Blessed by the Potato

Hat tip to Jonathan Chevreau’s recent blog post: “Younger folk aged 18 to 24 are leading the charge, with those “very likely to buy” almost doubling to 15% from 8% per in 2009.

This is one of the signs of the end stages of the housing bubble.

Low/no downpayments allow people to buy earlier and earlier in their lives, stealing demand from the future, and driving up prices in the present. Skyrocketing prices convince people to buy now or be priced out forever. But there is a limit to it all, unless we start selling houses to children. Home ownership rates are at ~70%, and here we have 15% of people in the youngest (least home-owning) age bracket planning to buy (more than that, actually, since there’s another bunch in the “likely to buy” category below “very likely”), and presumably ~8% who bought over the last year. Won’t take too much more robbing of the cradle here before we run out of ways to bring demand up and hit a wall when high school students can’t join in bidding wars.

That is of course assuming that tightening of interest rates doesn’t do the job first (and now most bank economists are calling for that to happen before the end of the year).

I’ve been bearish on real estate for going on 3+ years now, and I’ve been hesitant to get too excited about the correction that I know must be coming because real estate moves in long, slow cycles. It’ll be years before the time to buy (the undershoot) finally arrives… plus, I get in trouble for being “optimistically bearish” from people with house lust that I’ve convinced to hold off (“the market’s up 20% this year! We could have bought last year, damn you!”). Nonetheless, I can’t help but feel that the stars are aligning for this nonsense to finally end.

Flaherty brought in some rules that I thought would be fairly minor tightenings to the mortgage market. Real basic, common sense tweaks, like that banks shouldn’t give someone all the money they can borrow at today’s rock-bottom rates, but instead have to qualify people on the still-low 5-year rate. I didn’t think there’d be anyone walking that close to the bleeding edge of affordability, but apparently CIBC is forecasting that this rule alone will have a ~5% impact on the mortgage market (hat tip: Canadian Mortgage Trends). The new rules also require a 20% downpayment for non-principal residences, which should help reduce the speculation out there.

Canadian Business had an article this week on “Why Buying a House is a Bad Investment”. Despite the title, it’s not nearly as bearish as I am, though that may be because they’re talking about “Canadian housing”, which is a tough concept, because the market in London and Charlottetown is vastly different than Vancouver or Toronto.

Even some realtors are starting to think that there may be, possibly, just the teenist whiff of a bubble happening, despite their inherent bias towards believing that real estate prices will always go up.

So I think the end is finally arriving (well, the end did arrive in the fall of ’08, but low interest rates drove it back for an age), and I can start to make some prognostications. Time may prove me wrong, but time’s a bitch like that. I predict that by the end of the year rates will begin moving back up as the need for the emergency stimulus eases and inflation returns. The real estate market will stall around midsummer; by this time next year, it will be clear that the market momentum is down, and by the fall of 2011, the media should start picking up on the slide. Since real estate moves in slow cycles you probably won’t find a decent time to buy until late 2013 (rent-to-buy of <150X), with the final bottom coming somewhere around 2016. For Toronto, top-to-bottom, my crystal ball says we’ll see a 35% drop — still about 10-15% above the 1996 trough in real terms, but a real kick in the nards for anyone that bought in the last few years.

These prophecies of doom are for entertainment only of course, and I’ll be changing my opinions as new data emerges… but now you know what I’m thinking.

In other eschatological news, Netbug has cancelled his World of Warcraft subscription. The end times, they are nigh.

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.

In looking for descriptions of what happened in Japan’s economy, and what lead to the sustained low interest rates there, and why the same things don’t apply to Canada, I relied fairly heavily on some posts by John Hempton of Bronte Capital.

One thing that really struck me was his post on the difference between the banking crises of Japan and Korea. Critical to the story of the Japanese banks and the low rates was the tradition, the deeply held psychology that families (especially women) should have large, cash savings.

“The reason is the different banking structure. Korea started its Chaebol industrialisation later than Japan – and the one multi-generational part of the formula (educating young women that they should save and save and save) was just not done as well. This is a multi-generational process.”

