Blessed by the Potato

In today’s post at TRB David Fleming casually mentioned visiting National Trust as a kid. I had an account there too when I was younger, so it brought back some memories. I decided to dig up some historical statements for National Trust (which was taken over by Scotia in 1997).

The late 80’s were a wild time for Toronto real estate. National Trust, despite the name, was heavily concentrated in Ontario: about 75% of its business was there, with about 25% in Toronto alone. From ’87 to ’88, mortgage growth for NT was 13%, then 18% the year after, and another 9.8% into 1990 (as things were peaking in TO). Return on equity was 13.8%, 12.9%, and 13.4%. The provision for loan losses was peanuts in ’87, and they actually wrote some loans back up (a negative provision) in ’88. In ’89 the provision for loan losses was 3.4 basis points (0.034%) of the mortgage portfolio.

By 1992 the mortgage portfolio was shrinking, with provisions for loan losses at 85 basis points. Return on equity was down to 5.5%, and they had laid off 12% of their employees (by the time Scotia took them over, 25% of those who worked there in the 1989 peak were out of work).

I’ve made my bear case on real estate so many times I don’t want to go too crazy here. But this week I was once again hearing the meme that Canadian banks are invincible, that real estate will never correct and even if it does it won’t hurt them. National Trust came out more-or-less unscathed from the 1989 Toronto crash, and the dividend was never cut (though it also never increased from 1990 on). However, if you were a buyer in the late ’80s I’m not sure you’d be happy with the performance through the next half decade.

I’ve written many times before about how basement suites (BS) are not magical. They are a way to live in less space, in what becomes a non-detached house, with an option to take it over and make a SFH detached again. However, if the rental market in general is crazy, the added costs of a basement suite generally is, too.

Well MoneySense recently featured a very short article touting how a BS could help a Vancouver couple become mortgage-free faster. Unfortunately given the length, they didn’t examine any of the underlying assumptions.

The assumption was that they could renovate their house for $75,000 to create a two-bedroom BS, which would then rent for the princely sum of $1800/mo. There are no additional costs with this rent — which either means they had an even higher gross rent, or neglected the added costs entirely.

So, reality check time, how might this actually play out?

Firstly, $1800 sounds really steep for a basement suite. I know Vancouver is a bit pricier than Toronto, but really. So I did some checking on Craigslist. I found one outlier basement suite at $2495/mo, one at $2150/mo, a small handful at $2000/mo, and then just 10 starting at $1800 — so that might be possible for them, but it’s at the very upper end of the basement suite market (and at that price point I can see they are competing with a number of above-ground units or exceptionally large basement units). Even at $1700 many of the suites were above-ground or fully furnished. $1650 seems to be a more reasonable rent expectation.

And that is not going to come free. In addition to the effort and loss of privacy (which we won’t slap a price tag on), they’ll have increased utilities usage¹ and likely a higher insurance premium. Let’s call that $50/mo. So they’re now bringing in $1600/mo.

But they’re going to have some other expenses to account for, like vacancy and maintenance. Let’s be generous and assume the unit turns over every four years, with just a month of vacancy and a quick paint, patch, and appliance tune-up of $3000. Now they’re down to netting an average of $1500/mo. On which they have to pay some tax — sure, they’ll have some interest and property tax to write-off, but even figuring on 4% of the $75k invested, if they’re in the 40% tax bracket their after-tax amount to help pay down the dreaded mortgage is just $9k/yr.

Bring that figure back to the mortgage calculator and their mortgage-free date goes from age 68 to… 68. Yep, taking all that risk, living first in a construction zone and then with lowly basement-dweller renter scum beneath their feet will likely leave them paying off the mortgage on the very same date as if they had done nothing. To be fair, that’s using a 5% mortgage rate as in the article. If their base case is topping up a (today’s) realistic 3% mortgage to the same $3k/mo as used in the article, then they’d be done at 67.7 in the base-case payoff, and 67.5 in the rental suite case — ahead by two months.

Not examined in the article is the other alternative: downsize. If all they need/want is the space in the upper unit, and obviously don’t mind sharing walls, then they could move to a townhouse (or rent or move out of the GVA entirely) and move their mortgage pay-off day to right now.

1. Contrary to stereotypes, basement-dwellers² do shower, which adds to the water and water heater (whether gas or electric) bill. Plus the other incremental utility usage.
2. Again, 96% of my readership, so no offense intended in tackling these persistent stereotypes head-on.

The Star featured a story last week of a family in a tight situation: they had bought a pre-construction house, which was delayed by several years and had shrunk from the sales model. They decided to cancel the deal and get their deposit back, which led to trouble of one sort.

