Blessed by the Potato

There are at least a half dozen measures that you can use to tell whether the real estate market is over- or under-valued.

Some are purely historic, relative to a long-term trend line (such as looking at inflation-adjusted returns vs. a long-term trend of about 0.5-1% above inflation — a 5-year run of ~5-10%/yr probably signals trouble). Those can be handy, especially for looking across different sectors and for trying to point out to people that something has gone awry, but may not take into account actual “it’s different this time factors” that can kink the trendline such as the construction of a subway line, the changing of the laws (such as relaxing downpayment requirements), or large demographic shifts (post-war; Toronto vs Montreal).

Some reference a general affordability of housing; here I find the simpler ones are better. Looking at median income and median housing prices, and looking to see what the multiple is works a lot better than the formulas that try to measure affordability as a combination of interest rates, taxes, etc., because these formulas can be “tricked” by interest rates that are out of whack with historical norms (i.e.: if interest rates are very low, and housing prices high, you could get a moderate level of affordability when in reality things are getting out of hand). Worse yet are cases where your formula is constructed wrong, as happened with the UBC study that accidentally(??) included housing appreciation in its measure of affordability.

Personally, I prefer the measures of comparing rentals vs purchases. For the simple reason that it’s a measure that is easy to determine on your own (no need to run to Statistics Canada or a secret realtor cabal to get your data, just see how many times the monthly rent goes into the purchase price of the unit you want to live in), and it’s the most relevant to my personal situation of trying to figure out how I should live my life. After all, you’ve got to live somewhere, and you may have an idea of where that somewhere is. If there is indeed a premium to living in Toronto or Vancouver vs London or Seattle, and that’s where your job is and you want to live, then you’re just gonna have to pay that premium. Saying it’s not in-line with historical trends is not going to change the way things are for putting a roof over your head today. However, you still have to make the decision between renting a place or owning it (and surprisingly often, both options can be available for the same unit). If the rent multiplier is 200X then forgetaboutit, dilemma solved, you rent. If it’s 100X then hey, pick up two places and rent the other out, because you may have just found yourself an investment worth owning, or at the very least, you’ve found a city where it’s cheaper to own your shelter than rent it.

There are of course more factors to the rent-vs-buy argument, and you can calculate it out in detail if you like, but this is a nice, simple, round number that’s easy to use, and easy to talk about.

Hello faithful readers! I’m going to be doing some work on the back end of the site over the next week whenever I find the time to. It is very possible that I will temporarily break the site as I fiddle. Have patience, and remember to come back to holypotato.com if you have bookmarked the IP address directly (or if you’ve subscribed to the RSS feed and you don’t get any new posts next week). Also, I have a number of drafts here with further rants about the housing market. I’m not 100% pleased with these, but since Wayfare and I have found a place to move to, real estate is moving out of the forefront of my mind (or the secondfront of my mind, as the forefront is probably still that grad school thing I work on every day and dream about every night), so if I don’t push them out now, they’ll die a cold, lonely death in the drafts folder. I’m also posting them to give you something to keep yourselves busy with while I work on the server.

“…Through the mechanism of CMHC, Canada’s banks HAVE ALWAYS had pre-arranged taxpayer bailouts” — Future Expat, comment at greaterfool.ca.

The CMHC was created to help make housing affordable in Canada. Affordable housing. It sounds like such a noble goal.

Unfortunately it’s one of those things where what’s good for one person is bad when it happens to everyone in society at once. Maybe it’s related to Jevon’s paradox, though the closest I can come to finding a term for this phenomenon is “congestion” (opposite of the network effect).

It may be a noble pursuit to give low-cost government insurance to cover a mortgage for a young person to buy a house in a rural area, as they may not have any rental options in a small town, and with no appreciable down payment, a bank might not give them a loan otherwise. Government intervention in these small, inefficient markets probably does bring some benefit to people, at very low cost and risk to the taxpayer. However, CMHC insurance is not limited to those looking to buy in areas where rentals are not available, but country-wide. Even in the cities where a large rental market means it’s not needed. Even to speculators who have no intention of living in their investments.