That idea of indoctrination is interesting, because I suspect I see something similar in Canada and the US, except our young women are being indoctrinated not to save, but to buy real estate. Think about all the irrational opposition you face whenever you talk with people about even the possibility of a housing correction (or, if you’re one of the ones who just can’t believe me on that point, think about how viscerally you oppose me!). The same sayings/rules of thumb will get thrown out, and when you hear them enough you realize they’re not just rules of thumb, but mantras. “Safe as houses”, “they’re not making any more land”, “why pay someone else’s mortgage”, “renting is throwing your money away”, “you need to own a house to be secure/raise a family”, “it’s different here, real estate is local”, “investments you can touch/live in”. For most of the time (e.g., 1991 – 2004) they’re perfectly valid, but rules of thumb are just that — quick guidelines that aren’t true in all situations.

So armed with these mantras and innovative financing (0%/5% down, long amortizations, plus the gamut of sub-prime dreck dreamed up in the states), our society appeared to be indoctrinating people, young women especially, into puffing up the real estate market. Indeed, all considerations of bubble-like valuations aside, you know things have gotten ridiculous when single 20-somethings are buying places on their own (often sized for just one person). What happens when they find someone that they want to live with, or want to start a family? Ah, but that was just their way of getting “on the property ladder”. My sister, who can’t even buy a bicycle on her own, wanted to buy a place while she’s at school in Kingston to “get on the property ladder” (thankfully, not even the bank of Dad would lend her money to tilt at that windmill). Worried about how high the costs are getting? Don’t be: “buy now, or be priced out forever”. Not so very long ago it would have been very strange for a young person to buy a house/condo on their own — it was almost an admission of spinsterhood, locking yourself into the single condo lifestyle like that. An additional rule of thumb, that you should want to live in a place for 7+ years to make buying worthwhile, seems to have been lost along the way.

Now though there’s a cult of homeownership. Even after explaining the math to them* many people still give me that look when I say I’m looking for a rental when I move back to Toronto. It took months of repeating the explanations to Wayfare before she finally started to agree with me, and even then I can see it’s a tenuous hold, as the irrational hormonal part of her still wants to build and feather a nest of her very own. I was talking to a friend about the preliminary parts of the search for a rental in Toronto. With some places over $2000 per month, it seemed unfathomably expensive to him (to me as well — that much would pay for a very nice detached home in London, inclusive of utilities). “So why aren’t you just buying then?” he asked. Ah, that was easy: if you remember the very simple (though long-winded*) post earlier about the rent vs. buy decision, $2400 per month costs about as much as a $375k house in the medium term, and the places we were looking at were not selling for anywhere close to $375k. The landlords would basically be subsidizing us by taking on the risk of owning a $500-600k house while we lived there.

“Ah,” he says “well there are a lot of nice places along the Danforth for around $400k.” Of course, those places tend to rent for under $2k, so again, renting makes more sense.

“And that area is going up.” he says.

Ah. I see.

That area is going up.

Now, I don’t want to poke too much fun at my good friend, but here’s the thing when people tell me “that area’s going up/gentrifying/turning around”: if that was certain, it would already be up.

Ok, clearly I don’t believe 100% in efficient markets, but nonetheless, I don’t think my friend has a special knowledge of that area that all the other buyers, real estate agents, and investors lack. Given that the rental yields are really not any better than the rest of Toronto, it looks like some measure of gentrification is already priced into the area — and it’s not like the already packed 14′ wide houses can be torn down with more density built in their place. Plus what part of Toronto haven’t you heard someone say is “going up”? Everywhere is either “an exclusive with great schools that will always be in demand” or “a trendy area that’s finally getting the attention it deserves”.

* – very verbosely I must admit, so there’s always the risk of “TLDR” that the mantras don’t face.

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“You can’t time the market” is a statement that’s generally true for the stock market — it’s a highly liquid, fairly efficient market full of professionals who all have roughly the same access to information about the future of the market. The shares traded are identical, so as soon as one is traded at a new price, effectively they’re all re-priced, and they’re only traded with the goal of making money — nobody hangs onto a share because it’s what they owned when their daughter took her first steps or because it’s customized just for them. The theory says that any information that could affect the future value of stocks is priced in in short order, so you can’t successfully time the market — getting out before a crash, or in before a surge. At least, not consistently enough to make money. And for the stock market, I think that’s probably true.

