Blessed by the Potato

I haven’t posted much on the housing bubble lately because there hasn’t been much to say: I’ve been more of a bottom-up than top-down person, so each monthly release of building starts, sales numbers, or immigration figures doesn’t affect what I’ve already said about the individual decision of whether to rent your shelter or rent the money for one from the bank. I think I may have exhausted the limits of what a spreadsheet can do.

Plus, the story is all over the news now, it’s not like you really need me to keep digging up nuggets of information for you. The correction looks like it’s started in Vancouver, with both sales volumes and prices plunging over the past few months – though I’d wait a bit longer before lighting the ceremonial bonfire and starting the dance of the bear, as the typical summer seasonality is probably distorting things. I don’t have to stick to any kind of short-term news cycle, so I’d prefer to wait at least a year before calling it.

Hey, these things move slowly.

That torpid pace and the tendency for volumes to dry up as the correction starts also means that for many, it’s too late to cross over to the bear camp. The time to consider long-term implications was over the past few years — when I was most heavily posting on the matter — when it was easy to sell for a profit if you had bought, when you had the luxury of time to locate a high-quality rental. Not now that the cracks are starting to show. For most, by the time the procrastinating and hand-wringing is done there’s little to do but watch as it unfolds, particularly if they’re paralyzed at the prospect of taking even minor losses (preferring instead, as many do, to wait for major losses).

Toronto isn’t looking as strained yet: volumes are down something like 10% while prices hold steady… but there are anecdotal signs out there of realtors talking of slow-downs, buyers holding off and refusing to enter bidding wars, and new condos that aren’t sold out within minutes of the presale doors opening. But by this time next year I expect the correction to have (finally!) begun.

Meanwhile, the talking heads speak of soft landings and single-digit corrections. Many are quoting verbatim the things the US vested-interests said before the bubble collapsed there, like “it’s not a bubble, it’s a balloon, the air will come out slowly.” Kind of ridiculous.

The bank economists keep revising their forecasts down, and this by the way is a feature of bank economist predictions — for stocks as well as real estate. First they’ll predict that prices will be flat. Then maybe a 5% correction. Then 10%. As house prices fall and approach that 10% mark, the forecast will be revised again to 15%, and so on. The expectations are “walked” down. They don’t suddenly awake to the over-valued state one day and turn bearish (or at least, their writing doesn’t) which is why I’ve never put much stock in their predictions. Plus many like Scotia’s this week will talk about modest numbers for the country as a whole, leaving unsaid what happens to the particular cities driving the action.

The same is not true of home buyers: they can and do suddenly turn bearish. When prices are rising rapidly, people build rising prices into their assumptions and plans to buy (e.g., in their mental version of my rent-vs-buy spreadsheet, they’ll put in a high value for expected appreciation, skewing the decision towards buying). They don’t see a higher house price as a bad thing – the house being more expensive and shelter costing more – they see it as something positive. The opposite happens as prices fall: buyers don’t suddenly turn into value-hunters, glad to see that the house they were lusting after the year before can now be had for 10% less. Instead they put a lower number into that mental (or actual) rent-vs-buy spreadsheet, and hold off further. Why buy now if it will be even cheaper next year?

This psychology drives bubbles and crashes. It is inherently unstable, which is why all the calls for a soft landing are so misguided. There are very few examples in history of soft landings happening.

One example is recent though: Alberta. Going into the GFS, Calgary & Edmonton real estate was arguably even more over-valued than Toronto real estate. In late 2008, the market there seized as it did in Toronto and Vancouver, falling 10-15% in just a few months. Then, interest rates cratered, credit began to flow, and Toronto and Vancouver recovered and rocketed ahead to new heights in the years since while Alberta flattened out.

Alberta then has shown that a so-called soft landing is possible: a snappy 15% nominal price decline followed by a few years of stagnation while inflation helps the fundamentals catch up.

