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In the Front Door and Out the Back
Lately I have been updating the U.S. Recovery which looks like it is quickly turning into an Un-Recovery.
The top of the chart mashup shows the negative correlation building between the benchmark 10 year U.S. Treasury Yield ($TNX) and the iShares ETF (IYR) which tracks the Dow Jones U.S. Real Estate Index.
U.S. Real Estate cash proxy buyers (IYR) are selling into what looks like a top set last week while 10 Year Yields ($TNX) take another step up from the low set back in July 2011.
The lower chart above via ZeroHedge and the Wall Street Journal shows that short term flipping of real estate held for 6 months or less in California is at the highest levels comparable with 2004-05 levels. Get in, get out, don't overstay because there is negative yield if the property is held.
As I demonstrated in my recent Vancouver Condo Investor Case Study, a buy and hold investor needs a minimum positive cash flow yield in excess of a 10 year bond otherwise what is the reward for taking on the risk?
In the U.S. markets where flipping is the hot game, net operating income is not a calculus. The institutional money and cash buyers who can cherry pick ahead of the crowd are looking for capital gains not cash flow. Again from Zero Hedge
According to the CEO Bruce Rose of Carrington, one of the first investors to use deep institutional pockets (in this case a $450 million investment from OakTree) and BTFHousingD. "We just don’t see the returns there that are adequate to incentivize us to continue to invest" Rose's assessment of the market? "There’s a lot of -- bluntly -- stupid money that jumped into the trade without any infrastructure, without any real capabilities and a kind of build-it-as-you-go mentality that we think is somewhat irresponsible."
"6 percent to 8 percent a year, before costs such as insurance, taxes and vacancies" Dear reader, that is not an undertaking for investment yield, that is a speculation that a capital gain can be made in the short term, and that is the basis behind the so called "Housing Recovery". Get in first, get out first.
One more note should be made and again from ZeroHedge, and the L.A. Times is that the institutional owners of foreclosed properties have held them back from the market keeping the supply low and the retail bidding high.
"...and guess what states the greatest number of 'halts' are in from these banks - California, Nevada, Arizona - exactly where the surges in price have occurred."
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U.S. Housing R Word
The 3 chart mashup shows U.S. Census Bureau data of renovation spending charted by BofA Merrill Lynch Global Research and republished at Zero Hedge as well as StockCharts.com charts of the $LUMBER index and the U.S. Home Construction ETF ITB.
Renovation spending began to plunge right after Hurricane Sandy in the fall of 2012 and the Lumber market has been plunging for 9 out of the last 10 weeks. In the short term, the U.S. New Housing Construction ETF (ITB) looks like it has started to roll over.
It is well reported that in some U.S. metro areas, housing is hot and buyers are bidding up prices due in part to the competition by global capital flight looking for safe havens and large institutional buyers looking for investment returns from the rental market.
Buy, hold and flip down the road works when financing and job security is not an issue for these HNWI buyers. Judging by the above charts, the broad real estate market is not in a position to build as many new units for sale or take on major renovations as they have in the past.
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Recovery for Some
Recession for Others
For perspective, here is the CoreLogic S&P Case-Shiller U.S. Home Price Index showing the narrow trading band that prices have been in since the March 2009 Pit of Gloom.
Also included is the still declining U.S. Home Ownership Rate which is back to 1995 levels!
There are two worlds. One of those worlds has fewer individuals and they are buying real estate. Meanwhile for the rest, in the last 3 weeks, the 30 year national U.S. mortgage rate moved up 40 basis points (Zillow.com inset chart)
Buy a Vancouver Condo as an Investment?
5 Yr old 600sf 1 bdrm condo
Good location downtown
Good amenities & condition
$363,000 Purchase Price
There are dozens of similar offerings of MLS listed condos for sale and many more on Craigslist for rent.
If you want to use this spreadsheet for your own analysis, start here.
ALL CASH BUYER SCENARIO (Click the spreadsheet image above. SCREEN TIP: If you want to view the image enlargement of the thumbnail above even bigger than the default and you are using Google Chrome as your browser, right click on the image enlargement and select "open image in a new tab" and then Ctrl + to enlarge the image even more.
An investor buying for all cash ends up with a cash on cash Return on Investment (ROI) of 3.1% which is 1.3% more than the yield from a Canada 10 Year Bond (1.7%).
Is the yield worth the risk? Notice I have used low rates (2%) for maintenance, vacancy and management and have made no allowance for accounting or other professional services. Real estate management is time intensive and the physical asset suffers from depreciation while the value of the asset is subject to market and government caprice.
FINANCED BUYER SCENARIO #1 (Minimum Down Payment)
An investor who puts down 37% in cash ($136,719) ends up with a negative ROI of -1.4%
Why did the buyer finance 63% of his investment? Because the lender (in this case TD Canada Trust) requires a down payment of 35% of the sale price as a non resident (investor) owner. Leverage has a cost.
