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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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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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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Well, we have successfully found a place to live for the next few years. It is about 35% smaller than our current place in London, and about 30% more expensive — welcome to the cost of living in the Centre of the Universe! Compromises were made, but fortunately it’s on the low side of the rent range we were looking in, and that extra money in our pocket will go a long way in the form of take-out when I don’t feel like cooking in the small kitchen, or better yet if we can save it, towards the downpayment for a house that will be perfect (a few years from now… after sanity returns to the market, and I find some stability in my work life). Don’t get me wrong, it’s still a nice place (we wouldn’t consider it otherwise), and we simply can’t beat the location (right by the subway).

We had a few different places make the short list, and as you could probably tell, they were all owner (or property manager) listed. The owners all seemed friendlier than many of the agents, and certainly seemed more motivated to make things happen in terms of actually responding to our calls/emails and setting up appointments. Housing requires a lot of upkeep it seems, and the owners were always prepared to mention that something was new, or going to be replaced, or what have you — also giving us the impression that they would continue to do their part of the maintenance.

The house we eventually went with we found through Viewit, though we answered a lot of ads on Craigslist as well. We tried to see a few that were listed on MLS, but less than 1/3 of the agents there ever got back to us, let alone proved their use to the prospective landlords by trying to sell us on the house (though I forgot to mention Gian-Piero Furfaro in my last post — he was a nice guy, learned a lot of details about the house for the showing).

The landlord seems like a reasonable guy, and we were able to negotiate some improvements to the house, including critically central air. In exchange, we agreed to a longer than 1 year lease (which works for us anyway, since we hate to move). We’re also going to have a dishwasher installed — as a compromise, we’ll buy the dishwasher, and he’ll hire the plumber. We didn’t try to negotiate the rent rate itself (which was pretty typical for the area and size of the house). Like I’ve been saying all along, just because you’re renting doesn’t mean you don’t have the freedom to customize/improve your living space. We’re probably also going to install a bike rack in the garage, or at least a better way to secure the garage itself so our bikes will be safe.

Tips for potential landlords to get us to respond to your ads:

First, I’d have to recommend going to the effort of either doing the advertising yourself, or finding a good real estate agent/property manager. The majority of agents aren’t going to help you get tenants quickly!

Next, take pictures. If you have to use old pictures from the last time it was vacant, so be it; if you have to include your tenants’ stuff in the pictures, so be it (though try to get them to clean up as much as possible). We found we were mostly able to see beyond the stuff to what was under it, but we can’t see anything if it’s just a 2-line text description! Maybe it’s just me, but I found pictures of the kitchen and bathrooms to be especially useful — living rooms and bedrooms are just spaces waiting to be filled, but kitchens and bathrooms have to be functional the way they are, so if I don’t see photos of those, I assume they must need to be hidden for some reason! Most decent ads had at least 4 photos, with most on Viewit sporting 8-10, but you can always include more, and I’ve never said “wow, that was too many photos”.

Advertise everywhere. Our new landlord had ads on Viewit, Kijiji, and the Toronto Star that I found, and possibly elsewhere. I’ve heard various anecdotal reasons for picking one medium over another (e.g., professionals use the ‘net, seniors read the classifieds), but some are free and the others aren’t expensive. As a searcher, I preferred Craigslist to Kijiji (it was just a cleaner interface, and half the screen wasn’t taken up by irrelevant paid ads), but Viewit was also fruitful. Hometrader was ok, but didn’t have a lot of ads for detached homes (it mostly seemed to be apartments/townhouses). We never looked at the newspaper classifieds, but that doesn’t mean it isn’t an avenue worth exploring. The off-campus housing ads can be a good place to advertise if you’re close to a university and want students, but if you don’t want students, then obviously don’t bother.

Details! Almost every ad for a given housing type will say “clean, [housing type] close to [stuff]. [X] bedrooms and bathrooms.” so if that’s all your ad says, you’re not really selling yourself. If there are any details that help sell it, include them! New A/C or furnace? Nice garden? Crown molding? Finished basement? Parking for X cars? Storage locker? Price? Likewise, anything that’s included should be mentioned (and to be fair, if utilities are extra, mention that too) — utilities, cable, lawn care, snow removal, window service — these are all perks that a renter will see value in, and may help explain why your rent may be higher than average (if it is). Other important details include when it’s available (note: if it is now November and your ad says avail Sept 1, change it to “avail immediately”, or people will wonder what’s wrong with it that it’s been sitting vacant for so long!), the term of lease you’re looking for (e.g., for us it would have been helpful to say “1 year lease with option to extend” or even just “1+year lease”), and a location that’s as exact as you can (preferably the actual address). For a person that doesn’t drive, there’s a huge difference between a place that’s a 5-minute walk to the subway and one that’s a 35-minute walk, even though both might be in “Willowdale”. I’ve seen people mention which school district the unit falls into if they’re trying to attract families. Finally, one thing that MLS does right that the others don’t is report room sizes. If we do some work from home and need to set up an office space, then we might be looking for a 3-bedroom if the rooms are small, or a 2-bedroom if the rooms are large. For houses in particular, explicitly mention if it’s the whole house that’s for rent, or if there’s a basement apartment that’s rented separately.

Current tenants: For the most part, it’s not an issue to work with outgoing tenants to have the place clean and ready to show. However, as we experienced with “Mr. Superlative”, if your tenant is crazy and/or obstructive and/or messy, then it might be worth eating a month or two of vacancy to get them out before showing it to the next group. Likewise, if you’ve successfully managed to keep your unit rented out for 10 continuous years, it might be time to do some maintenance for the wear and tear that’s accumulated over those years.

Know the laws: Many landlords request post-dated cheques in advance; we usually give them since it’s fairly convenient for us and not worth fighting over. However, in Ontario it’s not legal to demand them, so you shouldn’t say so in your ad of all places. Likewise with security deposits beyond the last month’s rent. And of course, we’ve already covered the issue of discrimination.

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