The thing is, there’s a pretty exceptional set of circumstances that lead to that soft landing: namely an incredible drop in mortgage rates that cannot now be repeated in Toronto and Vancouver – where those same rates were insanely stimulative. Without that factor, who knows? Alberta real estate might have fallen another 15% by now.

Even with that unlikely soft-landing, it was not a good time to be invested in Alberta real estate: if you had bought in the few years before 2008 without much of a downpayment, you’d still be underwater now; those who chose to rent can be proud of that decision. The soft-landing, also known as correction by stagnation, will likely continue for a few more years yet while fundamentals creep their way upwards to meet the nominal prices.

And so it is in Toronto: though they didn’t explicitly say so, Scotia implied a forecast of 9 years of stagnation ahead by comparing the previous two corrections in the city. Plug that in to the rent vs buy calculator and you’ll almost certainly decide to rent, yet this is a report that is more positive than many out there right now.

There are some readvancable mortgages that are sometimes billed as all-in-one accounts at a few different institutions. The way they work is to basically pull together your mortgage, line of credit, savings, and chequing accounts into one product. The stated benefit is that your emergency fund and cash float from your savings and chequing accounts will be used to pay down the mortgage, but are still available for your use as needed.

All else being equal, this would be a great idea, and indeed recently Nelson at Financial Uproar had a post covering them.

The problem though is that these products usually come with a higher interest rate than you could get on a plain vanilla mortgage, about 0.5-1% more. So does the benefit of having your whole float working on your mortgage balance outweigh the extra cost of the higher interest rate? Like many things, the answer is it depends… but mostly, no.

You can grab a spreadsheet and play along at home with the full calculations if you like, but for once I’m just going to back-of-the-envelope it. There will be some minor effects from the compounding, but not enough to really worry about.

So let’s say you’re a fairly typical recent homeowner: you bought a few years ago, and just recently crossed over into having enough equity to try out this scheme. You’ve got $10k in your emergency fund, and your chequing account balance varies through the month depending on the timing of your bills and payroll deposits, but is on average about $3k. So you could potentially put an additional $13k towards your mortgage with this plan. If you’ve got $400k left on your mortgage, then the amount of interest you’d pay in a year would be $12k at 3%. With the new plan, you’d only be paying interest on $387k, but at the higher rate of 3.5%, which would cost you $13.5k. So the higher interest rate makes it a fair bit more expensive to go with this plan (and any impact of compounding would be balanced by the interest the cash would be generating in a savings account).

If you have more in cash and less owing on your house, it may look better: with $20k in cash and only $100k owing on the mortgage, you’d be paying $3k in interest the traditional way, versus $2.8k for the all-in-one. Still, you need almost absurd amounts of cash compared to the mortgage balance for it to work out.

Plus, with just a little bit of effort on your part, you could in those situations do even better with separate accounts: you can get a regular mortgage at the lower rate, put all of that cash on the mortgage, and open a separate HELOC to get the flexibility to re-withdraw your emergency fund if and when needed. All the money goes on the mortgage at the lower rate — you can even put your chequing account float on the mortgage and use the HELOC for the revolving cash needs (which sounds scary, but is functionally exactly what is happening with the all-in-one products).

Reader Rhea, from Seattle writes in:

We have a rental property in what was supposed to be an up-and-coming neighborhood near Downtown Seattle. We lived there for 2 years and loved it. It is on the top floor of what was a new condo (now 7 years old), and has amazing views of the water, mountains, and downtown. We paid $275,000 7 years ago. Then we moved and bought a house and rented it out for 4 years for $1500/mo. That tenant left and we tried to find another renter, but had a hard time at that price point, eventually renting it out for $1300. We pay about $2100/mo including HOD’s. We got into a bad mortgage deal, as was typical at the time. Zero down/Interest Only.

All condo sales in the building have been short sales, and estimation of condo [market value] is around 200k. Question is, do we re-finance, which would cost us 125k to get mortgage down an amount which renters would cover. Or short sell it?