An additional 2% down payment above the 35% required was added to account for also financing the additional closing costs and property transfer taxes that amounted to nearly 2% of the sale price. In BC, the property transfer tax is 1% of the first $200,000 of sale price and 2% of the balance of the sale price. The sale price is one thing but the actual closing cost (investment) is another. We want to see what the actual "cash on cash" return is.
Relative to the Canada 10 Year Bond Yield at 1.7%, this mortgaged real estate investment is 3.1% LESS than a zero risk bond that requires no effort. Let's reduce the financing to get a yield.
FINANCED BUYER SCENARIO #2 (In Search of Yield)
Before we address the issues of sale price and revenue, let's see what amount the investor has to reduce his financing, or in other words increase his down payment, to get a yield that is commensurate with a 10 year government bond yield.
The revised spreadsheet (left) shows that the investor must increase his down payment to 66% of his upfront cost instead of the minimum required by the bank of 37% to get a 10 year bond yield.
The lender does not care if you have a negative yield, their primary risk assessment is to determine if the market value will fall below the loan amount during the term of the mortgage; in this case the lender requires a minimum 35% spread and is in first position if the loan defaults. Read the fine print of your loan documents and consult a lawyer who works in contract law to see if the lender can attach your personal earnings or lien your other assets.
Remember this revised scenario is still using very low (2%) rates for maintenance, vacancy and management. In a flat or declining market or if the property has reached its upper revenue limit, a prudent investor would account for worst case scenarios because real estate is a "slow asset" and the real possibility is that ownership can end up being for a much longer period of time than originally anticipated during the excitement phase of purchase.
Let's look once more at our spreadsheet, but this time increase the potential costs so that we have a contingency plan in place.
FINANCED BUYER SCENARIO #3 (An Unyielding Market)
Now we have increased the maintenance, vacancy and management rates to 5% (from 2%) of gross revenue and if we have no maintenance or vacancy issues, we can build up a contingency reserve in the first year of operation of $2,430 ($810x3).
But remember, your investment unit is subject to the strata council, a third party entity that also does not care about your yield.
$2,430 may not even cover a modest repair to the building envelope or a strata fee increase for upcoming work. Before you purchase, read all of the strata meeting minutes as far back as records go and look at the insurance premium history to see if they are much higher than comparable buildings; this will indicate if the insurer considers the building an inherent risk.
With the increase from 2% to 5% on the variable expense side, our financed buyer has to increase his down payment to 76% of his outlay to generate a 10 year bond yield. The 100% cash buyer now has a yield that is only 0.9% over the 10 year bond. This investment potential is diminishing.
The more that we account for risk, the thinner the margins become. The risks are high if there is little or no capital appreciation on the asset via rising market values and if expenses rise or revenue falls the yield can turn negative very quickly.
There are only two avenues to get to a better yield; raise the net income or decrease the capital cost. Let's take a look.
REDUCE CAPITAL COST SCENARIO (My Heart Races with Joy)
Many market analysts think that Vancouver has at least a 30% market value price drop ahead. Some think a greater reduction is in store.
Currently average strata units in Vancouver are trading at 2007 price levels down over 10% from the highs set in the summer of 2011. If we believe a further correction will take place, let's get ahead of the market and reduce the price of our case study by 25% to see what happens.
This takes our purchase price down to $272,250 which is comparable to the winter of 2005 prices and a benchmark that the Plunge-O-Meter suggests Vancouver prices will reach.
Again we are using the 10 year bond yield as a target for our leveraged investor. The leveraged investor can now reduce his cash outlay to 55% (down from 76%) and get a comparable 10 year bond yield equivalent while the all cash buyer gets more than TWICE the 10 year bond yield. Wow, this gets my heart pumping, my blood flowing and I think real estate might be worth looking at again.
With a 25% drop in sale price, the GRM has dropped nearly 6 points (lower is better) and the CAP Rate has gone up 40 basis points (higher is better) which not a huge move but the yield on investment (ROI) has increased to more than twice the 10 year bond return and that provides an investor the incentive in a ZIRP environment to buy and hold and allow other people's money (the tenant's) to turn debt into equity.
In the late 1970's and early 1980's Canadian investors looked for 8-10% and even 12% or higher CAP Rates in real estate to try and match the then 10-16% yielding 10 year Canada bond.
Today in this ZIRP environment, if you cannot yield 2-3 times more than a 10 year government bond, then you do not have enough margin to protect against an interest rate uptick or net revenue erosion from rental supply competition, expense statement shock or demands by government for more tax and or fees.
The crucial metric today is purchase price. This Vancouver condo investment case study is clearly overpriced.
Buying real estate on a bet that its price will rise sufficiently to compensate risk is itself very risky.
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Tapped Out Canada?
Thanks to Pacifica Partners Inc. we have an update on their chart series showing that Canadians have hit a heavy ceiling of debt acquisition.
