Blessed by the Potato

Clarke’s third law:

Any sufficiently advanced technology is indistinguishable from magic.

Potato’s Third Law (of Finance):

Any sufficiently complicated analysis is indistinguishable from magic.

A few months ago, Brad Lamb posted this inane thing, suggesting that buying real estate in a highly leveraged way beat out investing in any kind of normal way because, with an average 5.5% return over 30 years and lots of leverage, you’d make scads and scads of money. Of course, that’s clearly a biased and overly simplistic analysis from a source that is, well, you get it. For instance, one important consideration in using massive amounts of leverage (95% in his example) is the cost to borrow. And if you look it up, over those same years the (simple) average mortgage rate was 9% — blowing the 5.5% appreciation out of the water.

Obviously there are lot more factors at play than just appreciation, but many people will have trouble following the red lady as these condo kings play their three-card Monte.

Similarly, Melissa Leong recently wrote about Sean Cooper‘s quest to save at an incredible rate and pay off his mortgage crazy early. While her article was very fair and level-headed, someone at the National Post decided to put this sensationalist caption to the preview: “Sean Cooper’s secret: He rents main floor of his house, while living in the basement and bikes and uses TTC instead of a car.” [emphasis mine]. While only part of the numbers are shown, if you work the math and make reasonable assumptions you get a fairly unsurprising result: he ends up paying about $800-1000/mo to live in the basement of his house. Which is what a basement apartment including utilities costs in that part of Toronto. Renting out the main floor of his house is no secret at all — the progress he’s making is solely due to the other insanely frugal and hard-working things he does, like biking everywhere and avoiding taxis or car ownership, working multiple jobs 7 days a week, and reusing everything to the maximum. The fact that he’s renting out part of his house is pretty much irrelevant to the story, but it looks like magic because it’s complicated and because for some reason being a landlord is high-status. Indeed, given the timeframes he’s been working under, he would have done much better doing all the hard working and frugal things he’s doing but plowing his money into index funds.

When there are a lot of factors in the analysis people just don’t want to deal with it. It all bleeds together and acts just like magic, so it becomes hard to critically assess what’s being presented. This happens a bit with a few topics in finance like investing, but it seems to be most prevalent — and most exploited — in real estate.

Take for example the terrible condo ads around Toronto that should be banned for what they try to get away with in the condos=magic department. Here’s a recent collection tweeted by Ben Rabidoux:

Four condo ads I just sent @preetbanerjee. Now tell me local, amateur investors aren't driving this market pic.twitter.com/bKW0HxwXLL

— Ben Rabidoux (@BenRabidoux) September 16, 2014

To pick one, the Thompson Residences in case you can’t read the image, it claims an 18.6% return on investment (such precision!) with no attempt to back it up (the fine text the asterisk leads you towards just says something about the parties not warranting or representing any of the figures). Another (Axiom) also claims 18.6% returns (they must have done some market research to show that this completely made-up number has some truthiness and feels more correct and gets people to buy than some other random number), this time on the unlevered condo. Of course they don’t provide the full details, just assuming that you’ll rent the place for $2355/mo (such precision — also that gets you a 3-bedroom detached house in many parts of Toronto, but sure, let’s just go along and assume a 1-bedroom downtown-ish is worth that because… George Brown?), and somehow make $685 in positive cashflow and $607 in principal repayment. So after interest (at just 3%) you’ll only have $227/mo for tax, maintenance, insurance, and condo fees (yes, that’s totally reasonable — oh wait, no maintenance fees for a year, of course that’s a representative calculation then). But then you take those phoney rent profits and add it to their phoney price gains ($58,993 — yes, also down to the dollar) and you know what you get? 17.8%. Not 18.6% like they say.

Clearly these ads are not targeted at the careful, numerate buyer — they can’t even be bothered to make their fake numbers internally consistent.

Where was I? Right, magic. Well, there’s clearly some smoke and mirrors going on in those ads.

I didn’t like the recent MoneySense tale of a capitulating bear in Toronto. It had some good stuff in there, but it was sandwiched by some awful thinking that does the readers a disservice.

