Blessed by the Potato

In almost all of my rent-vs-buy comparisons I have the renters invest their capital and ongoing savings, including in my most recent one about the three year condo holding (Toronto Condos: Best Case Scenario). Note that the renters didn’t have to in that scenario: the buyers lost so much to frictional costs¹ and higher ongoing costs² in their short foray into condo life that the renters could have left their cash in a chequing account and still come out ahead. But I had them invest it anyway because that is what you’re supposed to do. It didn’t hurt that doing so helped hammer the point home, making the spread in outcomes so large that you could be especially generous to the buying case (e.g. assume they were prescient about their mortgage needs rather than acting like a typical buyer) and still conclude that renting for 3 years is hardly throwing your money away — it’s the opposite. But that’s not why I chose to: it’s my default recommendation and assumption.

On Twitter, @barrychoi questioned the assumption that the renters would invest their capital. I wondered why you wouldn’t, to which he replied: “for time purposes. Is it worth risking your money if you might need that cash soon?”

Here is the thing, “need” and “soon” mean different things when you’re talking about housing. There are a lot of rules of thumb out there, but the general idea is that equities are volatile, while providing high return expectations. So you should invest money for the long term in equities, but not money you might need in the short term because you could be hit with a market down-turn just as you’re about to take your money out and spend it. The rules of thumb say money you need in about 5 years, or 10 if you’re really conservative, should be in something safer.

This is trying to take a heuristic shortcut to risk tolerance, but risk tolerance is made up of many components. The ability to recover is a big part of it, and it’s closely related to the time you have on your hands, which is where these rules of thumb are derived from. They’re also influenced by the history of the stock market and how long it may take to recover from a typical crash. If your timeline is too short, you could get unlucky and be caught in a crash just as you need your money, and have to eat the loss.

But when you’re talking about buying a house your timeline is not generally short: in the example David Fleming provided that inspired the previous blog post, the couple had been in a condo for ~3 years, and was looking to rent a slightly larger condo for another year or two before buying. Close enough to the 5-year rule of thumb to go investing the capital. In general, at the very least you’ll be signing a lease for a year, with a likelihood of renewing and maybe even having another rental stage before ending in your “forever house.”

Even if you’re not a housing bear³ and are just renting for a few years to avoid the ruinous transaction fees or until your career settles down enough that you have some certainty you won’t be packing your bags for the other side of the continent, you’re going to have a few years to play with. Just because the rule-of-thumb is 5 years doesn’t mean you’re insane to invest with a planned 3 ahead of you. Because if you are unlucky, you don’t need to buy a house on August 15th, 2016 like your plan says — you won’t vanish into a cloud of pixie dust and parental disappointment if you still have a lease on Tuesday — you can chill and rent for a few more years if you need to. Plans can be fluid that way, and that kind of flexibility is what gives you the risk tolerance to invest in equities.

Your plans are not set in stone, and the ability to defer your purchase date adds to your risk tolerance.

Aside from not needing to buy on a certain date, you don’t need a specific, immutable downpayment. If you invest a $100k nest egg, you expect that, with a 6% return, you’ll have $126k after 4 years when it might be time to buy. It could be better than that⁴, or it could be worse; uncertainty is something to deal with rather than fear. If you are unlucky and in four year’s time there is a terrible correction and you’re down 25%, well, you just lost $25k and it stings, but it’s not going to ruin your life. You take the reasoned gamble that you’re more likely to be up money by investing in equities for the next few years — and that, in advance, you’re not sure whether “next few years” will turn out to be 3 or 10. In many scenarios you will be proven right and be better off. But even if you do lose that bet, it’s not like you can’t buy a house at all, you just have to settle for less house or more leverage. Your original $100k (plus accumulated savings) might be enough for 20% down on a $500k place, but if you come to the table with only $75k you can still buy a house — with CMHC you can even still buy the $500k one from your twentysomething dreams. The risk to your life plans is not that large: it’s not a life-altering risk you’re taking, but a manageable financial one.

If you’re a housing bear like me and have recognized that with crazy price-to-rent metrics it just makes more sense to rent, then you’ll be doing so for as long as it takes. Housing corrections take years to play out. And a housing bust is almost never a “V-shaped” event, where you only have a few weeks or months to swoop in on cheap prices: once the excess comes out (which itself will be a multi-year correction event even in a crash with numerous accelerating factors like in the US), the market will very likely stay in “fair value” range for a few years. As a bear you may be living in a rental house that would sell for⁵ $500k in today’s bubbly climate. One day, if prices make sense, you might like to own a similar house, but it’s 30% over-valued. So you rent, invest, and get on with your life. But if the conditions have changed so that it’s time to buy then that house has likely come down over $100k in price — you’d still be way ahead even if you were unlucky in equities and lost $25k of your downpayment. And, if you want, you can keep renting for another few years to see if equities recover, knowing the house likely won’t. And conditions might not change: in which case your “downpayment” fund is really your “retirement fund” in a soft-landing world for renters.

