Real Estate asset bubbles

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.

A very brief primer on Canada-US petroleum trade

The US Department of Energy releases a weekly bulletin on energy, and this week they chose to look at the Canadian energy exports to the USA, and the impact of a pipeline blockage.

The oil sands is a huge strategic advantage, especially as fossil fuel mining becomes progressively more difficult. In particular, transport fuels are going to face huge demand pressures as China and India continue their very high economic growth.

Bank of Canada chief speaks

The Governor of the Bank of Canada, Mark Carney, made a speech today. Although the media is reporting otherwise, Carney is still keeping his options open:

Since the spring, the Bank has unwound the last of our exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate to 1 per cent. Following these actions, financial conditions in Canada have tightened modestly but remain exceptionally stimulative. This is consistent with achieving the 2 per cent inflation target in an environment of still significant excess supply in Canada and the demand headwinds described earlier. While Canada’s circumstances and the discipline of the inflation target dictate a different policy stance than in the United States, there are limits to this divergence.

At this time of transition in the global recovery, with risks of a renewed U.S. slowdown, with constraints beginning to bind growth in emerging economies, and with domestic considerations that will slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered. The unusual uncertainty surrounding the outlook warrants caution.

Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still low interest rates and relative price stability.

If you read the context of the rest of the speech, essentially he is saying the economy cannot be solved with monetary policy alone, which is correct.

Also, 3-month banker’s acceptance futures (the proxy for the overnight rate projection) are not moving as a reaction to this speech.

Market places a premium on yield

I have had this ongoing theory that the market is bidding up yield-bearing assets beyond what is rational.

Nothing is as good an example as today when a small asset management firm, Integrated Asset Management (TSX: IAM) announced that they were resuming an annual dividend – 4 cents a share.

IAM is a very illiquid company, but I have had the advantage of considering them as an investment candidate a couple years ago, but never invested because of valuation (too high). This turned out to be a money-saving decision (notwithstanding the economic crisis!). They had previously given out 4 cent dividends on a semi-annual basis (which was unsustainable), but in order to build up their equity they suspended dividends in early 2009.

Their balance sheet otherwise is quite clean – they have a small cash cushion (about 36 cents a share) and no debt.

Yesterday, the company closed trading at 62 cents a share on 1,500 shares of volume (that is about CAD$930 that traded hands, which is about half of its historical daily volume). Today, they are presently trading at 90 cents a share, and I see about 135,000 shares that have changed hands.

Suffice to say, a 45% price increase because of a dividend announcement is a good indication that the market is valuing yield above everything else.

In terms of actual valuation, it was my belief that before this announcement that IAM was trading at the lower end of my valuation range, but not quite at “buy” territory. In addition, the illiquidity would have made it prohibitive to accumulate a position with any speed and thus illiquidity translates into a lower valuation.

The company itself is an asset manager – they claim to deal with “alternative assets”. At the end of their last quarterly report, they reported nearly $2 billion of assets under management. Their year ends on September and 2009 was a very poor year for them, but it was also the case with every other financial institution. In a more “regular” year, the company should be earning around 6 to 7 cents a share, so their dividend payout schedule will be around 2/3rds of their income.

The dividend announcement shouldn’t change what the company earns, so it is puzzling to see it rise so much after the announcement. It also makes you wonder how many other yielding securities have their prices elevated strictly due to dividends and income distributions, rather than earning economic profits through their operations.

An astute trader can also try to time these announcements in other securities. I will leave this to an exercise for the reader.