Sandi picked up on one good bit: “It’s a purchase—it’s what I’ve been saving my money for.” While I do harp a lot on the insane costs and the importance of making a good comparison to renting, the purpose of that comparison is to make an informed choice of how to best spend your money for you. Many people are willing to spend more to own for the “pride of ownership” (me? Well, given how awesome this house is and the services our landlords provide, as well as seeing the risks inherent to owning, I would need a discount to owning to take the plunge). But how much more is always the question. So you do your comparison and you may say “meh, an extra $2k per year plus so much extra risk, that’s worth it to us.” Of course for many in Toronto and Vancouver, after running some scenarios it may be more like “Fuckity-buckity! It costs how much more to own?” So he said that money is for spending (which it is), and that his house is not an investment (which I suppose it’s not), but then never really clarified for readers how much more he was looking at or that it was a trade-off he was willing to make because yearly beach vacations are dumb and bad and nobody likes them anyway.

He does do a number of things right: he checks to see if his budget can handle an increase in rates; that he can survive a decent 20% correction and still stay above water in case he needs to move; he acknowledges that prices may fall and is not buying with visions of future gains in his eyes; and he’s not planning to move for a long time (though as a snarky aside, the assumption that he’s not planning to sell for at least 20 years may be a bit optimistic for someone in the magazine industry…).

However, the article also uses some seriously specious reasoning which brackets that good stuff. The worst was right up front:

“The reason is simple: I want to eventually retire with a paid-off house, and I was running out of time.”

There are many paths between not having a paid-off house today, and having a paid-off one in retirement (and that is not even commenting on the goal itself). For example, you can rent your larger family home right up until the day you retire — investing the difference the whole time — and then buy your retirement pad (which may be a downsizer from your working/family life place you rented) all in cash. Boom, paid off in one day and saved one round of transaction fees too. At no point does a mortgage have to come into it. Indeed, given the basic affordability issues he talked about in the preceding paragraph, the last way to get to a paid-off house in retirement should be to buy one now. The last part of that statement also makes no sense: there is no time limit, other than actually entering retirement. You don’t get to having a paid-off retirement pad any more surely from paying off a mortgage on a too-costly house at a young age than you do from renting and saving.

Let’s replace “house” with some other thing that isn’t so loaded and traditionally linked with a mortgage and the point should be clearer: “I want to eventually retire with a paid-off boat.” Well now it’s clearer: you could buy a boat now with a boat loan and pay it down, or you could rent a boat, save up, and buy one with cash when appropriate. That makes even more sense if you think there’s a good chance boats might be 20% cheaper in the future and that renting is less expensive for now — how does buying now make sense if your goal is to have one at some point before retirement? If there was a big boat sale on then maybe it would make sense to take the plunge and get a loan if you needed to. Instead, it looks like many buyers these days are getting suckered by the no interest until 2018 promotional event.

This whole “running out of time” thing reminds me of the Stockdale Paradox*: James Stockdale was in a POW camp in the Vietnam war for almost 8 years. When asked about his coping strategy, he said:

“I never lost faith in the end of the story, I never doubted not only that I would get out, but also that I would prevail in the end…”

When asked who didn’t make it out of Vietnam, Stockdale replied: “Oh, that’s easy, the optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.”

The paradox is that you have to believe in the fundamentals, that sanity will return. Trust the math, trust the logic, and trust that you will prevail in the end, but do not be too optimistic — the unrealistic hope for short-term salvation that is dashed again and again will wear you down and end you over time. You need to live in the gritty reality we face. When the bubble first started becoming a “popular” concern around 2008, some were calling for corrections to be as fast or faster than the US, especially given that we had the opportunity of witnessing their meltdown as a kind of sneak preview. I always figured it would be a slow, grinding process — but even I have been greatly surprised by how long the insanity has gone on for, originally pegging 2012 as the timeframe to be prepared to wait (4-5 years). The differences between the US and Canada that people loved to point out (such as how subprime lending was arranged, or non-recourse states) were largely differences of accelerating factors. It would make a Canadian implosion a painful, drawn-out affair compared to the US’s relatively fast (but still multi-year) implosion, but did not immunize us from a bubble.

Christmas has come and gone, and Easter too, but that does not mean that prices will continue to grow at triple the rate of inflation forever until only the Pentaverate** can buy in Toronto.

