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How Affordable is Canadian Housing?
Source Rob Carrick Globe & Mail"Royal Bank of Canada's housing affordability measure takes a quarterly look at what percentage of median pre-tax household income is needed to pay the cost of a mortgage on an average-priced detached bungalow, plus property taxes and utilities. Lenders deem a house to be affordable if the associated costs account for no more than 32 per cent of the borrower’s gross income."
The bidding up of property values in the last decade by 10-20% per year is well beyond the rate of growth of the real economy at 2-4% per year and slowing (the last GDP print was 1.4%/yr).
Low interest rates have not allowed most people to qualify for uninsured "conventional" mortgages at the best rates with 20-25% down payment and a 32% gross debt service ratio because prices are at fundamental bubble levels and the thinning number of buyers who believe prices will not correct deeply are still willing to take on high ratio debt insured by tax payers.
I say the disparity between housing affordability and the productive economy will correct unless we get a big surge in private sector household earnings. In the absence of earnings growth which at the moment is only happening in Alberta, the continuation of housing inflation is not a good bet since we are at money laundering price levels; a service not required by most of us.
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Snag 'em and Flip 'em
It's been well reported by the media this last week that Vancouver is in the record book for what is thought to be the highest price paid for a single condo in Canada via MLS ($25,000,000). The CBC reported
that a "Mystery buyer snags 14-room, two-floor penthouse condo"
That's a curious verb to use unless of course it is only the beginning of the blowoff phase of the real estate mania or if you prefer, the rational behaviour of investors betting on inflation?
I looked up "snag" and assumed the reporter used it to convey that the buyer wanted to "catch unexpectedly and quickly, ie: snag a bargain", and was not imagining a toothless grinning fisherman accidentally catching his prize other than by hook in mouth.
We don't know the buyer's motivation, but clearly the buyer has an excess of cash well beyond the sale price and it could very well be the unit was indeed "snagged" up as a trophy of sorts. It wasn't purchased as an investment unless the buyer believes that inflation will provide him with a capital gain at some point that will return the sale price of $25mm and the accumulating $10k monthly nut for strata fees, taxes and insurance with no allowance for maintenance and depreciation.
The seller on the other hand snagged the opportunity of a 47% capital gain, less 3 years of holding costs on his $17mm 2010 purchase. Wow.
The phrase "real estate tourist" identifies transient flippers; "accidental investor" works as well. "
In Coal Harbour (where the $25mm unit is), about one in four condos are “non-resident occupied” (and vacant), said Andy Yan
, a senior researcher with BTAworks, the research division of Bing Thom Architects." Coal Harbour is a sea level shelf of trophies in a rumpus room apparently not worth living in.
Click on the pink/green table image above and take a look at my back of the napkin comparison between two people with $25mm each wanting to go short cash and long concrete and steel. Both buildings are similar, both were built as hotels with dedicated residential floors.
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In the Front Door and Out the Back
Lately I have been updating the U.S. Recovery which looks like it is quickly turning into an Un-Recovery.
The top of the chart mashup shows the negative correlation building between the benchmark 10 year U.S. Treasury Yield ($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."
Carrington, which started in 2003 as a mortgage investment fund and has managed almost 25,000 rental homes for itself and others, has been joined by hundreds of institutional and international investors buying single-family homes after prices plunged following the housing crash. The firms are building a new institutional real estate asset class from the 14 million leased single-family residences that are worth an estimated $2.8 trillion, according to Goldman Sachs Group Inc. Even as demand for rentals rises amid a falling home ownership rate, yields are declining and companies formed to buy the homes that have gone public haven’t yet been profitable.
Funds are buying property now, including homes sold by Carrington, for rents that yield 6 percent to 8 percent a year, before costs such as insurance, taxes and vacancies, according to Rose. Carrington’s model called for mid-single digit net returns on annual rents on an unlevered basis, according to Rose. While returns would vary by market, they would generally be in the mid- to high teens over the duration of the holding period, with the profit from home price appreciation.
"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."
"Sales of homes in foreclosure by Wells Fargo & Co., JPMorgan Chase & Co. and Citigroup Inc. ground nearly to a halt after regulators revised their orders on treatment of troubled borrowers during the 60 days before they lose their homes."
"The banks said they paused the sales on May 6 to make sure that their late-stage foreclosure procedures were in accordance with the guidelines. The banks wouldn't say exactly which issues had been under scrutiny."
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U.S. Housing R Word CLICK TO ENLARGE
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.
Recovery for SomeRecession 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
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Buy a Vancouver Condo as an Investment? SUBJECT PROPERTY CLICK TO ENLARGE
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) CLICK TO ENLARGE
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) CLICK TO ENLARGE
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."
"The growth rate of GDP has fallen significantly and this should not be ignored. Historically, the economy could grow at 4% without creating inflation. With the current makeup of the economy today that is no longer possible. This is why we are likely witnessing the early stages of the transition from deflation to inflation and the end of my “love affair” with bonds."
"One of the factors that will be supportive of an economic push will be the end of the (U.S.) household deleveraging cycle. I think that the end of the deleveraging cycle is about 2 years away. As you can see in the next slide borrowing has started to rise once again and will be a tailwind for the economy. This has been the primary goal of the Fed’s QE programs - boost asset prices to stimulate consumer confidence and borrowing."
"There is a problem though. Productivity growth is heading lower because of lack of capital formation. However, unit labor costs are rising which, as I said, has a high correlation to inflation. The bad news is that rising wage costs negatively impact profit margins." AND "Here is the problem currently. The real fed funds rate is very negative. The last time this occurred was when Author Burns was Fed chairman (1970's, prior to the Volcker 1980's era of mega interest rate increases to kill inflation)."
"The following two decades were not kind."
Rosenberg goes on to suggest: "These are the areas that should perform the best should this longer term view of the world begin to develop":
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".
- S&P 500 dropped 50% in 2000-2002
- S&P 500 dropped 50% in 2007-2009
- S&P 500 dropped 17% in 2011
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.
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FX War "Abenomics"
Occasionally I like to point to Japan as a potential model for North American real estate values because try as they will, the Bank of Japan and the governments of the day have not been able to reverse the course of their multiple decades of deflation. My last post on Japan
looked at what the population does when faced with falling asset values and wage destruction; they reduce spending and increase savings.
The latest attempt to re-inflate asset values by Shinzō Abe (Abenomics), the current Prime Minister of Japan is a massive plan to double the BoJ’s balance sheet and get inflation up to 2%. So far after 6+ months of Yen printing the March 2013 CPI in Japan was negative at -0.09%
Y/Y. The flood of Yen instead of goosing the economy has driven the animal spirits to jack up the Nikkei stock market by over 60% in 6+ months.
See comparison of Japanese & U.S. CPI
as a potential Canadian path.