Hi Rhea, thanks for the question.

I’ll start with a question of my own: why did you hold on to the condo after you bought a house? Is it because you planned on moving back in later, or because you loved the idea of becoming landlords, or was it purely an investment motivation?

The fact is, as an investment, the condo turned out to be a poor one. You’ve lost money on it, and the thing to realize is that the money is gone and you can’t get it back. You can realize the loss bit by bit as the rent falls short of the monthly costs, or you can face the loss all at once by paying down the mortgage deficiency now or doing a short sale, but no matter how you slice it, it’s not coming back.

With that realization, the most important thing to consider for your decision of what to do in the future is your motivation for holding on to this condo. If you just love being a landlord and would do it even if you had to pay for the privilege, just so you could speak with tenants and help put roofs over their heads, or if you plan on moving back in to this specific unit in the next few years, then one of the options for continuing to hold on to it would best suit you. If you don’t love being a landlord, and were just looking for an investment, then you might want to think about just taking your losses and selling it.

At a current value of $200,000 and current rent of $1300/mo, your price-to-rent is 154X, which is in the roughly break-even range. Continuing to hold it shouldn’t hurt you further (at least not much), but it’s still not a very good investment. If you can get the rent back up to $1500/mo (while still maintaining good tenant quality and low vacancy) then it might be worth holding on to, with a price-to-rent of 133X, but it’s still not a stellar investment, especially if you find being a landlord to be a time-sucking chore (and the time commitment will only get worse as your unit approaches 10 years of age and starts to need more maintenance and appliance replacements).

So ask yourself whether you have a good non-investment reason for holding on to the condo, and if you don’t, then speak to a real estate broker about selling it. If you do still want to hold on to it even if it isn’t a good investment, and if you have the cash available to pay down the mortgage and refinance, then speak to a mortgage broker or your bank about your refinancing options.

For my Canadian readers (which I thought was all of you — no idea where Rhea came from!) this is an example of “speculative holding.” Rhea didn’t buy her condo with the intention of being a real estate speculator, nor the house that followed… but instead of selling the condo to buy the house, she held on to rent it out. Thankfully no one I know in person has become a speculative holder, but I’ve seen them around the various personal finance fora, choosing to borrow against the starter home to buy the second and then rent it out, rather than sell to move up… becoming real estate speculators in the process. This is a kind of phantom speculative demand: you don’t see them lining up in the cold, clamouring to buy pre-construction, and they’re not at any point applying for an investment mortgage, but the speculative holding has the same effect on the market… and on the speculators themselves.

Not to pick on Rhea, but in this particular case it was egregious speculation: with an interest-only mortgage if it’s cash flow negative you should know immediately something is going wrong. With an amortized mortgage if you’re not very good at math, it’s easy to fool yourself that you’re at least “building equity” while being “a little” cash-flow negative.

I’ve been scratching my head about the BMO special since the first iteration in January.

It’s puzzling because it seems so unprecedented: I can’t recall the banks openly competing on price this much before. I can think of a few reasons for it, but those don’t give me much comfort in the motives:

1. BMO is willing to trade margin for marketshare. This could work long-term for them, since many of these customers will renew in 5 years with BMO at higher spreads, but aggressive banks aren’t comforting. There’s a reason we like to comfort ourselves with the image of the conservative Canadian bank. There are news reports that BMO has been losing market share, which could explain this push to take it back, but desperation is no better a trait than aggression in a bank.

2. It’s about funnelling people into fixed rates. The 2.99% special is a lower rate than their (posted) variable-rate mortgage, and only a few basis points above a discounted variable. Maybe they saw something they didn’t like about Canadians’ abilities to handle future rate increases on variables, and BMO is trying to stabilize the portfolio at the expense of margins and shaking up the market. On the one hand, that could be seen as being relatively comforting: distressing that they got worried, but comforting that they’re taking steps to mitigate risk to rate changes. On the other hand, the fixed rate funnel also means that they have now lowered the qualifying rate from ~5.5% to ~3%, and if they needed to take that step to get people to qualify, I quake in fear. OTOH, the 25-year amortization suggests they’re not trying to scrape the bottom of the barrel.

