Primer #2: Is there a housing bubble?
Hello again
In our last primer we looked at how money is created and destroyed in
our fractional reserve banking system. We examined the implications of
this process on inflation (which buoys asset prices like real estate)
and deflation (which crushes asset prices).
In that primer I suggested that one of the main catalysts for a
contraction in the money supply would be a decline in real estate prices
which become self-feeding. This will dampen demand for mortgages and
home equity lines of credit, the two largest generators of bank-created
money, and will also cause people to save and pay off their debts as
they no longer feel as wealthy. This has the effect of 1) Shrinking
the aggregate money supply, and 2) Slowing the velocity of money. In
this primer we will examine the question of how fairly valued Canadian
real estate really is. We will use quantitative measures that are
universally accepted to examine this question, rather than the
qualitative fluff that is rampant in most discussions of real estate
values (example: “they’re not making any more land”, “real estate only
goes up”, “buy now or be priced out forever”, bla bla bla)
Now it is important at the outset to recognize that real estate is
priced based on local conditions. Some areas will definitely be hit
harder in a real estate correction than others. However, there are only
a handful of communities in all of Canada that are at or near their
historic norm when it comes to real estate prices (as measured by the
quantitative factors we will examine shortly). Furthermore, in a period
of persistent deflation, all assets are ravaged, including those that
are ‘fairly’ valued. So it is of particular concern that we are
entering a period of deflation with such widespread overvaluation. So,
for the sake of having a meaningful discussion of the state of Canadian
real estate in GENERAL, I have used data provided for the Canadian
market as a whole.
Let’s first start with the definition of a bubble. While there are
lots of definitions, the easiest way to think of an asset bubble is as
follows: An asset bubble exists when the prices of assets are
over-inflated relative to historic norms, as measured by widely accepted
fundamentals. Bubbles are a product of mass psychology (the topic of
our next primer). They occurs when people flock to a particular asset
class, such as real estate creating excess demand.
I know I referenced Chris Martenson in my last primer, and I don’t
usually borrow too heavily from any source, but he does an excellent job
of explaining asset bubbles in a straightforward manner in this chapter of his Crash Course.
So let’s dive in. There are three metrics that are commonly
referenced with regards to guaging the relative value of real estate:
affordability (usually measured as the percentage of the average income
needed to carry the average house), price-to-income (average price
divided by average family income), and price-to-rent (the value of a
house divided by the annual rental income that the house would
generate).
Any discussion of the relative value of real estate is meaningless
without referencing one of these three metrics. Otherwise, we revert
to anecdotes, second-hand stories, and the generally accepted wisdom of
our culture. None of which prove anything.
So, let’s take a hard look at these three metrics to try to
determine just how fairly valued real estate is. If anyone would like
to post a rebuttal to this post, please refute these facts with facts
of your own rather than anecdotes.
Let’s start with affordability. This one is misleading in some
ways. Record-low interest rates have kept affordability at what would
seem to be a reasonable level. In May, RBC released a study in which they concluded that affordability was quickly eroding due to house price appreciation.
Affordability is well above historic norms, and that is with record
low interest rates. Earlier in 2010, we hit new highs in house prices,
despite the facts that income growth has been slightly negative in the
past couple years and has been unchanged over the past decade when
adjusted for inflation. Should mortgage rates normalize, which they
must at some point, you will see affordability rapidly detereorate past
the 2008 lows. Any rational person would conclude that affordability
has to detereorate now that there are new mortgage rules tightening
lending standards, and higher interest rates around the corner.
Additionally, the Canadian Association of Accredited Mortgage
Professionals has recently released a report
indicating that 375,000 households are reporting that their ability to
make mortgage payments is already an issue. This is with RECORD LOW
interest rates! Think about it for a moment!
On to the price-to-income ratio. This one is perhaps most
important, as you obviously need a higher income to support the
increased costs of real estate. I’ll let the second graph at the
bottom do the talking on this one (thanks to David Rosenber at Gluskin
Sheff for this one)
Note that any time you pass the one standard deviation from the
mean, there is always a reversion to the opposite. We are currently
well above one standard deviation from historic norms. So, there are
only two possible options here: Either house prices decline to a level
where incomes can support them, or house prices remain level for a
period of time while incomes catch up. I think mass psychology (it’ll
make sense after the next primer) and the state of the economy in
general make the second option quite remote.
Now let’s consider the price-to-rent ratio. This one is akin to the
popular price-earnings multiple used to value stocks. Essentially, it
is a quick measure of whether or not it makes sense to rent a house or
buy the equivalent house. In this one, the graph is shocking.
