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:

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:

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.