Of course you invest it if you’re a housing bear.

So when you’re talking housing, you generally have some long timescales to play with. Maybe not the 10+ years needed for the chance of a negative outcome to go to nearly zero, but enough that investing in equities is not some wild, undisciplined gamble. Even a 3-year holding period has something like an 80% chance of beating cash. I think too many people are too afraid of uncertainty, particularly young people who have a lot of ways to recover from loss at their disposal⁶. Risk tolerance comes from many sources: you can be flexible with your timelines if needed, or adjust your expectations/budget. And you need a downpayment, not the downpayment you started with — ending up unlucky and losing a portion of your downpayment is generally a survivable event.

My dad taught me at a young age that you only put in the stock market what you can afford to lose. But the market doesn’t go to zero even in a bad crash, and the amount you can afford to lose is generally not zero even when you’re house-horny. So with that in mind I take acceptable risks to try to invest my money in a way that maximizes my expected value.

Plus I know that the risk I’m taking as a renter with equity investments is way smaller than the risk a buyer in today’s market is taking (both financially as well as to my future lifestyle and mobility options).

1: Realtor commissions, CMHC premiums, mortgage break fees, and possibly land transfer taxes (or the burning the opportunity to use the first-time buyer exemption later on a more expensive property), legal fees, inspections, and the inevitable over-spend on customizing (or as is often the case for new condos, finishing the job the developer botched).
2: The higher monthly costs to own (condo fees, interest, property tax, etc) that add up to more than rent, a renter can save in this market.
3: Why are you not a housing bear? Have you seen my spreadsheets? You must live in Hamilton… or non-waterfront Gravenhurst.
4: Indeed, I was more confident being fully invested in 2009/2010 coming out of a huge crash — with the valuations and recovery it seemed unlikely that a second major crash would take us yet lower. If, as in the previous example, someone had listened to me then but with $100k they’d have hit the $125k mark in just three years. Also, I’ll add down here in the footnotes that if you’re close to the CMHC threshold then the potential gain of going over the 20% mark might provide an added incentive — though the downside is there as well.
5: I refuse to say “worth”.
6: Again those are dodge, dive, duck, dip, and dodge… er… Wait, it’s: defer, earn, save, change expectations, leverage, and run crying to mommy.

Rob Carrick posted about a Toronto family frustrated by the high cost of housing and wondering what to do. There were over 100 responses from the community: some suggested renting, some moving away to more affordable cities, others accused them of being spoiled and entitled for thinking that a house in Toronto should be anything other than a crushing financial burden. About 10% of responses said that they should buy a house with a basement suite (“mortgage helper”), and that renting it out would solve all their affordability concerns.

Some quick math for all those who think “just get a place with a mortgage helper” is somehow a magic solution.

Assume they can rent out the basement for about $1000/mo inclusive. There are some added insurance and utilities costs, so say the real gross is $800/mo. Apply some reasonable rate of return — say an 8% gross yield, which might work out to a 4-5% cap rate — and that $800/mo income basically means that they can buy $120,000 more house than they would otherwise. So the $700,000 house they were looking at would effectively “only” cost them $580,000 — yet they’d have to deal with tenants in the basement, lose out on a 2nd or 3rd washroom, all the storage space, a ready play room for the kids, and quite likely share their parking and back yard. In other words, they lose a good portion of the benefits of paying up to get a detached house in the first place, without the lower cost of a true attached property.

Plus, the prevalence of this analysis-free HGTV presents Income Property-type thinking means that the house with a basement apartment roughed in usually costs more than the comparable true SFH in the first place! All those risks and drawbacks, in the end to only be a few hundred dollars per month ahead, if any at all. I don’t know how “mortgage helper is axiomatically good” became such a prevalent meme*, but playing amateur landlord to the basement-dwelling crowd** is not the solution to a young family pressured by high house prices.

* – though we can guess: most people probably think that the suites build and maintain themselves, with no additional cost, that the full $1000 cheque comes every month without default or vacancy, and that it is entirely profit because accounting is hard.
** – no offense intended towards basement-dwellers, who are 96% of my readership.