As you can see, we are dealing with a two standard deviation event.
Based on rents, homes are 60% above their long term intrinsic value.
Truly shocking!
Finally, let’s look at home ownership rates. They are at historic highs
(now breaching the 70% level, above the level the US experienced prior
to its crash). You need a steady supply of new home buyers to keep the
real estate game going. So it begs the question of who will be the new
buyers. You may be prone to say that immigration will be our short-term
salvation. I would beg to differ. Net household formation in Canada
is running at 175K per annum. That includes imigration and ‘organic’
household formation. Currently housiung starts are running at +200k per
annum. It’s not hard to see that there is oversupply in the pipeline
for the near-term future.
You’ll note that all three of these valuations have concrete upper
boundaries. You cannot have price-to-income ratios increase forever.
Clearly. And you can`t have price-to-rent increase forever, or people
will stop buying. Clearly. Affordability cannot detereorate to the
point that people require 80% of their net pay to service the costs
associated with the average home. Clearly. So consider the
implications. Weigh them out. Then, for the bulls out there, please
formulate a rational response that explains why real estate will do
anything but decline over the next few years. I don`t expect any
responses.
As always, don’t follow the crowds. The danger of ‘crowd thinking’
will be abundantly clear after the next primer. Think for yourself.
You’ll do fine!
Cheers and blessings,
Ben
http://www.flickr.com/photos/53587367@N02/4968594735/
I think Canadian real estate will go at least four standard deviations as more wealthy Americans expatriate north, south, and anywhere they can to protect their wealth from the syphon that's coming....
How about the Canadian government will devalue its credit to keep asset 'prices' inflated?
I'd say spot on! Unemployment is high and wages low, compared to the cost of housing. Canada is akin to mexico , a weak market held up by close association with the US when America hits the skids forget about Canada.
Living in Canada is a chore on the best of days. Between the unending lust for tax reform which typically gets downloaded to service fees, then the infamous GST @5% (which was put in place to pay off the national debt, Canada still has lots of it) now HST @13%. To give a picture of what the rental market looks like I'll use some of my own examples.
I came out of dot.bomb with a pile of money, moved back to Canada from NYC (a sad trade, but there was work here). I bought two shit pile condo's (800-950 sq ft each, a parking space for each right downtown Ottawa) for 105k and 117k respectively in 2000, condo fees/mgt fees weight in for around 820 a piece. I owe no money on these condo's btw at time of purchase, I took the pile of money I made during dot.com and rolled it into property. Now the rental on these places is around 1400-1650, not a bad haul really, although in the last three years the challenge has been to keep the space occupied regardless of the property management company I pay good money to do so (yes they are useless fucks).
Now flash forward today. I'm putting these shitpiles up for sale for around 370k and 410k, out of the buyers I've talked to about buying these I honestly think are on crack. Half are talking about renting the property in a building where the property management company makes the prices on the rental units as not to fuck the other investors. Then the other bunch of morons are planning on living there with 575 a month condo fees to essentially live in a hut downtown Ottawa. Just off the top of my head, even with 4% interest it'll take around 42 years for the condos to pay themselves off. For the dumbasses buying them to move into the condo's, with condo fees it'll take basically a lifetime. I'm selling them for the sake I want the cash out of them and be in a better position.
Alternatively the 300 acres I bought at the same time has paid itself off around four times in the last 10 years.
Yes, the Canadian housing market is saturate with people bad at math and just follow dogmatic drivel spewed endlessly by our very small, costly and incredibly dull public media sources. There's a reason multi-level marketing schemes work here, people sincerely believe that the government will protect them in it's typically incompentant fashion. Usually by adding another tax.
For those interested, yup, I had to pay income tax on the gross rent and now with the soon to be sale of those shit piles I again have to pay taxes on the gross. If anyone wants to see an object of futility, become a Canadian Businessman/Entrepeneur.
Nice.......I'm glad to see that your assessment of Property managers in Canada is consistent with my own in CA. I'll sleep better tonight knowing I am not alone. Cheers !
It's easier getting toothpaste back in the tube than trying to get those useless fucks moving. 10 years I've owned them and the 18k in fees they've collected on them, I've found all of my own tenants plus did background checks. In Canada you aren't allowed to evict between Oct and April for failure to pay and believe me there is a large cadre of assholes out there that know the law and will use it.
Worst thing is trying to get the expenses back in taxes under the Canadian tax code which should simply be put in a couple of sentences.
Every dollar you spend will be taxed on the way in and on the way out at triple your expense.
Canada is not business friendly, in fact I could state Canada's business sense is as geniune as phony as the petrol dollar it trades.