If new borrowers don't show up then it's doubtful that cash buyers will bid up prices. Cash wants a high yield to offset the term risk of holding real estate in an expense laden environment.
We (Pacifica Partners Inc.) remain bearish on the Canadian real estate market with real estate appearing overvalued by approximately 30% in most major markets. Canadian economic weakness, the expected contraction of outstanding consumer credit, and already heightened real estate prices serve as the basis for our bearish stance.
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Canadian Billionaire Edition (2012 data)
Here is another metric for grappling with the valuation disparity between Vancouver and the GTA. (Comparison Chart)
Toronto has more than twice as many billionaires as Vancouver, and more than Calgary and Vancouver combined.
Montreal has more billionaires than Vancouver and yet for the price of an average single family detached house in Vancouver you can buy 3 of them in Montreal and still have cash left over (Canada Chart).
We can guess that New York and London as Financial Centers have lots of billionaires, but who knew that Moscow ranks 2nd?
According to the Knight Frank Study, Moscow barely makes the list as a target for High Net Worth Individuals appearing only on the Political Power List at 9th place.
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Negative real rates in the past have always led to asset bubbles.
David Rosenberg Chief Economist and Strategist for Gluskin-Sheff makes the case here via Zero Hedge and Lance Roberts of Street Talk Live.
Rosenberg's Potemkin (fake) Rally "coffee table" presentation at the 10th annual Strategic Investment Conference presented by Altegis Investments and John Mauldin, is loaded with charts and he makes a persuasive argument for a sea change.
Says Rosenberg: "There has been a secular decline in Potential GDP (U.S.) growth. Here is a question for you. How does 1.8% GDP growth rate over the last year drop the unemployment rate by 60 basis points from 8.1 to 7.5%? That math simply doesn't work."
Remember, Roesnberg's view is U.S. centric and the U.S. has already witnessed a huge correction in real estate and a massive financial market sector bail out; something we have not seen in Canada.
Canadian real estate in the bubbly metro markets do not have positive yields and if we are to see a shift to rising rates as Roseberg suggests, then yield chasers don't need the risk of a "slow asset" like real estate.
I track Canadian "real" interest rates here, and they did shift to rising two years ago and are up over 200 beeps. That's a potential sell signal.
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WE'RE ALL IN!
The Canadian current account balance as a percent of GDP provides an indication on the level of international competitiveness of a Canada. Currently it's negative at -3.7% close to the historic low.
From 1980 until 2012 the Current Account to GDP averaged -1.18% with a record high of +2.7% in December 2000 after the .com blowout and a record low of -4.20% in December 1981 after the interest rate peak.
A current account deficit means we import more than we export, have low savings and high personal consumption rate as a percentage of disposable income.
Not pictured in the charts above and adding stress to the system is the Unemployment Rate in Canada which increased in March 2013 to 7.2% which is what it was in the fall of 2000.
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WE'RE ALL IN DEUX!
Thanks to Doug Short and Chris Kimble, we have this chart on "Margin Debt Hitting Levels Only Seen ONE Other Time in History!", the tech bubble back in 2000.
Negative net worth is the situation when investors have large amounts of money borrowed on margin and little cash in their brokerage accounts (2000, 2007, 2011 & now)
My phrase "Monetary Zirpitude" is a play on "Moral Turpitude".
From Wikipedia: "Moral turpitude is a legal concept ... that refers to conduct that is considered contrary to community standards of justice, honesty or good morals." and "an act of baseness, vileness, or depravity in the private and social duties which a man owes to his fellowmen, or to society in general, contrary to the accepted and customary rule of right and duty between man and man."
The main character in Vladimir Nabokov's 1935 novel "Invitation to a Beheading" is found guilty of "gnostical turpitude."
From Wikipedia: "The novel takes place in a prison and relates the final twenty days of Cincinnatus C., a citizen of a fictitious country, who is imprisoned and sentenced to death for "gnostical turpitude." Unable to blend in and become part of the world around him, Cincinnatus is described as having a "certain peculiarity" that makes him "impervious to the rays of others, and therefore produced when off his guard a bizarre impression, as of a lone dark obstacle in this world of souls transparent to one another." Although he tries to hide his condition and "feign translucence," people are uncomfortable with his existence, and feel there is something wrong with him. In this way, Cincinnatus fails to become part of his society."
ZIRP, the "lone dark obstacle" makes the true cost of money "impervious to the rays" of price discovery. As noted many times on these pages, I recommend that if you are or intend to be a landlord, you should do a yield analysis on the cash flow from your property.
History, Charts & Curated Readings
"Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement; and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it." George Santayana Vol. I, Reason in Common Sense
"History, real solemn history, I cannot be interested in.... I read it a little as a duty; but it tells me nothing that does not either vex or weary me. The quarrels of popes and kings, with wars and pestilences in every page; the men all so good for nothing, and hardly any women at all - it is very tiresome." Jane Austen spoken by Catherine Morland in 'Northanger Abbey'