The housing market is a different beast entirely. It’s composed of units which are not 100% interchangeable. It’s highly illiquid. The participants are to a very large extent non-professionals who are poorly or even mis-informed about the state and future of the market, and have emotional entanglements to their properties on top of that. Each transaction is negotiated in secret, with pricing details only released some time later — so when one is traded at a new price that incorporates information about the future, it doesn’t necessarily affect other sales.

So when I come on here and piss and moan about how the housing market is getting ridiculous, and how I really fear that there will be a crash/correction to come in the next few years, and people say “you can’t time the market”, well, that’s not entirely true for the housing market, since it’s not as efficient as the stock market. It is true that I can’t say “next June, a month before the BoC’s promise to keep rates low runs out, the market is going to tank 8.53%”. It’s true that I’ve been bearish for over 2 years now, and aside from the beginnings of a correction last fall (a tailspin broken by the low rates), Armageddon has not visited Canadian homes. So in that sense the timing is hard. Getting the exact “when” down is very difficult. It’s certainly not precise. But it’s enough to know that we’re near the “top”, even if we don’t know when the “bottom” will come — the “when” is often not as important as the “how much”.

For the stock market, there is no “renting” of stocks. There’s no set of metrics that tell you reliably when the market is over- or under-valued. P/E ratios, bond yields vs dividend yields, these might be useful clues, but nowhere near as handy as the rent-vs-buy calculation. If a landlord can’t buy a place and rent it out at a profit, then something has to change. It’s also hard to come across telegraphed messages like this:

But if home prices keep bubbling, the central bank might raise rates

If the real estate market momentum does not moderate in the coming year – “or worse still, if price growth accelerates – it could lead to an earlier and more substantial tightening in policy than currently anticipated,”

Not often you’ll see hints from that the central bank is out to keep a bubble under control.

Of course, interest rates are a blunt instrument. There are many interconnecting factors: the dollar is already getting too high vs the USD, hurting our exports in a tenuous recovery. The central bank wouldn’t want to start raising rates to control the over-heated housing sector just to doom the business sector. Even within the housing sector, urban areas have the fever the worst; the Maritimes and more rural areas aren’t too far off of realistic valuations. There are more precise ways to throw water on the housing market, such as taking away 5%-down 35-year insurance.

In all seriousness, I don’t think people have to worry about the BoC jacking rates before their self-imposed timepoint of next summer, unless non-house inflation also takes off. However, the fact that this is on the BoC’s radar at all should be troubling. We are, IMHO, near the top of the market, even if the “when” of the peak may still be another year or two down the road.

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Everybody’s moving to Toronto it seems lately, and with that comes the inevitable realization that Toronto has a really high cost of living. What’s a cash-strapped recent grad to do? Rent, of course… which always (no matter how many times it’s debunked) brings about the lament that “renting is just throwing money away.”

Of course money is equally thrown away when buying: interest you pay the bank you’ll never see again, likewise property taxes, transaction fees, condo fees, and maintenance. That’s just the cost of putting a roof over your head. The question is, which option will give you the quality of life you want? If one costs less, or offers more freedom, or has fewer risks, or some compromise combination of those, then which you go for might not be all that simple.

I’ve mentioned before the rule-of-thumb that if a place costs more than 150X the monthly rent to buy, then you’re probably better off just renting that. Today as I was explaining this concept I realized it might be easier to understand in reverse:

So, let’s say that you have a place you want to buy. You get a mortgage that is for all intents and purposes approximately the same as the purchase price (that is to say, we’ll assume the opportunity cost on your downpayment is the same as your mortgage rate, or that 80% — or 95% if you’re a first-time buyer in today’s market — is close enough to 100% for our approximation). Every year that is going to cost you your mortgage rate: right now that might be ~3%, but it could easily go back up to 5-7% within just a few years, especially as the economy recovers and the low, stimulatory rates aren’t as necessary. Just look at how quickly the rates came down.

On top of that, you’ll have property taxes: roughly 0.8% in Toronto. A general rule of thumb is that maintenance and repairs will run about 1% per year (condo owners will likely have fewer repairs to pay for on their own unit, but instead will see this vanish as a condo fee; TANSTAAFL). So let’s say 1.8% per year from this stuff.