And another.

The developer delayed for months on returning the deposit, which raises some interesting questions about the solvency and decency of Urbancorp. But as part of their complaint against the developer, the family claims that without the return of the deposit — a rather substantial $95,000 on a $850,000 house — they won’t be able to scrape together $5k for first and last on a rental.

It’s mind-boggling how an apparently well-to-do family with over a million dollars in real estate assets (between the pre-con house and existing condo), who were able to put down over a hundred grand on two places, doesn’t have an emergency fund of any kind — not even one month’s expenses.

Even if the pre-con house had been built according to plan and the original schedule, how were they going to close the sale with no assets? Where were their savings from living on a budget to prepare for the higher ongoing costs of the house? I could go on about this case, but that’s not what I’m here for today.

I don’t want to focus on their particular case: they were simply in no position to buy in the first place. It’s another Toronto family over-reaching for real estate.

Instead, I want to rant about the dangers of pre-construction. How most people are in no position to buy pre-con.

Lots of people made lots and lots of money in pre-construction in the early and middle phases of Toronto’s condo boom, without needing a lot of capital, effort, or smarts to do it. That’s helped create the widespread impression that pre-construction is a great, risk-free way to make lots of money — and developer advertising reinforces the investment message every chance it gets using dirty tactics that would not be legal in other investment industries like mutual funds or stocks.

Part of how these people made money was that pre-construction came with a discount to existing units — as David Fleming has most famously covered, that discount has been essentially non-existent for years. It’s supposed to compensate the investor for the risks and inconveniences of pre-con, so when it vanishes it indicates that the average pre-con buyer is not doing so from a detached, analytical investment perspective — or if they are, it’s from the footing of a speculator looking to boost the leverage used. The other big part that contributed to the profits reaching stupid levels is the use of leverage inherent to real estate and pre-con purchases (and again, the magnifying benefits of leverage are highly played up in developer ads).

However, leverage is risk and that cuts both ways. If things don’t go as hoped and there are problems, people buying pre-construction can face massive cash calls and losses. To try to protect the stability of our economy, development projects in Ontario must sell a certain percentage of units before they can get financing from banks to fund the construction. This helps provide the banks with a buffer so they won’t end up foreclosing on massive, empty towers that no one wants to buy in a few years’ time, leading to the collapse of the banking system. However, the pre-con purchasers then end up shouldering a lot of the risk for the project, risk they are by and large not equipped to evaluate or handle.

What are some of the worst-case scenarios with pre-con? Well, consider the case where you have done your due diligence on the builder perfectly, and they deliver a unit to you that looks exactly like the sales demo, exactly on the expected occupancy date (note: none of these things ever actually happen) — but the long-feared condo downturn actually appeared some time in the three and a half years between committing to the purchase and the completion of construction. Your unit is now worth 25% less than you thought, and because you haven’t been able to unload the place you were living at, the bank won’t give you a high-ratio mortgage. So you need to come up with ~30% of the original price to close.

Put some numbers to that: you like the looks of a $400k pre-con condo. You scrape together $40k as a deposit for pre-con, and plan to sell or refinance your existing place to free up another $40k upon completion so you can close. Instead, the market crashes and your pre-con is only worth $300k. The equity in your current place is gone, and the market is locked up so you couldn’t dump it even if you could stomach realizing the loss. The bank is only willing to lend against the current value ($300k) of the new place, but you’re contracted to pay the developer $400k for it. Somehow you have to come up with $60k just to get you back to even, and another $60k to get a mortgage on your second property — where are you going to get $120k from on what might be as little as a year’s notice?

Yes, it’s a rare event. But for many families, the low-but-not-zero likelihood events that can happen with pre-construction represent extinction-level events for their finances. Especially if they own two properties by buying pre-con before selling an existing place.

Pre-construction is too risky for most people out there who are doing it anyway — they are in no position to buy or to assume the risks that they are. It is not the everyday riskiness of the stock market, where there’s volatility and unpredictability and small losses all the time so you never forget it. It is the risk of rare events — the “black swan” — coupled with massive leverage that leads to what we term “blow-ups”.