That’s why I focus so much on the price:rent metric and rent-vs-buy comparison: you have to live somewhere, so you may as well settle in somewhere nice because it’s gonna be a while. Even after the crash, it’s likely that there will be an undershoot in prices that will last for years, so you’ll have plenty of time to dance out of a stock portfolio. Of course you invest it.

Anyway, back to the MoneySense article at hand and the other half of the bracket — the conclusion:

“So do I feel like I got a good deal on my house? Not at all. By historical measures, I overpaid by quite a bit. But it was either that or no house at all…”

Either that or no house at all? That’s a false dichotomy. A really obviously bad one at that. Where has he been living until today? Is this another instance of the implicit assumption that if you don’t own you must be homeless, that renting is somehow equivalent to cowering under a sheet of cardboard? For such a massive purchase and component of the typical household budget, there is a surprising degree of reliance on memes, mantras, tradition, false dichotomies, and surface analysis. A bubble is as much about belief and memes as it is about interest rates, new developments, and price momentum. To see it as the conclusion in MoneySense by a self-described happy renter was infuriating. This isn’t “native advertising” in the Sun saying that, this is the concluding remark from the MoneySense editor-in-chief, and it just washes away all that good stuff about considering risks that came right above it.

Ugh.

Update/clarification from G+: in the article I’m not trying to slam the individual choice he made (the outcome). It’s not the choice I made, it may be sub-optimal, but he’s done his risk assessment and whatever, that’s his choice. So it’s all good there in the middle “here’s my choice, I’ve got my eyes open, and I’m prepared to deal with the consequences.” What set me off was that the good part is undermined by bracketing it in with things that basically say “and I had no choice whatsoever and was forced to do this.” Which just kind of blew the top off Mt. St. Potato, because I know people who would see that as being just as good as “rent is throwing your money away” or whatever. All the careful risk stuff sounds like an unnecessary aside when it’s the only choice there is anyway.

* – Hat-tip to Brooklin Investor for reminding me of this tale at precisely the right time for this rant.
** – The Queen, the Vatican, the Gettys, the Rothschilds, and Colonel Sanders before he went tits-up.

I’ve done a lot of things I’m proud of. I think the rent-vs-buy spreadsheet has to feature somewhere near the top of that list (at least if we limit the discussion to things I’ve done for personal finance). It’s the only such calculator to let you include the risk of future rate increases, and includes many important factors without completely blowing the whole thing open to the maze of apples-to-basement-suite type comparisons. Rather than starting blank or with valuations that may have been relevant in 1995, it’s prepopulated with recent data from Toronto (and every 6 months or so I even update the interest rate projections based on what’s available in the mortgage market). Moreover because it’s a spreadsheet you can check the math (or tweak it to do an apples-to-basement-suite comparison) if you so choose.

Really the only drawback is that it’s a spreadsheet rather than a flashy widget (and I keep meaning to get around to learning how to code those but it’s just too big a time commitment for me now), which seems to hurt its popularity. Because other rent-vs-buy calculators are still popular, let’s take a tour through the options.

New York Times: The NYT calculator was updated recently. It takes a neat approach in that instead of getting you to tell it what the cost of rent is, it computes what the equivalent breakeven rent would, and leaves it up to you: “if you can rent for less than this, then rent.” It also has itty-bitty graphs that show you the sensitivity of the outcome to each factor. Now, I prefer my approach because it’s clearer what the magnitude of that is. Maybe you can rent for less, but if it only works out to $10k more over 10 years, maybe “pride of ownership” is worth that. Or maybe the difference merely looks small when expressed in monthly terms: if NYT says to rent below $2500/mo and you find a place for $2000, maybe that sounds like it’s close enough to break-even that you’ll just buy. But if you saw how quickly that difference compounds into hundreds of thousands of dollars, maybe your decision would be different. There’s no way in the current NYT calculator to enter your market rent to make a comparison.

My main beef with the NYT calculator is that you have to tweak it for Canadians in really non-intuitive ways. The big change is that you have to set your tax rate to zero — in the calculator it’s not the investments that are being taxed, but that Americans get a tax deduction for mortgage interest. I think the NYT one is the most-recommended one out there. Even Rob Carrick recommends it on a regular basis, which stings because the refinements to my calculator came about through discussions on his facebook page. Rob Carrick why don’t you love me??? Ahem. Anyway, it’s not bad — actually rather good if you’re American — it’s just that the link doesn’t usually come with the appropriate Canadian conversion kit, and there are Canadian calculators [waves] available.