Real estate is not liquid, and you’ll likely have to pay an agent something like 5% when you move, and lawyers and the governments will take another 2% as well (especially in the Toronto land transfer tax area). If the average person moves around every 5-7 years, we’re looking at a little over 1% per year when we spread things out over the 5-7 years owning the place. Let’s call it 1.2% so that we sum up to an even 3% with the fees above.

A mortgage rate of 5% + 3% of other “throwing money away” costs is 8% per year. 8%/12 = 0.667% per month. If your rent is costing you 0.667% of the purchase price per month, it probably doesn’t matter whether you buy or rent, financially — flip that around and you’ll see that 1/0.00667 is 150, so that’s where the 150X monthly rent rule-of-thumb comes from. And of course that’s really the upper limit; if you instead take 7% as your average interest rate, plus 3% for the other costs, you’re looking at 120X monthly rent, which pretty much defines the “grey zone” where choosing to buy or rent basically hinges on how long you plan to live somewhere and what you anticipate the average interest rate to be (below 100X, and you’re generally staring at a decent investment that you can snatch up and rent out).

Surf MLS for a while and you’ll find that in Toronto places are selling for over 200X rent — go the other way now, 1/200 = .5% per month, or 6% per year is what the cost of shelter is. The only way that makes sense is if your mortgage is at <3%.

And rates are there… for now. And that explains why the housing market came back from the land of the zombies this spring. Things were crashing out as people finally hit the breaking point with the prices the way they were last fall, combined with the general financial panic. Then as rates hit bottom (and they are at bottom — there is no room left for rates to go lower; it’s only up from here) the affordability didn’t look so bad, so prices have been treading water the past few months, much to the dismay of bears such as myself. But I can’t bring myself to believe that prime rate will hover at just over 2% for more than a year; and buying is barely a breakeven proposition at these rates; much higher and we’re back to real estate being overvalued and due for a crash/correction, eventually.

So, what do I mean when I talk about the costs and quality of life? Well, I’m saying that when you look at the money that goes out the door and is lost completely, the cost of shelter, it’s a fairly significant sum — it is the largest component of pretty much every person’s budget. If a place that rents for $1500/mo sells for $300k right now, that’s just about break-even at an interest rate of 3%. At 5% for the mortgage (plus ~3% for your other lost expenses) that place will cost you $24000 per year to own — over six years, you’re looking at $144k down the drain. Not an insignificant amount of money by any stretch of the imagination, and not an implausible rate (in fact, you’d have to pay about that now to lock in for 5 years rather than play the variable rate game). The rent that’s gone will total $108k over those six years, still not easy for some people to accept, but that’s $36k that you’d have extra: you could get an apartment and a car, or just a condo. Housing and a $6k European vacation every year, or just housing. Throw the savings in your RRSP and retire 5 years sooner. This is enough money that it does affect your quality of life, so it’s a decision that should be made with all due diligence. Or, if you find your quality of life best improved by more housing, and you’re able to pay $144k over six years anyway then instead of renting a similar place, you can find a better one and afford to spend $1900/mo in your first year — enough to upgrade from a 1+den to a 2-bedroom with a second bathroom, or into a building with better amenities, or a better neighbourhood, etc.

Note especially that in this scenario the renter is building exactly as much equity as the owner since we haven’t considered the principal repayment portion of the mortgage to be an expense — that’s considered forced savings here (though again, “actually saving” is a better savings plan). Also remember that I am talking about apples-to-apples comparisons: with condos or townhouses I’m comparing as much as possible to the identical units within the same building.

Now, there are of course more “depending on…” factors. For example, people who buy, especially in my recent-graduate-and-fertile age bracket tend to buy more than they need for the immediate few years so they don’t have to move and waste the transaction fees. That is, they skip the “starter house” and go straight to their “forever house”, but have to pay more for that for the first few years when they don’t need the space (that is to say, if they did decide to rent, they’d rent a smaller place because the only cost of moving up in a rental is the stress, the truck rental, and possibly one month of rental overlap — fairly trivial compared to the direct costs and risks of being house poor by overreaching early on). In favour of the home buyer is the fact that the house price gets “locked in” (though IMHO, that’s not a good thing in this market), whereas the renter is subjected to the ~2% yearly increase in rents (although as my experience has shown, this is negotiable). Still, that’s a fairly minor factor: sapping just $360 of the $6k renters benefit in the second year, and up to $2k in the last year, which again is peanuts compared to the risk of interest rates spiking, having your condo levy a special consideration, or some other major repair. For people with poor financial discipline, the principal portion of the mortgage payments are a form of forced savings; for those who don’t need that structure, only paying the “lost” fees gives you freedom for those situations (job loss/paycut, emergency, etc) to not save if you need to use the money, i.e. it’s easier to manage your cashflow, and you can expect a higher return on those savings to boot.

