What’s Wrong With Real Estate?

September 12th, 2008 by Potato

I’ve had a number of only vaguely related thoughts on real estate lately, so let’s see if I can string them together into a coherent post:

A report recently came out from UBC asking the question “Are Canadian Housing Markets Over-priced?” The answer was not quite what I expected: the paper figured that Toronto was at equilibrium, Vancouver was 11% overpriced, and Ottawa 25% overpriced. If I were to rearranged those numbers based on my current understanding of the housing market, I would say that Toronto was 11% over, Vancouver 25% over, and Ottawa at equilibrium.

Some people have, naturally, been tearing the paper apart, especially since they rely on ads on Craigslist and in the newspaper to determine the market rent. While this will tend to give a higher rent than might perhaps be the true market rent (since those are the asks and not the actual agreed-upon market rent), I’m ok with using that as a tool to get an estimate. Others complained about how they figured the average (SFH, detached) home price.

My big issue with the paper is how they get to their equilibrium. It understates what the equilibrium yield should be. They include the cost of the capital (mortgage costs), maintenance, taxes, insurance, and then takes out the anticipated capital gains. They say that the market would be in equilibrium when the rental rates equal that net cost of owning. However, that leaves zero profit for taking on the risk and effort of owning/landlording. IMHO, there can’t really be an equilibrium until there’s at least some kind of profit/risk premium margin. If we were to put in even a 2% premium to where equilibrium should be, then the Toronto market for example goes from being balanced at ~$420k for the typical house to being over-valued, with a target of ~$308k to get to equilibrium, a drop of over 25%. Heck, just adding in the amortized transfer costs for owning real estate vs renting (taxes, closing costs, commissions) would up the equilibrium by a percent or two, again indicating that house prices should fall and are not at equilibrium.

That would also bring it more in line with the rules of thumb I’ve read about: for instance, that a house is overvalued when the price is more than 200X monthly rent; a 5% yield (as for the balanced Toronto market in the paper) translates to about 240X, whereas using my arbitrary 7% is a more reasonable 171X. ~125X should be the buy range, which is a gross yield in this sense of 9.6%.

Of course, the more pressing issue is perhaps how they managed to figure in anticipated appreciation into their return. Leaving aside the validity of attempting that at what they admit might be the top of a cycle, it leads to positive feedback and chasing performance: the markets that have gone up a lot then have more anticipated appreciation, so they’re not considered overvalued, whereas the markets that might be in equilibrium are considered overvalued because they didn’t have the price run-up, and so don’t have the same amount of anticipated appreciation to offset high house-to-rent values.

The days of bidding wars seem to be coming to an end, but I’ve always wondered about that mispricing. It’s often newsworthy when a house sells for significantly over asking price (sometimes 20% or more). My question/revelation is: how could the house have been so mispriced to begin with? Shouldn’t the selling agent take a drubbing for that one for being so off on setting the asking price? Shouldn’t the buyer’s agent take a drubbing for letting things get so out of hand that a bidding war sent things up that far above the asking/market price? I never see any such issues for the realesnake agents…

A recent New York Times op-ed says that the subprime mess wasn’t all bad. After all, “only” ~15% of subprime borrowers defaulted, so those subprime loans helped 85% of people who took them buy their own home, and that’s a good thing… right?

I don’t necessarily see it as good that some of these sub-prime borrowers got to become home owners. Everyone needs an (affordable) place to live, but not everyone needs to be a homeowner. Should young single people be homeowners? It was never really something I thought of single people doing, but there are a lot of condo projects out there with a lot of bachelor/1bedroom units, and a lot of young people jumping into the market earlier in their lives thanks to loose lending. Especially when they’re buying on zero-down — home ownership carries risks and potentially costly maintenance, so these people should have been showing that they could save and budget by coming up with a down payment.

Plus the rampant home inflation/bubble prices caused by suddenly opening the floodgates and letting everyone get credit to buy meant that people who would have been traditional prime buyers suddenly found that housing costs were going up faster than their downpayments were growing, and that they needed to become subprime borrowers themselves in order to “get in before they were priced out forever”.

By its illiquid nature and the way the data is kept and tracked, it’s difficult to say what the health of the real estate market is until months after the fact. The anecdotal evidence is not looking too good: it may not be a subprime wasteland in Ontario, but things definitely look to have slowed down. Of course, anecdotal evidence is so unreliable it almost isn’t evidence at all… but that said, I saw my first set of houses up for auction here in London today. They were all student rentals near the university that had been on the market for a while (I think — hard to say if it’s the same houses when I only bike by every couple of weeks). I can’t tell if it’s a bank/foreclosure auction, or if the seller is auctioning themselves just to get things moving.

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