My favorite thing that is an annoyance recently as a business man, I'm being asked to pay into Employment insurance (it's really unemployment insurance...double speak for the win) even though I would never, ever, ever qualify for it because...yup...I run my own businesses there by how could I ever be dependant on the state to pay my salary.
So far my plan is to dump everything, go pure cash and continue living in my cheap/paid forhouse around 80km outside of Ottawa. My option is simply just not to participate in the Canadian economy and sit on my money. I ended up selling my engineering business in 09 (my previous primary business) and I've watched the idiots that bought it run it straight into the ground. Had to pay taxes on the sale of that on top of lawyers.
I'm not the only one either, most of the guys I know that build businesses are in the same mood. Let it rot and as builders we'll let the fools that think they can manage business attempt to keep the shit together and invent that next technology/business development/medical need.
So the plan is to sit on deck chairs, drink beer, go fishing and watch it burn. When they have finished burning it down, the bunch of us will go collecting heads then start rebuilding again. Should be another ten years before that happens if we're not dead from liver cirrhosis.
What will happen to your cash while "it" is burning down or rotting? Won't your cash share the same fate? Vancouver BC here.
I already know my cash will suffer the same rot as anything made of paper does. However I am looking to approach another direction. My 300 acres of farm land has out performed any of my investments, even the couple of bars of gold in the bank included.
My intention is to keep buying more farm land to lease from the sale of my craptacular condos. The goal is to have roughly 1200 acres of working land in total. Unlike the craptacular condos, which seemlessly have an unending stream of turnip truck casualities. I can take the capital that is currently worth something and buy something that doesn't have nearly the same risk now and maintain my position of having zero debt.
With corn, a single plant, my return has been 300% per annum. Here's the weird thing about corn, the seed to plant corn is more expensive than the corn sold, so guess what I contract my corn for. Seed, or if the bid is right, ethanol production. I don't have to sell into a market to feed people, I can store my product because it is seed, I don't have to abide by futures, I sell on demand. I've never understood farmers that use brokers honestly, as if they really have an obligation to feed people and run their businesses into the ground. After selling, I get glorious privilage of being taxed on it by the People's Socialist Republic of Canada so I can have dull Canadian media content to fill 300 channels that I've never seen and pay for a ballot being cast.
Cash is king for now, gold and food for the near future. Since gold only lasts as long as you have it, I'll go with land that produces food over long term. I'm not saying I'm building a fiefdom...well sure I am building a fiefdom but it'll be mine. If you look around BC there are a couple of guys I talk to out there with identical intentions. It won't be so much of a coup as it will be an "ignore" to death.
China, India, Russia and Brazil can have as much development as they want. So far with the leaps and bounds they are making economically, my bet as they continue to have exceptional difficulty producing food for the HUGE populations that need to eat.
Their cash won't be accepted, but I'm pretty sure some arrangement can be made for all those gold bars they've been buying recently to determine the direction of (guessing here) 1.6 billion people in China and 1.4 billion people in India.
Now...
We have shit in our own sandbox so baddly and filled it with so many people and our by product, people are dumbfounded that we are starting to see our own food supply collapse because of environmental conditions. To be blunt, over ten years, the yield on my lands has decreased yearly, that for me means "charge more", which I quite happily do. So what is a Prince to do but collect now for the day when people don't even remember what a Canadian Savings bond is (yet another form of fiat garbage).
Don't for a second think Canada isn't in the shit btw, when the US goes tits up, we follow around two seconds after the fact. And knowing the Canadian government, they'll levy some sort of tax then take off for the summer as usual so they can collect that well deserved 280k a year and gold plated pension. (Only thing with less responsibility is a 19 year old stoner making the executive decision of joint or bong).
Some farm land in |Canada is waaaaay overpriced. Parm land in the lower main land of bc goes for around 60 to 80 thousand an acre
I'm not sure where they are buying but they are growing hops in BC. Very important for delicious beer. I'm pretty sure they are growing pot as well, it would be one plant that would blend well in with it's closest cousin hops. If it's 80k an acre it's the only way i could see them making money on land out there. However they are fairly well off so I'm unsure what their line up is and who they are choking to obtain land.
For myself I'm in the Ottawa valley and just drive around eyeballing property, most of the farms that are currently in production are simply being left fallow. The idea of a single family farm is long dead and land is cheap (buying another 300 acres for 98k on Thursday, have to clear 75 acres on it though. (Wood chip the forest then flog it on auction so people can mulch their gardens with wood chips, should break even on the cost of ploughing it down although I'll get taxed in and out of the whole affair).