Even if a rental is an option, give a girl some low-cost government insurance to step up to owning her own condo, and she’ll take it.

As the housing bubble has inflated here, everyone started needing CMHC insurance. Houses went up faster than people could save for the downpayment, so more and more people got past the stigma of having to pay for the insurance, and took the CMHC option to “get into the game” earlier and earlier. This started a positive feedback loop, made all the worse by the government lowering the minimum CMHC downpayment to 0% (since raised to 5% — still not much!).

At the same time, amortizations increased to 40 years (since reduced to 35 years). Again, something introduced with the intention of giving home buyers a safety net and to make housing more affordable — if you could afford a 25-year amortization, you could opt to take a 35-year one and just top up your payments as long as things were good, but have a lower minimum payment if things went poorly (e.g.: if you got hit with a big repair bill, or lost some hours at work). Instead, people just bid houses up to the point where most people needed a 35-year amortization just to afford things. Houses, paradoxically, became less affordable.

CMHC insurance is also perverse because the insurance isn’t just on the part of the downpayment missing, that is, it doesn’t insure the 15% difference between the 5% downpayment made and the ideal 20% down. The government is on the hook for the whole mortgage, leaving the bank with essentially no risk for writing a CMHC-insured mortgage. For this reason, people with no downpayment, who have shown no history of financial discipline (as long as they meet some minimum credit score), can get just as good of a mortgage rate as someone with skin in the game, all because the risk is offloaded to the government. This leads the banks to be less stringent in the loans they make — the same sort of incentives towards risky behaviour that securitization of subprimes in the states had. Not quite the exact same since CMHC does have some standards, and will occasionally check up on a borrower and/or appraise the house — but saying “we’re not quite as bad as the Americans” does not bring me any joy. It’s a difference of degree but not of kind. The banks have a split interest in housing bubbles: they want to drive bubbles (at least on the way up) because it leads to larger mortgages, which means more interest income for them. Simultaneously, they want to limit losses, so they don’t want to stoke a bubble too much. But with the CMHC the risk side of the balance is blown away completely, as from the bank’s point of view a first-time buyer with 5% down, a 35-year am, buying the absolute most house they can afford and with no credit history is less risky than a millionaire putting 50% down with the intention of paying the rest back in 15 years.

Canadian Capitalist recently had a post about the bubble, shaking his head at Canadians who are driving housing prices to the moon with (currently) cheap mortgages, even after seeing the disaster that caused in the US (and many other nations), saying: “Those who fail to study history are condemned to repeat it. Those who ignore very recent experience are just being stupid.”

Over at the Canadian Money Forum, I saw something that made my jaw drop. The CMHC charges insurance fees, and if we assume that ~6% of mortgages written today will default when the bubble collapses, which a severity of ~40% each (i.e. in the same ballpark as the US experience), then the fee of 2.75% is probably not too far off. However, one poster said that:

“…CMHC mortgage insurance operation is a great expensive rip-off of Canadian homeowners. […] last year cost Canadians $1.2-billion in premiums paid to CMHC. The net claims against CMHC for mortgage default totaled $117-million, for a premium-claim ratio of 10 to 1.”

…which made me wonder what was going through his head. On the surface, it does sound like the CMHC is a cash cow for the government, netting over a billion dollars — indeed, put like that, you could see a motive for a government facing record budgetary short falls to perhaps play with fire and stoke the bubble a bit. However, the housing market has been on steroids for the last few years, and interest rates were on the way down to the ground floor. The fact that there were any payouts made me wonder what the hell was going on. Anyone who bought more than a year ago should have been able to easily sell (or in the parlance of the times, “flip”) their place if they ran into trouble for whatever reason, and break-even at the very least. Yet somehow the CMHC had to pay out hundreds of millions to the banks on defaulted mortgages. What’s going to happen when we actually have a housing correction? Is CMHC insurance too cheap for the risks being assumed?