One peculiar trait that I find baffling is that people who are seemingly allergic to debt and leverage seem to not give a second-thought to leveraging up to 95% on an illiquid asset that then in many cases also becomes their only asset (talk about under-diversification!). Indeed, the run-up in prices over the last few years has been fuelled by increasing amounts of leverage (due in no small part to the relaxing of minimum down payments and increasing amortization times). With great leverage comes great sensitivity to interest rates, so listen well to the words of Carney:

“…over time, things will normalize – interest rates will normalize. And the way to think about managing your personal affairs, I would submit, is can I borrow at what would be a normal rate?” Carney said.

Instead of first-time buyers soberly pondering that question after a good night’s sleep, a hot cup of tea, and a spreadsheet, we get people desperately buying something so that they can “take advantage of historic affordability”. Indeed, it is truly baffling how little independent thought people put into the biggest decision of their lives.

Finally, as was pointed out in the RL discussion that prompted this post, nowhere have I mentioned “property appreciation”. And that’s for the simple reason that if you need to rely on the housing market going up at some ridiculous rate (or I should say, continue going up at some ridiculous rate) just to make your purchase make sense, then you are speculating. Plus, while people seem to think housing prices going up is a good thing (and I suppose for buyers it is better than the alternative), what do you do then? Once prices go up do you sell your home and start renting to realize the gains? It seems that while people want to buy something to get in on the boom, they haven’t really thought through what might happen if they’re right: “I’m like a dog chasing cars, I wouldn’t know what to do with one if I caught it!”. Even less do they consider what might happen if they’re wrong: just look at the rest of the world, or even Toronto’s market during the meltdown last fall: housing prices do not always go up. What happens if they go down and you find yourself needing to sell? You’re a typical Torontonian first-time buyer, so you only scrapped together 5% down, and after a few years of living in your house you have maybe 10% equity — the bank owns the other 90%, and unlike in the US there is no jingle mail, you have to service your debts. But, a small made-in-Canada correction has occurred: only a 10% decline in house prices, nothing like what the subprime meltdown in the States was like… but now you have no equity left; no downpayment to buy your next place, yet your psychological biases may nevertheless prevent you from “selling at a loss”. Since you “locked in” your price when things were high, you can’t even just hold on to the place and rent it out, since you’ll be losing money every month (especially when you consider that beyond the “thrown away” money in the above comparison, as a landlord you need to add a vacancy provision, etc.). It’s not a happy scenario… where’s the downside protection?

So now you get to the bottom of this giant rant and you ask yourself: “Why is Potato ranting about this again? He’s made his point very clearly before, how is just working at the valuation in reverse worth a new 1500-word post?” The answer is two-fold: first, as I explained at the top, I was trying to dispell the “throwing your money away” myth with a co-worker, and found the bottom-up rates approach to be a little clearer and help show where the 150X rule-of-thumb came from. The second is that this morning Wayfare sent me a dozen links to Toronto houses. I’m about a year away from finishing my PhD: we are in no position to buy a house — even it was fairly valued — and yet the grip of housing mania, the emotionality of the whole thing is so surreal that I can’t even convince my own wife of the truth of this. Fortunately, with her being self-employed, and myself being a grad student (and I’ll have no job history when we first move back to Toronto even if I do manage to land a job right away), no lender in their right mind will give us the mortgage to hang ourselves with… but I try very hard to not depend on the rationality of 3rd parties to keep myself out of trouble; after all, while lending standards have tightened up a bit recently, lenders still don’t have a reputation for being terribly rational this decade. Still, it’s hard to fight decades of indoctrination and tradition that buying a house — no matter the cost — is just something you do when you get married and graduate. Like putting on funny hats and having old men in colourful robs hood you, it’s just a tradition that may not make any sense, but you do it anyway because that’s what society expects of you. Of course, the one graduation tradition is a lot less costly than the other.

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