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.

More Genworth MI propoganda

Another reason why Genworth MI Canada (TSX: MIC) is a cash machine is because delinquency rates have significantly decreased since the 2008-2009 financial crisis:

Also, a stress test scenario where unemployment goes from 8% to 11% and property values go down 15% (which seems to be a low number – higher decreases in property prices would increase severity):

Unless if there is a huge crash in the commodity market, I don’t see this happening. The crash might occur, but not when you have massively loose monetary policy like we do today. The only reason why the stock got as low as it did (bottoming out at $16.72) is betting on a massive real estate bust. Now those expectations are moderating somewhat.

Genworth MI Canada volatility

The past five days of trading of Genworth MI Canada (TSX: MIC):

The last day’s volatility (remember: volatility means down and up) is relatively unusual for the company. In the 722 trading days preceding this one, the largest volatility was a 7.4% increase in price on November 4, 2011. The largest volatility down was 5.2% down on October 17, 2011. Both of those days were on higher volume than today’s average. Today’s performance (5.61%) was its fifth most volatile day in its trading history.

The market is coming to my idea of fair value much sooner than I was originally thinking. It would be even nicer if Genworth sold it off for $30/share, but I digress.

It appears interest rates are headed higher

Despite the federal reserve opening up the monetary spigots again and vowing to bring down the long part of the yield curve, markets had the opposite reaction lately:

While present rates are low from a historical perspective, the trend indeed is now up. If this continues it will have more visible financial consequences. Essentially, those structured with long durations will take valuation losses. Conversely, those that financed their debt with long durations will do favourably (as long as the market believes they are able to pay back or refinance the debt!).

My quarterly performance so far today is absurdly good and this actually frightens me somewhat. Higher interest rates eventually will affect the valuation of the equity markets.

Generating synethic performance – catering to yield chasers

Finance is a very funny industry. The primary way of keeping score, change in cash, is not really used as a performance measure. Instead, the performance measure is return on investment, which is a proxy for change in cash, but not the same. Return on investment is a flawed metric because it does not take into account risk.

A clever formula to weighing historical risk and performance is the Sharpe Ratio, but I will leave that mathematical dissection (and the weakness of the Sharpe Ratio) for another post.

If I told you that I made 2% this year, an observer in an “up” market environment would say that is a horrible return on investment and bad performance. If I then said that my portfolio was 100% cash, then the performance would be fantastic. You might chide the decision to be all-cash in an up market environment (missing the wave) but at least the performance in the constraints of a 100% cash portfolio was great (given that the most you can do these days is less).

However, if you wanted to juice your performance, the drug of choice in the finance industry is leverage. And in today’s interest rate environment, the rate on leverage is cheap. Even retail investors can get into the action by loaning money from Interactive Brokers (depending on how much money you actually borrow – the first US$100,000 is at 1.65%, the next US$900,000 is at 1.15% and the next US$2,000,000 is at 0.65% and everything above that is at 0.5%).

Assume you get a 1% borrowing rate, which makes the arithmetic easy. So if you manage to earn a 2% average on cash, why not borrow cash at 1% to invest it at 2%? So I will set up a mutual fund. All I will do is invest at a risk-free rate of 2%, and apply some leverage. I invest $100 in my own fund, but borrow $900 at 1%. What happens financially?

Interest income: $20
Interest expense: $9
Net income: $11
Return on investment: ($11 net income / $100 equity investment) = 11%!

So I have magically transformed what was a 2% return into a 11% return with the magic of leverage. Using this technique, and unlimited borrowing power, I can generate any return on investment you desire. Want 101%? Easy – borrow $10,000 instead.

This concept is introduced in introductory level finance courses across the world, but most people fail to appreciate how the rate of return figure that is being advertised in a lot of cases is simply a synthetic return. The use of leverage creates this return. Parenthetically, a similar way of generating “synthetic yield” was used in the mid-2000’s when income trusts were raising equity capital and just giving back cash to unitholders as a return of capital to generate false yield when they weren’t really making any money to justify their distributions.

Where do you see synthetic performance currently occurring? Mostly in the US financial REIT markets like Annaly (NYSE: NLY) and others. They borrow money for cheap, invest them in mortgage-backed securities, and then skim the spread. They goose their performance with leverage.

While this is a valid way of making money, the danger is on the reliability of returns – even if the asset you are investing in inevitably gives out the desired return (both of interest and principal), if the asset value itself has severe variations, funds will be forced to liquidate such securities for losses because they will have lost borrowing power. If you have enough capital being driven into these financial structures and they keep leveraging the capital to generate high returns, there will be some blowups along the way simply because the asset pool they are investing in will be well above true vale. One blowup will likely cause others to blowup since they are essentially invested in correlated products.

Yield-chasers are going to get crushed. I am not sure when this will occur, but the current trend toward yield chasing is crystal clear. I’m not going to be shorting such securities presently since I think the momentum still has quite some way to go, but when this insatiable risk reaches some sort of crescendo, that would probably be a good time to sell everything and wait for a 2008-style crash in asset values. Maybe in 2013 or 2014?