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Back in February, just weeks before the market bottomed, I did a quick post about the log transform, using the Dow as an example case. Here I’ve just updated my spreadsheet with what the market’s done in the last few months.

It has been a wild ride: half of the decline from the highs in 2008 have come back in just a few short months. Many people, myself included, have wrung our hands and worried that perhaps this is too much recovery too quickly, and we could be in for a (less severe) correction… but when you look at it, we’re still a bit below that long-term post-war trendline. So perhaps the crash was overdone, and the rapid recovery was what was needed to bring us back to “fair value”.

Rob Bennet has a guest post at Four Pillars today discussing the idea of adjusting your exposure to stocks depending on where the markets are relative to this long-term trendline. Edit: sorry, he’s using a different measure, but it’s still a related concept.

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I wanted to wait until we actually had a place lined up before starting to rant about our Toronto housing search, but I’m so angry right now I just can’t help it. As an appetizer to start, the more level-headed part of the post drafted months ago:

In past posts I mentioned that a landlord couldn’t buy a house at current prices and make a profit. I just thought I’d provide a few specific examples (without direct links to the ads or addresses since I don’t want to tip off a potential landlord just yet!) from our housing search.

First off, a quick bit of background: Wayfare and I are looking for a place to move to in Toronto. We’re being exceptionally picky in the places we’re looking for: ideally less than 1 km to a subway station (since she works downtown and doesn’t like to walk, drive, or take the bus), preferably close to a major highway too (since I don’t have a job yet and don’t know if I’ll have to be commuting by car or where I’ll be commuting to). A host of other things, like two washrooms, ~1200 sqft, 3 bedrooms, air conditioning, etc., but right up there is the fact that we hate to move. So we want to find a place that we’ll stay in for at least a few years, and a landlord willing to continue renting to us for that time. Part of ensuring that means that we’ve been doing quick searches on potential rentals to see if they sold or were listed recently, and at what price. Our reasoning for this is that a landlord that tried to sell but couldn’t might try again, and then we might have to move out 60 days after a sale. A landlord that just recently bought a place might only be renting for a year or two before moving in themselves, or may decide to bail (or just as bad, neglect repairs) if rates go up and they find themselves losing money. While the market may be crazy and I wouldn’t want to be a landlord when you can take the quick money right now, many landlords have owned their properties for years, and don’t consider the current yield, but rather their yield-on-cost, so those sorts of issues probably won’t apply to landlords who haven’t recently listed/bought their houses.

Finding past sale data is quite difficult to do reliably without an agent, but Google’s cache has been surprisingly useful in this regard. For brand-new buildings it doesn’t take a leap of logic to know that the landlord must have just bought it, in which case similar recent sales is all you need to get an idea.

Anyhow, one example is a house between Finch and Steeles that sold for $560k just a few months ago, and was up for rent for $2400 a month after the sale. Neither the sale price nor the asking rent are unusual for the area and size of the house, so this is pretty representative for the area. But if you do the math you see that that’s a rental yield of just about 5% (234X rent multiplier). If you assume that the costs (property tax, insurance, maintenance) run about 2%, that leaves them making only 3% on their money. If they have a large mortgage and rates go above 3%, they’d probably end up losing money renting the house out. Of course, I’m not about to go and offer them more rent, but I am going to have to consider the possibility that despite all the protections Ontario offers tenants, I might be having to look for a new place to live in a year’s time. [Plus this one was above our price range]

Mr. Cheap had a post recently on “discount purchases” and mentioned that co-ops can sell for less than comparable real estate. Indeed, our one counter-example from our rental search was a townhouse that was up for rent. The asking price on the one next to it was just $200k or so, giving the rental a 8.5% yield (127X multiplier). The trick there was that the co-op required, in addition to other restrictions, a 25% downpayment. That perhaps gives you some idea of how far prices have risen on the back of negligible down payments.

Realestate agents: The biggest thing I’d say I have grown to hate in the search for a rental home are realtors. I don’t know why landlords want to use them, they’ve been nothing but obstructions so far.

