on density, which has definitely been the case in Richmond, Vancouver, Burnaby and New Westminster. We also see, strictly as a function of geography, that northwest Surrey has a good chance long-term of being the economic centre of the Lower Mainland area.

Finally, there is an interesting study to be made to comparing the prices of real estate in Blaine, WA, versus that of neighbouring White Rock, BC or South Surrey; $250,000 purchases you a pretty nice home in Blaine, while that amount gets you into a 35-year old 2-bedroom apartment in White Rock. It is clear that geographical constraint is one major variable in explaining large real estate prices in the Lower Mainland area, and is the primary supply-side consideration.

Immigration: There are two categories of immigration of concern – net intraprovincial migration (mainly people moving from Ontario to British Columbia), and international migration (people moving from overseas to BC, from mainly Asia). The vast majority of people coming into BC are moving into the Greater Vancouver area, and is neatly summarized by reports from BC Statistics. The BC Stats Q2-2009 Population Report is worth reading. Of note is that the net migrants from the rest of Canada tend to be older people, presumably escaping to BC for the better winter climate. These people will likely be more asset-rich than average migrants (they can afford to move into a more expensive area), thus adding more demand to the local condominium or townhouse markets.

The formula is pretty simple – increasing population means an increased need for housing supply. Due to the subsequent demand from more people via migration, the net result is an increased price for housing.

Culture: It is drilled into the fabric of society that owning is better than renting especially with housing. The ‘ownership premium’ is an economically relevant variable – it essentially says that if the costs of renting or ownership are equivalent, a rational individual would choose to own. This, in itself, would explain a higher amount of demand and thus higher prices, especially when compared to relative costs of renting.

In addition, a significant minority of international migrants that have come into the Vancouver area over the past 20 years are Chinese, and in Chinese culture, the importance of owning your own strip of real estate is even more powerful than it is in western culture. As a result of increased net international migration and this cultural mindset, demand for ownership is increased, increasing prices.

Contrasting this is the European mindset, where property prices are generally so high that the thought of owning them (unless if you are part of society’s elite) is a foreign concept.

Fortunately in North America, everybody can be elite enough to own their own piece of real estate – and jump on the opportunity, whatever the cost may be. The urgency to do this (typically seen with the lines such as “you will be priced out forever if you don’t get into the market now”) seems to be awfully attractive to those that don’t know how to generate returns elsewhere.

Historical Performance: The Vancouver real estate market has endured quite well over the past 10 years (a non-logarithmic chart is here), and as mentioned previously, survived two stock market crashes with great resiliency. Since the mentality of Joe Public is to extrapolate the financial trajectory of asset classes out to infinity, it would give the impression that real estate is a stable investment, and will continue producing gains at historical rates (which if you randomly ask people on the street, should be anywhere between 5 to 20 percent annualized over the next 10 years). The confidence in future capital gains increases demand for real estate for two reasons – one is because it makes sense to borrow money for less and buy into an asset class that will return more, and secondly because of the sense that real estate will not depreciate.

Putting a different spin on this, if everybody “knew” that real estate prices would go down 2 percent a year, a significant amount of demand we see presently would evaporate, and we would see increased supply as people would try to unload their depreciating properties.

A significant number of people got burned in the stock market crashes in 2000-2002 and lately in 2008, with both crashes seeing the stock market indexes down from their local peaks about 45% and 55%, respectively. The same people, investing in mutual funds, will have seen similar performance, whether they have invested in active funds (taking a 2.0-2.5% reduction each year in management expenses) or passive index funds (typically taking 0.2% to 0.6% for most exchange-traded funds). Either way, people would have taken a huge haircut in 2008, similar to how most Canadians fared when they invested in Nortel shares at $100 a pop back in the tech boom.

So Joe Public, based on past performance, is unlikely to invest in stocks, simply because they are seen as a money-losing financial instrument. Risk-free money also earns nearly nothing in the present low-rate environment. Historically (over the past 10 years), the only three sectors that Joe Public has been able to obtain a significant return on investment has been one of the following:

1. Gold, or related precious metal commodities that are typically seen as a store of value when confidence in paper currency erodes; five years ago, gold was roughly US$430 and is now US$1160.
2. Long-dated government bonds. As short term rates continue to drop, long-term risk-free debt with higher coupons trade at premiums; depending on when you timed this, you would have realized roughly a 7% compounded return.
3. For the Vancouver area only (although there may be other regions of Canada that this analysis will apply to), real estate. Note that most of the US real estate market has been decimated with the sub-prime mortgage crash (caused by excessive foreclosures).

I would argue that capital allocation is a major part of real estate demand locally in Vancouver, simply by the virtue that the real estate market has not crashed.

These four variables alone contribute to a significant amount of demand in the market, which likely explains the performance of the market for the past five years. However, there is another factor that has increased demand even further, and that is interest rates.

Interest Rates: With short-term interest rates at an all-time low (the Bank of Canada’s overnight target rate is 0.25%, which is as low as it can practically get, and Prime is 2.25%), this has the effect of skewing people’s dollars from savings accounts (which earns roughly 1% in a short-term savings account) into more riskier assets. For “Joe Public”, where does most of this risk capital go toward? Real estate. In addition to other variables which tend to favour real estate, I would content that low rates cause an already expensive market to be fuelled by further incremental demand.

The simple example is that a variable rate mortgage these days will result in a 2.05% interest rate, as long as rates continue to remain dirt cheap. The result is an interest payment of about $1,400 a month on a $800,000 mortgage loan, which is comparable to rental rates (seeing the Richmond house example above).

Conclusions: If we were to use some marginal analysis, it would suggest that whenever interest rates rise, it will have a disproportionally negative effect on real estate demand, as mortgages would become quite expensive. The second analysis point is that one would have to look at net immigration into BC to see whether demand will increase or not. Finally, likely the real reason why real estate in Vancouver continues to remain high is because… prices have remained high. It is the perception of stability and high prices that keep demand high in Vancouver.

Will the real estate market see pricing decreases in the future? I don’t know. The market is quite reflexive in terms of its price as a determinant of future pricing. Any commodity market (and this does include real estate) faces periodic 40% downturns (Vancouver’s last 40% downturn was in 1981-1982), but timing this event, if it indeed does happen, requires luck – pundits have been calling for the downfall of Vancouver’s real estate valuations for the last five years. The strongest argument for a downturn is valuation, but just like in stock markets, valuation is rarely a just cause for short selling a stock – there needs to be psychological circumstances that changes the nature of the investing climate in order for prices to permanently decline. My guess is that such a psychological change would be perpetuated by… lower prices.