Deja View: Another Look at Real Estate


By John Nicola CLU, CHFC, CFP

IN THIS ISSUE: Just like any other market, Real Estate experiences ups and downs. Booms and busts move in cycles and we’re likely undergoing a transition now. After witnessing the fallout from the subprime blunder of the U.S., the question for many Canadians (and Vancouverites in particular) is “what about us?” With housing prices at improbable highs, zero down payment mortgage options fueling the fire, and unsold homes increasing on the market, are we headed for a similar fall? In this extended issue of Tactics, John Nicola reviews the climate of Real Estate locally and abroad, as well as other available options.

 
It’s hard to imagine two more interesting dinner guests than the great writer Mark Twain and the master of malapropisms, Yogi Berra. In their respective ways, each captured an idea’s essence with a remarkable economy of words.

This issue we have chosen two quotations that remind us of the current global situation in housing and, perhaps more importantly, how it has played out in the past. I think this is a particularly important subject to many of our readers. We who live in certain areas of B.C. take for granted that in paradise house prices never fall. Those of you who know the writings of Mark Twain better than I might have directed me to another of his famous quotes: “Buy land – they’re not making any more of it.”

On the other hand, this could also be a marketing line for U.S. housing developers who are sitting on thousands of unsold lots as their own crisis continues unabated.

In this newsletter, we want to try and answer these questions:

  1. How bad is the U.S. Housing crisis now and what might we expect over the next year or so?
  2. How does this compare to other housing markets elsewhere in the world both now and in the past?
  3. How will Canadian house prices (more importantly B.C. for the majority of our readers) perform in this environment of shaky equity markets and restricted credit?
  4. And for first time home buyers – How much does it really cost to buy, own, then sell a home or condo? (Hint: More than you might imagine.)

 
Taking a look at the current U.S. Housing situation.

As of the end of May 2008, the following statistics were true:

  • The Case Schiller Home index of all housing markets in the U.S. was down 14.4% from a year earlier. The largest annual drop in house prices since records have been kept (WWII). In some markets, such as San Diego (the most livable city in North America according to some), house prices are down 20%.
  • According to a John Burns Real Estate Consulting survey, anticipated total price drops will eventually hit an average of 25%, with some markets (such as Florida and Southern California) falling as much as 45%.
  • Nine million homeowners in the U.S. have zero or negative equity. Given that the real cost of those homes (mortgage payments, taxes, maintenance etc.) is about double the cost of renting the same homes, this begs the question: why would these homeowners not default on their mortgages then offer to rent the home back?
  • Subprime adjustable mortgages will be renewing on higher rates until the end of 2008 (at which time the inventory of these loans drops dramatically). However, foreclosures lag renewals by between 12 and 18 months. That suggests the huge inventory of unsold homes in the U.S. could last easily until 2010.

In the end, the dramatic drop in U.S. Housing is a simple reversion to mean that one sees so often in equity markets (such as the Dot-Com bust or the current 50-60% drop in many emerging markets). The chart below shows just how far beyond the long-term trend U.S. Housing prices have risen.

In real terms, between 1995 and 2006 house prices rose more than 70% – a far higher increase than the rate of incomes. Lower interest rates facilitated part of the price increase, but creative lending with incredibly lax standards was the major culprit. It will be several years before that debt is liquidated and the U.S. housing inventory normalizes.

And how long might that be? This brings us to question #2: how does this crisis compare to other housing bubbles?

Recently, Goldman Sachs provided a report that analyzed 24 housing busts in 15 OECD countries over the last 35 years. In each case, house prices are measured in inflationadjusted real terms. This is an important distinction that homeowners often forget. If house prices remain unchanged for five years, but inflation increases by 20% over those five years, then house prices in real terms will have dropped by 16.7% [(120-20)/(120)].

To make it even simpler: if house prices remain flat, then the best thing first-time home buyers can do is wait, because each year in real terms all aspects of that house become less expensive (more on that below). This, of course, is provided that salaries keep pace with inflation.

What are  some of the key numbers?

  • The average duration of the housing busts was 25 quarters (6+ years) with a real drop in housing prices of 31%.
  • In Canada, we have had two housing bear markets. The last one ending in September 1998 after almost nine years with a real drop of 16%. (MLS numbers for the Lower Mainland suggest that our last bust was between 1996 and 2002 with houses falling about 20% in real, inflation-adjusted terms).
  • The following is an interesting introductory quotation from the GS Survey:
    “The general lesson of historical experience is that housing busts are generally prolonged episodes with significant and long-lasting macroeconomic consequences. The ‘typical’ housing bust involves a sharp slowing in growth followed by sluggish recovery, significant declines in equity prices and credit growth, and falling nominal interest rates, though both the economy and equity markets usually bottom well before the housing market. In a significant number of cases, banking crises have also followed.”

Cheerful group these analysts are. It is also interesting to note that with the exception of a relatively small correction during the U.S. Savings & Loan Crisis, this is the first housing bust in the U.S. since the early 1970’s. Perhaps a little overdue when compared to other countries.

Using recent data from The Economist, there are now several countries with declining housing prices including Japan, Germany, Ireland and Britain, with Spain looking just as vulnerable (their largest real estate firm, Colonial, has recently predicted a 30% drop in house prices over the next three years). The U.S. is not alone in this housing bust, it is just leading it.

This brings us back home. How are we doing during this crisis and what may be in store for us?

If we look back to The Economist chart, the table shows Canadian house prices rising 80% in the last ten years; quite a bit less than Spain’s 195% or 138% in the U.S. (Case Schiller Index). However, according to a report in the Globe and Mail (June 28, 2008), Royal Lepage reports Canadian housing prices have in fact risen 129% over the last ten years – far more than incomes.

