Category: Real Estate

The Government of Canada came out with an incremental announcement regarding the policies surrounding mortgage credit:

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.

(Link to news story: MLS real estate deal ‘may force out agents’)

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.

David Merkel writes the following about financial asset bubbles:

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.

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.