Many of the listings by agents don’t bother putting any pictures up, which is just ridiculous since that’s basically their whole job. Oh, no, their job is to also act as intermediaries between the landlord and the potential tenant, which would involve a few very simple tasks such as answering the phone, and maybe setting up viewings. However, they can’t manage that either: most agents we had to call an average of 3 times before they’d call us back, usually a week or more later. Only one has responded to email. Then they’d know nothing about the listing except for the 2 lines of text already in the ad, and would either just continue to be unhelpful, or have to ask the landlord to then get back to us. It’s an unnecessary obstruction — and an expensive one for the landlord, since the agent’s fee is usually a month’s rent.

Some in particular have driven me crazy. Let’s call one “Toad”. He has dozens of listings up on craigslist, and they’re all basically carbon copies of each other: no real meaningful information, no pictures of the unit itself, just a cut & paste description and photos taken from the sales literature for the condo building. While some of those units may have been of interest to us, after seeing how useless some other agents (who did take photos!) were, I can’t bring myself to waste my time with Toad, especially since a highrise apartment is a second-choice for us. Who knows, maybe he’s (she’s?) a really nice, capable froody dude, but the inability to even grab some photos with a blackberry and upload them to the web turns me right off.

But the worst has been “Mr. Superlative”. We paged him through the office (the number on the listing) 2 or 3 times over the span of a week or two, and he never once called us back. Finally, we got ahold of another agent in that ReMax office to show us another listing, and she gave us his “direct” cell number (half the time it just ends up forwarding back to the office, where we page him, and get nothing). We set up an appointment to view the house (his house, as it turns out), confirmed it the day before… and then we show up, and the person who lives there now tells us it’s cancelled, then closes the door on us (not that he opened it more than an inch in the first place)! We walked away super pissed, since he never called us to say it was cancelled… Now, this looks like it may be an issue of the soon-to-be-former tenant being a crazy asshole, since about a half hour later we did get a message from him saying that the appointment wasn’t cancelled and wondering if we were still interested in the house. Nonetheless, it’s been days of phone tag here — we still haven’t managed to get this guy on the phone to find out what exactly happened when we were supposed to view the house…

Probably a good thing though, since if he’s this hard to get a hold of when something isn’t leaking/on fire, we probably wouldn’t want to have him as a landlord, either. Or maybe it’s a cautionary tale, that if your tenant is batshit loco, it may be best to just eat the loss of having the place sit empty for a month so you don’t have to deal with him (or his stuff) while you show the place to the next tenants. On the other hand, we don’t know the full situation: maybe he forgot that the landlord has to give the tenant 24 hours notice before a showing, and didn’t, and that’s why the tenant decided to go nuts.

Maybe it’s just a co-incidence because it’s such a big company, and so prominent in the areas we’re looking in, but almost all of our “stupid realtor” anecdotes are about ReMax agents (the Willowdale office specifially — “Team Oulahan” did return calls and even answer email!). Maybe the whole place is full of tools (though “right-at-home/homelife realty” was not much better), I don’t know. But here’s the big thing that bugs me: they’re getting paid a lot more than I am to do a job that is basically all about dealing with people. It’s a sales job — you don’t need to know much about architecture, or structural engineering, or finances to muddle through as a realtor, as long as you can answer the phone, and show up at the door with some forms, a key, and a camera (and refer people to a lawyer, engineer, inspector, broker, or accountant for the heavy lifting in those areas). It’s also a job that depends a lot on word-of-mouth referrals: there are thousands of real estate agents in the GTA, and people are generally going to go with one recommended by a friend. Right now we’re looking to rent a house, but in 5 years or so, we’ll probably be looking to buy one, so why treat us like shit now, and jeopardize that future business?