Other issues of concern:

  • Home sales in Canada are 13% less in the first five months of 2008 than in 2007 and listings are rising. By way of example: in Vancouver’s West Side, active house listings were about 100% more in June of 2008 than in June 2007.
  • Contrary to popular opinion, house prices can and do fall in the greater Vancouver area, as shown from the chart below.

A couple of interesting numbers from this chart:

  1. The two periods of time with house prices dropped in real terms are 1981-1989 (conservatively 25%) and, as mentioned before, 1996-2002 (just over 20%).
  2. When inflation is factored in, house prices did not get back to their 1981 peak until 2004 (23 years later).

One of the big issues in the U.S. Housing crisis was easy availability of credit, which allowed many families to acquire homes they really could not afford. Ironically, they then added to the demand for housing which exacerbated the rate of price increases. In Canada, we have historically had a more conservative approach to mortgage lending. Recently, however, that has started to change and we are showing signs of U.S. irrationality (just as we are watching their housing market implode).

Consider the following:

  • You can currently get up to 100% financing for a new home;
  • You can amortize the mortgage over 40 years, which lowers payments by 15% over a 25-year amortization, but increases total interest payments by 55% (it must be nice knowing that you’ll pay off your first starter home just in time to apply for Old Age Security);
  • You can buy extra insurance in case you can’t afford a 40-year amortization, choosing interest-only for the first ten years (that way it’s not too hard to figure out what you still owe on the principal of your mortgage).

So why would CMHC do this? Seems simple to us; it’s “show me the money.” Their fees for a regular 75% loan with 25-year amortization are 0.65%, but for a 100%, 40-year, interest-only-for-ten-years loan, the fee is 3.6%. On $400,000 that is a difference of just under $12,000 in front-end fees.

Where we are now:

  • On July 10, 2008, the federal government indicat ed that after October 8, 2008 it will no longer allow zero down payment mortgages or 40-year amortizations to be insured. Good to see somebody has come to their senses.
  • Still, the 5% down payment and 35-year amortization will remain insurance eligible. Seems like serious leverage to me.

While it’s nice that the federal government is at least trying to bring this foolishness to a halt, what they’ve really done is bolt the barn door after the horse has left.

In effect, CMHC and lenders are running out of legitimate house buyers and are using financial wizardry to make homes and condos appear far cheaper than they truly are. This tempts some first-time buyers to switch from renting to buying, because the cash flow to support the payments seem the same and rental units are hard to find. This is very similar to what occurred in many U.S. markets: people stretched to the limit with teaser terms that make it difficult to repay the debt obligations they have taken on.

Perhaps more importantly, if these buyers can resist the dark side of unaffordable debt and the siren song that ‘house prices can only rise’, then they can be the part of the market that, at the margin, keeps prices lower – possibly even causing them to drop as they have in previous cycles.

Some reading this newsletter may assume I am all doom-and-gloom, preaching that we should all sell our houses, rent a new one and bury the cash in gold and silver ingots in the backyard. In fact, I am a big fan of home ownership and I am fully aware of how expensive it is, especially for first time buyers in markets like Vancouver.

That being said, housing has cycles as all markets do (yes Virginia, even in Vancouver) and I believe we have seen the peak of the last cycle. When we combine that with rising inventories in Canada and far more aggressive lending practices, it all suggests to me that if you are not in this market now, you can afford to wait.

And for those who feel I am being apocalyptic, you certainly won’t want to read Greater Fool, Garth Turner’s latest book on Canadian housing and its likely future (www.greaterfool.ca). For those comfortable with more extreme positions (but in my opinion well documented and considered) you might want to pick this up and, perhaps more importantly, share it with your adult children who are looking to take the plunge into real estate for the first time.

One of the key lessons to understand about home ownership is that in a flat or falling market, it is very expensive to buy a first-time home or condo as a stepping stone into future longterm housing needs.

For many years now, common advice and practice is to get in on whatever you can afford and use the magic of leverage and rising home prices to build tax-free equity for your next home. However, all tides eventually ebb and this successful tactic in rising markets is terribly expensive in flat or falling markets.

A Case Study:

Consider Bob and Carolyn, both age 28, who want to buy a $500,000 condo in Yaletown with $100,000 down payment (which they saved, begged and borrowed from all available sources). Let’s assume the following:

  • They can get a five-year mortgage at 5.5% and elect the interest-only option we discussed before;
  • Their taxes and strata fees are $600/month
  • This apartment is also available for lease or rent at $1700/month
  • Their closing costs to buy the condo will be $9000 including property purchase tax, conveyance and mortgage costs
  • When they sell in five years time, the real estate commission will be 5%
  • If they invest their $100,000 down payment in a balanced portfolio for the next five years they will earn a 6% return net of tax

So over the next five years, what are the real costs of ownership and how much does the condo have to increase in price to allow the owners to be better off than the renters?

Let’s add up the costs over five years for each side

So in this example, as long as housing prices continue to increase over the next five years at about 4% annually (considerably less than they have since 2002, but considerably more then they did between 1995 and 2001) buying makes sense financially.

Each transaction is unique and there are many reasons for buying a home vs. renting that are personal and important and have nothing to do with financial gain or loss. Nevertheless, perhaps this chart might be a useful exercise for new homeowners to balance the emotional excitement about owning their first home.

In the end, owning one’s own home is a combination of rite of passage and an important psychological achievement for most of us. It is something worthwhile and I believe it improves our lives and our commitments to both ourselves and our families.

Sometimes when we want to make an important financial decision, the wind is at our backs. Other times it may feel like we are sailing into a gale. The prices of almost all assets move in cycles and I believe that after many years of increases well above long-term averages, housing prices will now revert to the mean in Canada as they are doing in many countries of the world. With any luck it will not be precipitous, but it is overdue.