IMHO, only accredited investors should be allowed to buy pre-construction in the province, or the rules should be changed to limit liability to the deposit. I’m a lefty protectionist bastard that way (and housing bear to boot), but an investment product that can lead to losses that are an order of magnitude higher than the deposits people are putting down (what they may naively assume is the limit of their liability) is one that should be most highly regulated. But that’s not going to happen, so instead here’s a short list of things to bear in mind with pre-construction:

1. 1. Pre-con should be cheaper than something you can live in (and inspect) today. This is to compensate you for the risks, the inconvenience, the uncertainty, and the time you have to wait. If there is no pre-con discount (and David Fleming has made the case that there is not in Toronto), then do not buy pre-con¹.
2. 2. The moment you lock in to the contract (which may be as many as 10 days after you sign if you have a cooling-off period), you are on the hook for the unit, at the price you agreed to. If you also have a current owned unit (house, etc.), you now have two units. Do you have pockets deep enough to own and maintain two units through thick and thin? If not, then do not buy pre-con; or sell your existing unit and rent it back (or rent something else) until your pre-con unit is done for safety.
3. 3. You will likely need liquid cash to close. If you do decide to ignore point #2 and hold two units, this is not the time to aggressively pay down your mortgage by making extra payments — you may need that liquidity, and you’ll need it most in the scenario where it becomes inaccessible as real estate equity (whether due to a down-turn in prices, tightened lending, or slowing in turnover in the market). That may mean losing out on interest rate differential by paying a 3% mortgage while holding cash that’s only earning 1% — it’s the cost of protecting yourself against a blow-up, and may serve as a reminder that you are in no position to buy pre-con.
4. 4. Do not do it by the skin of your teeth. There are many things that have to go right for pre-con to work out: if even in that scenario you would be stretching, just don’t do it. You will need big buffers and emergency funds for the rare cases where it does not at all go according to plan — and some buffer for the exceptionally common cases where it’s off by a bit. These include:
• a. The unit is not as advertised, or as polished as you expected, and you have to renovate your brand new unit in some way (e.g. refinishing floors, patching holes, replacing appliances, fixing plumbing issues). Do not count on help from Tarion.
• b. The unit is late. Late here is a relative word as no condo project in the history of the city has ever finished by the date on the sales office billboards.
• c. The unit cannot be flipped. So it’s no longer your bag, baby. Maybe in the 5 years you were waiting for your swanky 1-bedroom ultimate bachelor pad to be built you found a mate and spawned, and now live somewhere else. You want to flip upon completion — only to find that 42 other people in the building had the same idea. You’re going to have to either accept (and cover!) a loss to under-cut them all, or come up with the funds to close and rent it out for a year or two until the supply spike subsides and you can find a buyer — or carry it empty for months looking for buyers.
• d. There has been yet another tinkering in the mortgage market and the financing terms you were expecting when you signed the contract 5 years ago no longer apply. Now you need to come up with more money and/or pay a higher rate than you expected. Or the unit isn’t worth quite as much as you were hoping for when the appraiser is done and you have to cough up a larger down payment to close.
• e. Occupancy and carrying two units. Occupancy is a weird period in a new development. You have to pay monthly fees, but don’t really own the unit yet. You can live in it, but don’t want to because the rest of the building is still a construction nightmare. Add on illiquidity on one side or the other, and if you have two units you may have to be prepared to carry both of them for a time.

1. The bold statements here are for regular people who risk bankruptcy by placing leveraged bets on pre-con. Go ahead if you greatly resemble a land baron from Monopoly and are trying to spice things up with a bit of speculation.

As a housing bear I often get the recency bias retort: bulls rule, bears drool, look how much housing was up over the past few years; how can you even show your face after being “wrong” for so long?

Looking in the rearview mirror is not a good way to make decisions, and in cases where random chance has a large role, a particular outcome working out does not necessarily mean the course chosen was actually the best one. Today let’s just say “whatever” to all that logic. People like history and anecdotes so let’s take a look at how “wrong” renting turned out.

Yes, the past three years have been unbelievable for Toronto real estate. Absolutely blow-the-doors off amazing couple of years for detached houses (condos less so, but still), even the bulls didn’t see it coming that “good”. Low rates that got lower, bidding wars, HGTV and animal spirits. But you know what? It hasn’t exactly been terrible for the rent-and-invest-the-difference crowd, either: rent inflation was basically nothing, and the stock market was on fire. To take my case as an example, from late 2011 (when we last moved) to now, an equity index portfolio was up over 15%/yr, and actual rent inflation was 1.1%/yr. The average Toronto (416) detached house was up 9%/yr according to TREB figures, and that more-or-less meshes up with sales in the neighbourhood that we’ve been watching over the years.