David Fleming says that (gasp!) renting is not throwing your money away in a recent blog post. I’m always amazed at how close he can come in his arguments to seeing the bearish light and yet not quite cross over. As usual he has his realtor I-work-in-today’s-market blinders on: “That was then, and this story takes place now.”

Though renting may not be throwing money away, he concludes near the end: “Is it worth living in a rental for three years? I don’t think so.” Now conveniently, he provides a backwards-looking example of a couple that bought for just about three years rather than rent. These past three years — two of which represented some of the strongest, hottest Toronto real estate markets they could ever wish for. This was as close to the best case scenario as you can come as a condo owner for three years. Let’s even go back and revisit that choice — was it worth buying for those three years?

One criticism people like to make of bears like myself is that the analysis for rent-vs-buy says how distorted the market is, yet it irrationally keeps going up anyway. The timing is hard — irrational prices are irrational — so it’s all too easy to say “if you had listened to Potato back in 2010 you would have missed out on an incredible market!” My thinking is that you have to make the best decision with the information you have available at the time. Taking a bad bet and having it pay off does not mean it was a wise, justified move, it just means you got lucky despite the math. Considering and accounting for risk moving forward is how I have to live my life, and when I take extra steps to avoid a calamity that does not occur I don’t consider the steps “wrong” any more than I consider paying for car insurance wrong even though I’ve never been in an accident. But let’s say that you are swayed by backwards-looking logic, and run the numbers for David’s clients and see just how worth it it was to buy a condo for just 3 years in one of the best possible appreciation scenarios.

So far he hasn’t provided the full details so we’ll have to make a few extrapolations/work from an average couple over the same timeframe.

Buying scenario: The couple bought in mid-2010. The average 416 condo price was $340k in May 2010. David says that their mortgage is $1500/mo. Most likely they took a discounted 5-year rate, which at the time would have been 4.1%, suggesting a 30-year $310k mortgage. On purchasing they would have had to pay $6700 in land transfer tax (or burned their first time buyer credits), and with just $30k down would have had to pay $6820 to CMHC/Genworth. Pretty typical scenario for a young couple. Assume they also paid about $1000 for legal and inspection, and another $3k either up front or over the course of their time there in maintenance/remodelling. So their starting capital would have been $47.5k — money they could have invested as renters.

Their annual cash flow would break down as: $18k for mortgage, $5.4k condo fees, $2k property tax; total of $76.2k paid out over the three years (some of which went to principal which will come out below). They would have some additional costs over renting as well in terms of insurance, but we’ll let that slide.

Upon selling they are delighted to see that the “bears were wrong” and they can now sell their condo for $357.5k in August of 2013. They pay Dave his 5% commission ($17.9k), the bank it’s mortgage break fee (IRD of $7.5k), and they are free and clear, ready to move up to something bigger. At the end, they have had a condo to live in for 3 years and, after paying the remaining $293k on the mortgage, are walking away with $39.1k in their pocket.

Renting scenario: The couple, after reading my blog and doing the math themselves (this is back in 2010 before the spreadsheet calculator was out), find that the Toronto condo market is kinda, well, insane. So they take their $47.5k and stick it in an ING Direct Streetwise account and decide to rent the very same condo and get on with their lives. A comparable unit runs them about $1525 in 2010 (a price-to-rent multiple of 222X). The landlord hits them with a 3% rent increase in 2011, and in 2012 after reading a ridiculous Condonation report summary in the Star, hits them with a shocking 10% increase. Over three years, the renters pay $57.9k in rent.

After the end of the three years, their initial capital has grown at 7.83% per year net of fees in the ING Streetwise growth account, giving them a nest egg of $59.5k. They saved an additional $18.3k, which let’s face it, I don’t even have to pull out the spreadsheet to trickle into an investment account because renting knocked it out of the park. Their total capital is north of $77.8k.

The renters are $39k further ahead — after just three years, in what has been a relatively good real estate market (keeping pace with inflation, no signs of a crash anywhere, naysayers defied… at least according to the news). Even if you’re more generous to the owning case (or as I would call it, less realistic) and ascribed no value to burning up the first-time exemption to the land transfer taxes, started with more capital to avoid mortgage insurance, assumed that the buyers were prescient enough to go with a variable-rate or 3-year mortgage, or that the investments wouldn’t have done quite as well: it’s not a good outcome. And it could have been so much worse if a correction did occur in those years and they ended up underwater — as could still yet happen.