What is bought and sold with a vicious appetite around here is dairy quota so people can eat cheese/drink milk. If you have enough dairy quota in Ontario you can make a million a year after costs. Milk quotas, like taxi license plates, you usually have to wait for someone to die to find it for sale. However since running a diary farm is pretty hazardous to human health, you have until 50 to spend it all (cows are filthy shit machines, even the organic ones). Most of the guys I've known or know have some type of cancer a doctor gets to name after their patients. Go figure wading around in animal feces/bodies/illness, diesel fuel and rotten bails of hay for 30 years would cause cancerous growths.
Right now the tomatoe processing and apple harvest is on and then the gourds (pumpkins, squash, etc).
If anyone is unemployed btw, the seasonal work in the valley is available. To make sure the food gets picked, a couple hundred guys from Mexico are flown in for 15 an hour to work the farms. Unlike SoCal though, 99% run away as soon as snow/cold hits. It's good money though, however white Canuck kids don't work until they are 20-22-30-never. However strawberry picking is the most profitable though. People have a weird misconception that people are lining up to pick their own berries and apples, which is a complete lie. If able you get on site at six, pick berries for 3 hours, load it on a truck then get $100 in your pocket for three hours work. Strawberries have a short life span and jam factories don't run off of wishes. Apples you just haul ass and pick/paid by the bushel.
Great stuff! Thank you for taking the time to write this. Ain't no substitute for boots-on-the-ground reporting. I guess in this case you an an imbed.
http://www.medicalnewstoday.com/articles/45124.php
Same plan here...plus coffee.
there is lower taxes on dividends in canada compared to the states
With a severe cap of 425k (or is it 455K now) on privately issued dividends against capital gains over a lifetime. It isn't infinite. The guidelines on capital gains is strict regardless of individual or a Ltd (LLC for US cousins) and you have to qualify for it, you don't just get to claim it. Capital gains exceptions are, yes, higher than the US to the Federally mandated number, but if you are weighting the options over a long term 425k is made fairly quickly if running a company worth something that employs people.
If looking at Canadian stocks that issues a dividend worth risking perfectly good capital on, I would love to see one. Since I wasn't privy to the Canadian stock market in the 60's when growth was a required factor of the economy and I didn't have an "in", right now the dividend payouts are about the same as if I stuck it in a savings account at 3% a year.
Not exactly awe inspiring or smart, nor does it give anything back when discussing how the Canadian government is being kind enough to give back what you made in the first place.
Okay, theorectical situation. You make a hamburger, took you a bit of effort, it's taken you years to learn how to make that burger. Now you are about to take a bite out of the hamburger however some pencilneck walks up, takes a bite, chews a bit. Stops chewing, puts a thoughtful look on their face and spits up part of the bite then hands it back to you. You look at the partially chewed bite and then gladdly eat it, all the meanwhile trying to figure out why that guy just took a bite out of your burger.
Then you explain people handing back things that were yours to begin with was the best deal you've seen for your whole life.
God, I need to sell insurance or start a political party if people are that dumb without letting my ethics get the best of me.
mmm...."there's no bubble as long as people want to buy something..."
You are not alone:
http://www.scribd.com/doc/28454918/Canadian-Housing-Bubble
and
http://www.scribd.com/doc/36383418/The-Elusive-Canadian-Housing-Bubble-S...
by Alexandre Pestov
i assume by "tits up" you mean something....bad? that hasn't always been my experience. in any case Canada is a beautiful nation with a special nod to both Vancouver and Ottawa. Montreal is a close call but they really botched the 70's. Toronto really is a weird place. Are the people weird, too? and of course the countryside of Quebec is truly spectacular. who wouldn't want a fishing camp on the Rideau? Beats Florida hands down that's for sure. at one time the St Lucie River use to glow in the morning the most beautiful azure green...not since the canal and whatever they've poured into it. there's still Key West but unless we invade Cuba soon and turn it into a National Park with a "stuffed Fidel Castro exhibit" I really don't see much of value until you get deep into the islands.
Tits up for Canada is a collapse of the real estate market, second is the collapse of 80% of our exports. I would go into the mutual funds being a total dogshit sandwich and pensions being around 70% funded but that's just math against demographics. Why bother the discussion has been had so often people use it as a chaser to a shot of rye.
Things aren't in great shape regardless of our mini-media coughing up well wishes.
If we're lucky, global warming turns Ottawa into Florida and I don't have to pay for my parents to hide there over the winter months (ugh...insurance...). Other than that, when it tanks in europe and the US, we as Canucks are right screwed. We have 200 years of intertwined economies that would be damn near impossible to seperate.
Nice article thanks.
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