While the rent vs buy calculator was built to look at the future based on estimated rates and figures, we can over-ride the future estimates in the calculations with the actual historical figures to see how the comparison played out. And as you might expect, buying a detached house would have been better in the recent past… but perhaps by less than you would think. In fact, if you had bought in 2011 and wanted to sell now to lock in the amazing gains you made over renting, you’d only come out with about twenty-two grand more^# in your pocket after the transaction costs despite seeing the sticker price on your house swell by $228,000. Still you may fairly say, that’s a win for detached houses.

What’s more amazing is how segmented the Toronto market has become and how dependent that result was on picking a detached house. If instead you had bought a semi-detached, townhouse, or condo^* — which about 65% of the people buying in the Toronto market did at the time — the equivalent renter would have come out ahead, despite the complete absence of a crash, correction, or soft landing. Far, far ahead in the case of the average condo buyer who only saw appreciation of 3.2% and would be likely to be facing a move after just 3-4 years.

Now, it’s just as unfair to put 15% in for stock returns going forward as it would be to put in 9% for house price appreciation — the future is looking much bleaker for both asset classes, and just given how much faster it moves we’ll likely see a stock market correction before a housing one (though we’ll also see the recovery first in equities). Using some reasonable estimates for what will come, it’s hard to make the case for owning unless you believe this incredible luck will strike twice. In beta right now, Preet has a new spreadsheet that will do a Monte Carlo simulation of multiple outcomes for the rent vs buy comparison in case you need a second opinion.

Looking back, I still think I made the right choice given what I knew at the time, and the situation looks even more skewed towards renting now so it’s nice to be able to stay put. And that opportunity cost came with a lot of convenience and freedom. So that makes it very easy to be comfortable staying with the choice to rent going forward, because I really don’t think we’re going to see another three years of 9% annual price growth in Toronto RE.

* – at the same price:rent and rent inflation, which is a bit harder to verify as I didn’t live it.
no marker – “good” in scarequotes because higher prices are not intrinsically good.
# – for clarity: the difference is relatively small because the renter also sees their net worth increase by over $150,000 through those amazing equity returns and the ongoing cost savings. [note added after publication]

In a shocking change from vague mumbles about concern over debt levels, the Bank of Canada broke out The Potato Gambit this week, explicitly saying that houses are over-valued and by how much.

I’ve said several times over the past few years* that the housing bubble is held up by a number of factors: belief that there isn’t a bubble being the main one. There are many possible ways for that belief to be tested and for the bubble to end. Having someone credible coming out clearly on the news stating that there is over-valuation could help end it overnight, as the veil is lifted from the eyes of the masses in one move. In other words, that it would be possible to talk the market down by pointing out that the emperor has no clothes, absent any other catalyst (despite the “need” for rates to rise, or unemployment to rise, or for the yield curve to invert, or CMHC to be reformed, or whatever other supposed necessary condition people come up with).

Stating how much housing was over-valued by was a key component of the gambit — the end of bubbles is always a nasty, drawn-out affair as the market gropes to find solid ground. Many houses will go unsold, their owners trapped as the market goes “no-bid” with people waiting to see where the bottom is, unsure if 10% off the last traded price is a good deal, or just the start of a more substantial correction. So, the theory went, if someone like the finance minister (or as it turned out, the BoC) stood up and said “the market is over-valued, and by this much” then people could bid 30% less, and sellers would know that indeed, that was not just some totally flaky buyer taking the piss but a legitimate post-correction offer that they should take. And the sellers won’t list just to see what they can get — if they’d rather hold than sell at those prices, then they can do that without all the listing and rejecting offers business, keeping inventory at normal levels. Boom, the correction could be over in a day.

All that has to happen is for all the buyers and some of the sellers to get with the program.

I know we’re only a few days into the new enlightened age, but it’s not looking good so far. The government is not presenting a united front, with Joe Oliver sticking to the old party line that there is no bubble. The media is not following-through on the gambit with the “so there, correct your bidding strategy now!” message, and headlines of “what a 30% correction means for your local town.” There are a few stories taking it seriously, but no real call to action. This article in the Globe has the headline “Why Canadians should consider Poloz’s overvalued housing warning “, which kind of starts to make the case that this is a real issue, but then it ends with “You can, of course, brush off such threats…” And I’m not seeing a massive shift in sentiment on the various forums or at a party this weekend — as credible as the Bank of Canada is, the message isn’t taking hold.

So maybe it will work if it can stay in the news cycle a little longer, but given that this is already the nadir of the market for housing activity, and the story may be forgotten come spring, it’s not looking good for the Potato gambit’s effectiveness. It was worth a shot.

* – Apparently mostly on forums, as I can’t find a post in my archives to link to, other than an unpublished draft.