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.

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.

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.)

Specifically, the following provisions will be enacted immediately:

* Reduce the maximum amortization period to 30 years from 35 years for new government-backed insured mortgages with loan-to-value ratios of more than 80 per cent. This will significantly reduce the total interest payments Canadian families make on their mortgages, allow Canadian families to build up equity in their homes more quickly, and help Canadians pay off their mortgages before they retire.

Notably, this does not prevent people putting 20% down from getting a 35-year amortization mortgage; it does prevent people putting less than 20% down from getting a 35-year amortization mortgage. This change will only impact those mortgages where mortgage insurance is required.

On March 18, 2011 the following will come into force:

* Lower the maximum amount Canadians can borrow in refinancing their mortgages to 85 per cent from 90 per cent of the value of their homes. This will promote saving through home ownership and limit the repackaging of consumer debt into mortgages guaranteed by taxpayers.

This lessens the amount, slightly, of the home equity people can withdraw in a second-line mortgage.

On April 18, 2011 the following will come into force:

* Withdraw government insurance backing on lines of credit secured by homes, such as home equity lines of credit, or HELOCs. This will ensure that risks associated with consumer debt products used to borrow funds unrelated to house purchases are managed by the financial institutions and not borne by taxpayers.

This is probably the most important of changes – second-line mortgages will no longer have the public guaranteeing the loan value via CMHC.

Clearly the government is worried about CMHC guaranteeing mortgages that will eventually default. My opinion is that the government should not be in the market of guaranteeing mortgages at all – this is precisely why we have a financial industry, which can appropriately price the risk. If they cannot price the risk properly, they should either get out of the business or go bankrupt.

About thirty years ago, the stock trading business was cracked open when brokers could charge whatever commissions they wanted – the eventual result of this was automated stock trading and dirt-cheap commissions. A trade in the old days could cost $100 (and that was in 1970′s dollars), while today you can get them done for a dollar.

Essentially, the full-service broker was supposed to provide “value” in their advice to buy or sell securities, but there was an embedded conflict of interest – the broker made money by performing transactions, as opposed to giving good advice. Discount brokerages alleviate this problem by allowing individuals to make their own trading decisions.

The same trend toward discounting will happen to real estate transactions. Currently a typical commission scheme is 8% for the first $100,000 and 2% thereafter; so a transaction on a $500,000 place could be around $16,000 or 3.2% of total transaction price. Suffice to say, this is a huge liquidity penalty (not even including the property transfer tax in BC).

What value does a real estate agent provide? It is one of being a liquidity provider – trying to find somebody to purchase your property. They also provide some supplementary paperwork (mainly copied from templates), but you still have to engage in a lawyer and/or notary to get some other paperwork done to close the transaction.

It is debatable how much “marketing value” is provided by an agent, but what is clear is that real estate transactions are likely to become cheaper as service components become separated. Also, people that can actively shop their property around will likely be able to save significant amounts of money.

Reducing property transaction costs will strongly help to increase liquidity in the real estate marketplace, which would also increase the accuracy of valuation.

One of the primary reasons why I do not dabble in real estate is simply due to the lack of liquidity and the transaction costs. I’d much rather prefer to invest in companies that specialize in real estate since they are likely to have better skills in property management than I ever would.

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.

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.

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.

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.

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%.