Real Estate Shotgun Rant

November 18th, 2010 by Potato

I fell for absolutely no good reason today — was running to grab the phone, then PLOP! flat on my face on the floor. So I’m kind of sore and miserable, and my glasses are now sitting a little crooked on my face, which is just adding to my general thesis-related misery, so if I’m particularly snarky and scatterbrained here, please do forgive me faithful readers.

First up, I want to go back through the haze of memory to an earlier time, back to when I first really started getting concerned about a housing bubble in Canada. I was an imaginative lad back then, and had a picture of how the unfolding would happen: how it would differ from what was happening in the US at the time, and how it would be similar. The picture in my head was complete with all the lavish details. When I saw the lineups for people to snatch up preconstruction condos for 1 Bloor at ridiculous prices, I figured that would be the mania moment. The image that would get played on the news 3 years hence when the folly was evident. I figured that the downturn would start in the winter of 2008/2009, and while a bottom might not be in by late 2010/2011, things would have come off enough that with hard negotiating you could get a place and at least be back to breakeven vs rents. Of course, I’ve been wrong. I thought I was close in late 2008 when the market seemed to just seize up alongside the stock market crash, but it was not only revived but sent into overdrive by the emergency interest rates. 1 Bloor was cancelled, wiping out the imaginary headlines of speculators trying to back out of their units on completion.

Now it looks like Vancouver may get the prize of being the quintessential bubble example, as the former Olympic Village (Millenium Water) condo project has gone bankrupt after being unable to sell units in a timely manner. Yes, it looks like there is some limit to how much the people of Vancouver (or — tongue planted firmly in cheek — China) will pay for a box in the sky. Once the news that there may be a cap on how high valuations can go, will the speculators continue to fuel the market? I would be inclined to say no, but hey, I’m the guy who thought this correction should already be in the 2nd inning by now.

Oh, speaking of the Chinese, the Globe has an absolutely ridiculous article on Chinese buyers driving the Toronto real estate market, claiming that they are responsible for up to 40% of all new condos purchased. I’ve written before about how the “immigration will make real estate go up” meme is junk, but this article is still chalk full of fuzzy thinking rant bait. Now, that number is probably not too far off, but some of the others are demonstrably false, making it appear as though these buyers are disproportionately driving the market. For example, in the first paragraph, the article says that there are 100k “local Chinese”. Now that’s not a rigorously defined term, but it’s too low by at about a factor of 5. I don’t have good demographic information on sub-regions of Toronto, but my understanding is that the people are not uniformly distributed: people of Chinese descent are concentrated in Richmond Hill, North York (esp. along Yonge, Finch, and Sheppard), and downtown (esp near Spadina). The article doesn’t touch at all on the facts that a large amount of the new condo construction has been in Richmond Hill, in North York along Yonge and Sheppard, and downtown near the Gardiner (with the biggest clusterfuck concentration near the base of Spadina). I.E.: neighbourhoods that are already largely Chinese (perhaps upwards of 40%!). In which case the figure is perhaps not so outrageous.

“Just two years ago when prices for new suites reached the stage where they made little economic sense as a rental unit, investors fled the market. […] This fall, however, builders managed to cut selling prices at newly launched projects simply by reducing the size of suites. The cost per square foot remained the same, but the price per suite was down by about 10 per cent. Once again investors could plunk 20 per cent down and see enough in rent to cover mortgage and maintenance payments with a reasonable return.”

Err… that seems to be making the assumption that the rent for a unit that’s 10% smaller will fetch the same rent as a larger one… Anyhow, it doesn’t matter who’s doing the speculating, or why (“They often avoid resales because they want to make sure nobody died in the home,” – really??): if there’ s a lot of speculation in the market, that will eventually end badly. You can’t keep building units no one will live in forever.

Anyway, to finish off this mini-rant, I’ll point you over to a post by Barry Ritholtz. The “Chinese buyer” meme is not unique to Toronto or Vancouver. Heck, neither of these supposed hot Chinese meccas even made it to the summary infographic.

Next up, over at CMF poster dogcom started a downright silly thread, trying to argue that renting was throwing your money away, and that “Of all the people I know I don’t know anyone who has done well in stocks or mutual funds and never owned a house. Everyone I know despite the expenses who owns a house and have kids and the whole bit are worth a lot more then those who have always rented.”

I composed a response that, in my admittedly sleep-deprived and pain-filled state, I thought was borderline brilliant, and will repost it here:

I’m a huge housing bear as you may well know, but even then I would say that most of the time owning your shelter is the better way to go. After all, under normal conditions landlords make money.

But, my contention is that for the last few years these have not been normal conditions, and that first time buyers would be better off continuing to rent, and putting their money to work for them in the stock market. In a few years, things should return to normal for housing, and it will once again make sense to own. Someone who bought their first house at the peak of the last market top (1989) may be worse off than someone who got into RE a few years before, or a few years after. I don’t think anyone just buying a house to live in found themselves destitute as a result of overpaying, but they could have had a noticeably easier go of things. Consider it: if you’re a typical family that’s only saving ~10% of your take home pay each year, then there’ s a big difference between your housing costs being 25% of your pay or 30% of your pay.