A few agents have actually been somewhat helpful. Jenny Wu at ReMax actually returned our calls, and did set up an appointment (and called us when the landlord changed her mind and cancelled); Julia Warren at Royal LePage was nice and competent and even tried the expected realtor move of chatting me up and trying to become our agent; it was a shame that we felt the unit she was representing was over-priced by ~10%. David Fleming writes a blog, and while I think his views on leverage are borderline insane, he offered to help us out sight-unseen, and — crazy concept, I know — values business. Even when they’re competent though, I can’t really justify using an agent in my head: while MLS has a near-monopoly on listings for sales, it’s probably second (or third) fiddle to craigslist, viewit, or hometrader for leases. A landlord doesn’t really need access to it to find a tenant. Sure, an agent can do some of the advertising, screening, and showing legwork, but being a landlord is not exactly a completely hands-off job: you’ve got to be prepared to deal with your tenants at some point, so you might as well start from the time you first offer your house for lease. Plus we’ve had much better luck when dealing with potential landlords directly in terms of getting information, actually getting appointments to see places, and of course, giving us a feel for whether the landlord would be a good fit for us.

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I don’t usually get too crazy about growth stories and tech stocks — despite being a scientist and fairly technologically-minded myself, I get turned off by the hype and the projections to the moon. I also first started learning about stocks in the midst of the tech boom, and was wisely steered clear of that trainwreck by my dad, who doesn’t believe in negative/imaginary P/Es (negative for a few quarters is one thing, but massive valuations for a company that’s never turned a profit is another).

However, I’ve had my eye on First Solar (NASDAQ:FSLR) for some time. I never bought any before now because the valuations frightened me, but it’s starting to look a little more attractive now.

First Solar is a manufacturer of thin-film solar panels. Solar, green, alternative energy — all buzz words for a hot sector, something I like as an environmentalist, but which actually turns me off a bit as an investor. First Solar is not a pie-in-the-sky startup though: they actually have several plants up and running, some long-term contracts, and are actually turning a profit whilst still in that early “parabolic” growth phase.

On the positive side, they have had a phenomenal growth track record, and have managed to reduce their cost of production while expanding. According to their annual report, they have 2 more production lines that are coming online over the next year or so, to bring them to a total of 24 — so from a volume standpoint they should have at least another ~10% growth in them. They also have very modest debt levels, and a US government that believes in climate change might help subsidize solar plants there. They are the low-cost producer of solar panels, and have focused on improving their margins through the years.

Piling up on the negative side are a number of worrying factors: FSLR depends on a very small number of power companies, all(?) in the EU for the vast majority of their business. Any issues with even one of their customers could trickle down badly for them. Indeed, government subsidies for solar power (esp. in Germany) may be critical to them making sales, and those policies may be on track to be phased out sooner than expected. While there is some advantage in thin-film solar for many applications, large-scale power plants really isn’t one of them — it’s largely just a cost issue. So their main customers have really only been buying due to the low price relative to crystalline solar cells. Recently, those have come down in price as the cost of high-grade silicon crashed (used, as I understand it, in both solar cells and microchips).

So FSLR could be facing some increased competition, squeezing their margins going forward, and depending on how long silicon prices stay low, that pressure could stay on for a long time.

I played around with my spreadsheets for a little while on this one, there are a lot of places to guesstimate how future earnings will play out. I figure the stock is worth anywhere from $60-$160 depending on what assumptions I make, but it does definitely have some value. I figured the most realistic assumption was that their earnings could continue to grow at 10-25% per year for another few years as their production volumes ramped up (even if cost pressures prevent them from significantly improving their margins any further), and after that would settle into a long-term growth rate of 5-7%. I also believe (hope, really) that demand for solar energy will pick up in the US to more than offset any declines from the EU as their subsidies are phased out. From that I get a value of (from memory, since like a genius I closed my spreadsheet without saving) ~$110/share. It was at $116 today, which I figured was close enough to get my fingers into the alternative energy sector, so I bought a few shares. It’s not enough of a value that I can recommend it to anyone (not that I ever make recommendations!), but with the recent pullback it seems to have shed that “hot thing in the news” over-hyped smell.

What are your thoughts?

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