Getsmarteraboutmoney: This one IS BROKEN. Stop sending people to it. I talked about the “wonky” results back in December, and emailed them about it as well. They acknowledged the problem back in March and said they would fix it soon. Well, it’s still broken and there isn’t even a notice on the webpage about it or anything. The main problems are that it always sells in year 30, so you can’t compare other holding periods (even though the graph visually implies that it is looking at break-even times), but the larger error is that it does not compound the differences in cashflow between the renting and buying option. That can really skew the difference between the options over a long time period. Otherwise it is flashy and pretty and has sliders for all the right things, so it should be good to go in a couple of years when they finally fix the back-end calculations. Of course, that just makes the math errors that much more tragic because it looks like it should be fancy and trustworthy.

RBC: To be clear, they call it a “rent or buy calculator,” not me. It is simply not a calculator to compare the two options. The only inputs are how much you pay in rent, what interest rates are, and how long you want your amortization period to be. Then it tells you how much house you could buy with a mortgage payment “equivalent” to your rent — note that it ignores tax and maintenance and opportunity cost and insur– just all the costs. Every ownership cost you can think of, it is ignored. I’m hoping it ranks so highly in Google because they bribed someone and not because people are actually linking to that POS.

In fact as a short-cut, if a rent-vs-buy calculator doesn’t have an input for your investment return as a renter, just throw it away. It’s likely missing a number of other important factors for the decision. Naturally, Genworth’s is similarly biased, as are most of the other big bank ones. CIBC’s is not that bad, but it does miss transaction costs and insurance. Its rates of return for a renter’s investment and the house are are unhelpfully labelled “market appreciation” and “rate of return” — you tell me which is which.

First Foundation: They recently launched their suite of calculators, including a rent-vs-buy calculator. It seems to do all the calculations properly and includes the most relevant factors. I could nitpick and add the ability to include future rate increases or whatever, or to start with all three tabs open, but the only real criticism I have of it is that the default for maintenance is zero rather than some wrong-but-better-than-zero approximate number. Also, the property taxes are annual while the maintenance is monthly. It’s explained in the tooltip, but the average user buzzing through it might get wonky results before realizing the problem. It’s not mine, and I can quibble, but the math checks out and it includes the important factors others often miss — First Foundation gets the nod.

Money Geek: I opened it up and I was like “nnnnnnuuugggggghhhhhhhh…” as my brain started to overload. This must be how other people feel when they open one of my ridiculously overly detailed spreadsheets. I can’t actually evaluate it because it only works in the bleeding-edge versions of Excel. But it’s there if you can get past that technical challenge.

Yahoo Finance: I’ve seen this exact one around on other sites, so it must be a licensed calculator/widget. Anyway, all the tax issues of being American, without the benefit of sensible defaults (0% selling cost yet 5% house appreciation?). It’s also a little odd in that it subtracts the opportunity cost of investing the down-payment from the owner’s side rather than adding the value to the renter’s side — I haven’t thoroughly tested it to see if that still gives the correct results but a spot test looked in the ballpark.

While there may be great disagreement over whether a crash is coming, most people can agree that

1) this past decade has seen an incredible increase in real estate prices
2) that this rate of growth cannot continue forever

The issue is that the ultimate barrier and outcome is not so clear. Some think prices could continue at high-single-digits growth until Toronto is approximately as expensive as London or Tokyo (or Vancouver!). Others (such as myself) don’t think Toronto incomes can support that level — indeed, there is a question as to whether the current level can be sustained.

The Toronto market has started to segment in the past few years: condo price appreciation has moderated, while detached houses have gone on a tear (especially those under the new $1M CMHC cap). In the last post I was trying to figure out whether there were enough rich people to support the current prices — if we had already crossed the point where a soft landing is impossible. If price increases do abate, but the levels stay this high relative to incomes and rents (a soft landing), then houses will continue to turn over year after year like this — are there enough households rich enough to keep buying for decades to come in a soft landing? I have my doubts, and tried to put some math to it.