The Globe has a little article on what to do to put your money where your mouth is if you think there’s a real estate correction coming. Unfortunately, the advice isn’t very good:

– Selling your home is really the only option to ‘short’ the housing market. Even downsizing is not a good option unless you want a smaller place anyway: all the transaction costs and hassle of moving, plus the inconvenience of living in a smaller place… and you only modestly reduce your real estate exposure. The best solution is to sell your current house to an unwary investor and rent it back — eliminate your exposure and you don’t even have to move! Note that the real estate guy’s comments about the cost of rent making the attempt of selling your house at the top and renting until you’re comfortable with buying back in a bad idea are a red herring: if real estate is over-valued, one of the best indicators is that it will be cheaper to rent than the carrying costs of the same house. It’s really just transaction costs, inconvenience, and the uncertainty of being wrong that should stop you from taking that action if you currently own.

– Shorting the banks is not a great idea because the yield is a stiff headwind, and mortgage lending is explicitly guaranteed by the government via CMHC, so you don’t have the opportunity for a bank to blow up and go to zero like in the states. Even in a bad housing downturn, the banks will probably just suffer reduced earnings as new mortgage originations slow. Not a great case for shorting. There are no CDSs to short (or to take out a default swap against), again, because the mortgage securitizations are largely explicitly government guaranteed.

– Similarly, shorting say Rona wouldn’t be a very good idea as it’s already underperformed since the 2009 lows: the expectation of slowing renovation expenditures may already be baked in.

– The thinking on going long the apartment REITs is also flawed: rents may very well go down in a housing crash, as speculators who currently eat carrying costs in the hopes of a quick flip and sky-high appreciation may look to start renting out their empty units. Plus it’s not like rents are low relative to incomes or other measures at the moment. Plus, the apartment REITs like Boardwalk are already trading at a premium to diversified REITs.

Really the only way to go short real estate is to participate in the Teranet derivatives market, and to do that you must be an accredited investor.

Oh, and speaking to my first point above – selling your home and renting, there was another article that got under my skin a while ago on the Star’s real estate porn blog. [Sorry, didn’t keep the link] In it, a reader asked about what to do in the situation where they bought a new home in pre-construction, and it won’t be ready for another 2 years. Should they sell their current house now and rent, or just hold on? The responder starts with some preamble about not trying to time the market, and then concluding that the reader should stay in their house because of the fees involved. Unfortunately, in that case not timing the market means selling as soon as you agree to buy the pre-construction house. Otherwise you’re effectively carrying two houses for a time, and you’re exposed to the risk of a downturn over the next 2+ years — if there is a crash, you could be in a bad spot, especially if you’re counting on extracting a certain amount of equity from the sale of the first house to close the deal on the new one. Yes, it may be more expensive on average to sell so soon and have to move twice, to have to discharge your mortgage then get a new one, rather than porting… but think of it like insurance. Most of the time, it costs you a small, manageable amount. In exchange, you avoid the risk of a large rare event that could make your life suck.

I have talked in general before about the “you can’t time the market” statement. About how it comes from the world of equity investing, and may not strictly apply to the real estate market — where, I believe, measuring overvaluation is more straightforward, allowing you to say when you may be close to a peak or trough, though the when part of timing is still difficult (as you can perhaps see based on my old predictions not coming to fruition yet; ah well, if you can’t predict well predict often).

And I will end on this: remember that pretty, but overpriced house that I linked to in my last post that was up for rent or for sale? Well, the ads have been revised, and the asking rent lowered to $2400, while the asking sale price reduced to $650k. It’s now an even better option to rent rather than buy this house, as the rent multiple is a rich 270X now, or if you prefer percent, a gross yield of 4.4%.

2 Responses to “Real Estate Shotgun Rant”

  1. Patrick Says:

    I think your observations about the housing market may support the capital-limited efficient market hypothesis published a few months back by a particularly astute amateur economist. It makes perfect sense that a market that’s hard to short would be subject to more extreme and persistent bubbles.

    I also, like you, disagree that “not trying to time the market” in real estate means holding on to your house. That advice makes sense in the equity market, which is expected to appreciate in the long term; therefore, all else being equal, exposure to equities should yield a long-term profit. The same is not true of real estate, which grows only at the rate of inflation long-term. Therefore, there’s no value in having exposure to the real estate market per se; the only value is the rent you can earn or avoid paying.

  2. Potato Says:

    I would agree and have argued that you may time the real estate market (if not the bit along the time axis, at least the bit along the valuation axis, at least close enough to make the attempt worthwhile), but even then, I can see where people come from with “don’t try to time the market” advice. Yet in the case here of someone with exposure to two houses for over two years (one pre-construction, one being lived in) then not timing the market means selling the existing house at approximately the time of the pre-construction purchase. It’s one of the many reasons why pre-construction is not an area average people should be mucking around in, at least not without getting a property at a significant discount. Yet somehow that “don’t try to time the market” advice gets twisted into “hold on to your old house until you’re ready to move into the new one.”