3. It’s about the lack of features. Combined with #1 (adding business down the road), the lack of prepayment means people won’t take as much advantage of the low rates to pay down principal, so upon renewal they’ll get a larger mortgage (or more certainty of that larger mortgage) at the new rate.

On a systematic level, I don’t know what to make of this policy. It could help stabilize the housing market, or contribute to the last hurrah of getting marginal buyers in. For BMO, it could be a shrewd long-term move, or an act of discounting desperation. It’s a puzzler.

One meme out there regarding the housing bubble is that today’s price doesn’t matter because immigrants are going to create so much demand that they’ll support the market. “Toronto has X thousand immigrants. Every year.” To paraphrase & combine a few examples. Thing is, you can’t look at immigration in a vacuum. Ben Rabidoux must be seeing the same chatter, since he also just had a post on population growth.

Consider my shower. Let’s say I just bought the AwesomeSauceâ„¢ 8-head shower system, capable of spraying out an amazing 23 litres of skin-scorching hot water a minute. I clamber on in there, intent on scrubbing away the shame of being a renter.

How long before I flood my house?

You can’t answer because that’s just one part of the problem, on the other side is my drain, taking away the influx.

So for immigration, part of that is just offsetting the natural population decline in the country. The net national growth rate is just a touch over 1%. It’s higher in Toronto and Vancouver, but still just about 2%. For comparison, the US growth rate is about 0.8%, and was running neck-and-neck with Canada over the last decade. Ben has some charts showing how much higher it was in some states that boomed and busted.

Ok, 2% growth per year every year is a fair bit of growth: enough to over-power infrastructure and public transit and the like over time. Toronto is full and getting even more crowded. But is that demand driving housing prices, and will it continue to drive housing prices? How can we consider other metrics in the face of the unstoppable immigration tidal wave?

Another important factor to consider is the ownership rate: in 10 years we went from something like a 65% ownership rate to 70% nationally. That seems like a trivial change: half a percent a year. Let’s try to put that ownership rate change in perspective with population growth to get an idea of some of the trends driving housing:

In the GTA, with all that immigration, we went from 5 million people to 6 million in 10 years. That’s something like 650k-700k new owners created by immigration/population growth (households would be lower by some factor like 2.4X, and about 300k of the newcomers would be renters). We also created 250-300k new owners by increasing the ownership rate. And that’s if you are conservative and assume that the increase in the ownership rate in a boom town is the same as it is nationally.

To get to my point: there’s a limit to how much that ownership rate can be increased. There’s a hard limit of 100%, but even below that, there will be some portion of the population that just isn’t going to buy. Even if we don’t reverse course and bring it back down to 65% — just stay here at 70% — that has consequences. Over the last 10 years, demand has been 40% higher than it “should” have been because of the expanding ownership proportion. We had ~1M (or likely more) new owners in the GTA rather than ~700k expected from population growth alone. If the next 10 years features a reversal of that trend — owners becoming renters again, or the average age of owning pushing back a few years — then demand could swing from 1M/decade to 400k/decade, or a 60% drop. Even just stopping the process of borrowing future demand and hitting a plateau represents a 30% decline in demand from the current run rate.

What will that do to prices? To be fair to my point above about looking at both sides, you have to know what the supply situation will be like. But everything suggests supply will stay robust.

Unfortunately like many other pieces of the puzzle, there’s no timing information with this one: though the US topped out at 70% homeownership, that’s not to say that Canada can’t keep going for 75% in the next decade, or 80% in the one after that. But the seemingly small change in this number represents a very meaningful slice of demand, so it’s important to understand — doubly so because it’s a factor that has changed over time, whereas population growth and immigration have been steady for much more than just the last 10 years.