I think it’s getting close to the breaking point if it’s not already past it. Note that there is nothing stopping the market from running well past the point of sustainability — just that once it does a soft landing is nigh impossible to pull off.

I normally like to look at the housing market from the bottom-up using a rent-vs-buy analysis. After all, you have to live somewhere and that’s the key to deciding what to do with your own life — the macro stuff will work itself out eventually over many years. I still like reading and thinking about the macro stuff, it just wasn’t really my area of expertise for analysis and Ben Rabidoux used to post a lot about it. But he’s not posting any more so screw it, let’s have a look at the Toronto market with some Fermi-esque math.

In 2013 the overall average price of a detached house in Toronto (416) was $842k; 11.4k such houses traded hands, according to TREB. Some of those would have been $500k crack shacks, while others would have been multimillion dollar mansions bringing the average up. TREB doesn’t publish median figures. Up in subwayville/North York a “normal” house runs for about $700k so let’s take that as a reasonable average for the city based on those numbers.

How much income do you need to carry a $700k house in Toronto?

Property tax would be about $5,600/yr.
The mortgage, if you want to use 4.5% to give yourself a small buffer against increasing rates, and assuming 20% down, would run $37,356/yr.
Utilities, insurance, maintenance, etc. we can ballpark at $10,000/yr.
Rough total with these minor contingencies/conservative estimates: $46k/yr.

Assume that the owners of such lavish mansions have other things to spend their money on (cars, daycare, hot yoga, Muskoka cottage, pusateri’s, retirement savings) so they want to limit their spending on shelter to something reasonable like 45% of their pre-tax income. That means they need to make over $100k to afford a house at this level. At least. Of the roughly one million households in Toronto, fewer than 120,000 180,000 290,000 of them have household incomes over $100k. How many houses are there to buy at those prices? If the average detached house turns over every 10 years, then there are only 110k or so.

That doesn’t look so bad: as long as everyone who has the income to do so is behind the current prices and willing to ignore traditional affordability rules-of-thumb (forever), they can be sustained.

Except that about a third as many semi-detached houses traded hands last year at an average price exceeding $600k, so we’re looking at at least another 1,000 sales and 10,000 units or so of semi-detached houses over our $700k threshold. A quick scan of MLS also tells us that there are still a few thousand units that cross our $700k level, even though condos may have an average price of less than half the detached/semidetached class. That’s another 15,000 or so rich families we need to be committed to the expensive property cause, getting us well within the error bars of the total number of rich people available.

Looking closer at that estimate of detached houses, it comes out kinda low — mining the StatsCan data suggests that there are closer to 300k detached houses in Toronto [edit: or if you have the power of Ben Rabidoux to find the correct table rather than subtracting others, you can say it is precisely 275,015].

I’ve heard the argument more and more lately that the housing bubble is just a new reality in Toronto: the days of an average or middle-class family owning a detached house — even in the burbs near the subway — are over, and such things are only for the rich. Condo living or extreme commuting are the new normal. Except current prices are so insanely high we don’t even have enough rich people for that narrative to make sense.

Toronto’s going to run out of rich people before all the houses can turn over. Fixing the income numbers, I can’t say definitively that Toronto doesn’t have enough rich people to support the house prices any more, but we’re still cutting it kind of close. The question circles us back to many people needing to commit to stretched affordability to keep the prices up, and with prices increasing every year how stretched can affordability get before it all falls apart? Unfortunately that’s been a question for a few years running now, and kind of depends on how insane people are willing to let things get. The longer interest rates stay low, the more willing people are to stretch every last dollar and throw out their contingency for rate increases. So the median detached house price is right now $700k. At what point does it rise enough that the question I raised here does become an issue — when is affordability stretched so much that there aren’t enough rich for all the houses? Maybe when the median price hits $875k, another 25% increase from here? So like, 2 years at current price increases?

[Edit: I had a report that put the percentage of households with incomes over $100k at 18%, and I had the total number of households as about a million. In the original post I multiplied those out to get 120k, failing once again at simple math. That report was based on 2005 data, I’ve since been informed the 2011 census figure is 26% of 1.1M households.]