Revisiting fundamentals

You know you’re in an asset bubble when the price of that asset grows far beyond the fundamentals that support them.  In the case of real estate, the fundamentals that drive long term growth are incomes, affordability (interest rates), rents, and inflation.

When house prices stray too far above or below the long-term trend, a correction back to the mean is inevitable.  That is not to say it is immediate, as all markets have a tendency to remain irrational far longer than it would seem possible.  But they all correct.  Bank on it.

The Globe and Mail ran a nice piece yesterday.  It was based on a Desjardins report that examined the price/rent ratio in Canadian real estate.  The conclusion?

Housing buy/rent ratio shows real estate ‘vulnerable’

“Canadian house prices have rebounded markedly from the depths of the recession, hitting a fresh record in may and bringing the buy/rent ratio to about 1.85x. That means that, even excluding major factors such as taxes and maintenance, homeowners pay about twice what renters pay.


My own experience certainly bears this out.  People are funny.  Real estate holds such emotional value that it often clouds reason.  I always chuckle when people tell me that real estate has been their best investment over the past X number of years.  Most people take the price their home is worth today, subtract what they paid, and calculate the difference as their ‘return’.  Of course this is without subtracting interest paid, property and transfer taxes, maintenance which usually runs at ~2% per year when averaged out, lost opportunity costs, and associated sales fees.  Once you figure all those out, it’s not quite the handsome return most figure it is.

Anecdotally, the house I currently rent is a beautiful, modern, fully updated 4 bedroom, 3 bathroom home on 5 manicured acres.  The owners (who couldn’t sell at the price it was ‘worth’ and decided to rent it to me on a two year rental agreement) recently had to replace the electric heat pump and a couple other items.  The cost of those items were more than an entire year’s rent!  And that’s still not considering property taxes, income taxes on rent received, and lost opportunity costs.  Needless to say, I am quite happy ‘throwing my money away’ on rent while banking the difference each month. There may be areas in Canada where the rental market is tight and the numbers may not apply, but nationally, I have no doubt these numbers hold water.

Another important fundamental in long-term house price appreciation is affordability.  It is essentially the percentage of the average take home income that is needed to afford the average home, including all related costs.  Even with fixed interest rates at all time lows and variable just a couple notches from its own record, affordability is at the top of the long-term range.  The Financial Post made an astute observation about what was keeping affordability in the stratosphere:

Low rates bail out housing

“Rock-bottom long-term mortgage rates appear to have handed the housing sector the lifeline it desperately needs…”

There you have it.  As long as interest rates remain at historic, artificial lows, no problem.

But there is a problem.  Low rates imply low inflation expectations in the future.  Low inflation and outright deflation are destroyers of leveraged assets.  Yet perhaps the most telling quote of the entire story is the following:

“I’ve been working for 38 years and I don’t recall rates this low ever in my career,” said (mortgage broker) Mr. Siegle. “The question I wonder about is at these rates is why are people not all over the real estate market?”

The quote is referring to the tanking sales volume, which has led to less movement of property, particularly at the entry level, leading to a skewing of house prices in one of the great statistical aberrations.  It’s a great question, really.  Where are all the friggin buyers.  Granted there will always be a few suckers left; suckers are a strange species that never seems to go extinct, despite their best efforts.

Likely the answer to the question lies in the fact that we have the highest home ownership in history.  It is now above 70% of the population.  As I’ve been saying for some time now, CMHC, central bank, and government policies have all worked together to stimulate a 10 year boom in housing.  This boom, driven by falling interest rates and loosening mortgage requirements, has done nothing but pull a tremendous amount of demand forward.  Maybe the bulk of the people who want to buy have already bought.  An article today in the post seems to make that very point:

Housing boom blamed on subsidies

“Craig Alexander, chief economist with TD Bank Financial Group, said homeownership has long been a goal of Western society.”

“There is no question the policy environment provides incentives and support to homeowners,” he said.  But there is a risk subsidizing the sector, he said. “In the case of the United States, one could make the argument that part of what fuelled the housing bubble was oversubsidization of the housing market or maybe just excessive public-policy support for homeownership.”

Interesting!  Recall that the stated (and self-defeating) goal of CMHC is to

“help Canadians access a wide choice of quality, affordable homes…and to work to enhance Canada’s housing finance options and assist Canadians who cannot afford housing in the private market…”

It sounds noble, and the original intent really was.  But as we have seen in the US, you can’t pull demand forward forever.  You cannot have a massive housing boom based on continually slackening lending standards.  Eventually you hit a point where there is a gap in potential home buyers (which I believe is where we currently find ourselves).  When that gap hits and sales slump, prices follow.  When prices follow, even those who were considering buying quickly abandon that idea as it becomes obvious that better deals will be had by waiting.

I believe that this is exactly what is coming.  Sales will remain weak.  Prices will start to experience year-over-year declines soon (though it may not be October if the mid month sales data out of Toronto is an indication), with prices off 5-10% by the New Year.  Next year will be the big show with a 10-20% melt followed by a multi year grind lower.

The timeline may not be perfect.  We’ll see.  Perhaps the government will step in to once again alter fundamentals and kick the can down the road a bit.  Perhaps CMHC will insure zero down 100 year mortgages tomorrow.  That’s the great unknown.  But in the end none of it matters.  When too much demand has been pulled forward and prices have gone too far beyond their long-term fundamental values, they will correct.  And when they do, no amount of government intervention will halt the fall.  Just look south of the border if you don’t believe me.

Cheers

Ben

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This entry was posted in Real Estate, Social trends and tagged , , , , , , . Bookmark the permalink.

3 Responses to Revisiting fundamentals

  1. keller says:

    sorry to see that the chinese buyers,weekly boat load of immigrants was not considered by the writer, btw i see a jeff rubin connection here

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