At these price-to-rent multiples it really doesn’t make sense to buy. Even at more normal price-to-rent multiples it wouldn’t make sense to buy for only three years: the transaction fees are killer. When you’re 24 and just slogged through a two-year MSc, or are barely into your career after a four-year undergrad, three years seems like forever; how are you to supposed to be able to plan what your space needs will be that far out? It really makes more sense for people in that situation to rent: both projecting forward as well as looking at the past few years. Add in the current extreme prices and there is basically no scenario where it makes more sense to buy — this is the era of the renter.

Note some important real estate mantras shattered by the short timescale:

1. Renting was not throwing money away, it was the wiser move here. Even if they were poor budgeters with little savings discipline — people who “should” buy for “forced savings” — and spent the ongoing savings from renting on enjoying life more, just the growth in their nest egg and not blowing tens of thousands of dollars on transaction fees still put them ahead (though just barely in that case). And though I would not recommend that scenario, such a couple would have been able to go on more trips or eat out more or whatever it was that they spent the money on not being house poor.
2. Buying did not build equity. With such a short holding time and such steep transaction costs, they walked away with less capital than they started with. And that’s with decent growth in average prices over those three years and low mortgage rates.
3. There is no such thing as a “property ladder” and if there is, they were not climbing it. With the reduction in their capital base they ended up further away from being able to afford a detached house in 2013 than if they had rented and built up a downpayment through savings and investing. This was exacerbated by the different growth rates in the property types: while Toronto condos were up about 5% over the time period, the average detached house was up more than 13%.

2010-2013 were a couple of pretty decent years for the economy and real estate, and yet for this pair renting was still the better move.

…or Real Estate: Changing Sales Mix and the Effect on Averages.

The average is a very important way for us to reduce the complexity of a large number of things down to one measure that we can then compare to other groups of things. It’s a simple grade-school concept, yet we must at times remember that there are different ways of creating an average, and they may give different results depending on how the raw data is distributed. There are issues of weighting data, and that we have to be aware that sampling subsets of a large population does happen, and that how data is sampled can affect the outcome.

For the real estate boards (e.g., TREB) they report the “average house price” which is a simple average of all the property sales in a given region within a given month. Now for an organization that is primarily concerned with how much commission-generating activity is taking place, a simple average is great (multiply the average by the number of sales and you get the total sales volume). However, it doesn’t truly answer the question many people have, which would be something like “how much more/less is my house worth?”

The sales mix — how many condos versus detached houses, which neighbourhoods have more activity — affects the average, especially when it changes. You see, the average price in a month or a year is not a census; not the average of all properties across the city, weighted by how many of each there are, but rather the average of those that sold. With a large enough city over relatively normal periods the distinction shouldn’t matter that much: the properties that sold should be a random and consistent sample across the city. Maybe condos turn over more often than houses, but as long as that’s a constant influence over time then you can still make year-to-year comparisons.

But Toronto has seen a massive real estate boom over the last decade that included an insane amount of condo construction: 50,000+ units built and another 60,000+ under construction*, in many cases removing single-family houses in the process. And the sales mix has changed even more, as condos become investment commodities to flip rather than places for long-term occupation.

The result? The increase in average price that so many find concerning may actually be understating the degree of price increases that have occurred (though price-to-rent analyses sidestep this). Moreover, as this effect unwinds it will mask price decreases. For an example of the change in weightings affecting the average, see the May condo numbers: 416 condos were up 1.2%, 905 condos up just 0.6%, yet the overall GTA average was up more than either at 1.6%. This seemingly illogical result came about because the sales volume dropped so much more in the 905 — these lower-priced units counted for less in 2013 than in 2012 so the overall average was up much more than any single component. With a large enough swing in sales (the weighting factors) you could see average prices rise even if each individual component had decreasing prices.

My thinking is that condos are the most speculative component in Toronto real estate, so as the market starts to correct the sales volume (and prices for that matter) on condos will be affected more. Indeed, sampling** a few months shows that this year is showing a decrease in the ratio of condo sales to detached sales from the previous few years (detailed data doesn’t go back far enough to show how the mix changed as a bubble inflated). So as we get through the Wile E. Coyote phase of the correction, the change in average prices may continue to look positive (or less negative) due to changes in the sales mix, even if the actual prices on individual properties are going down.

Now, it’s not a huge effect: a few percent one way or the other, and it doesn’t compound. But when you have a market on the edge, with large changes in sales mix happening, where a few percent one way or the other would have large psychological effects, then it’s an effect worth keeping in mind.

In a similar vein, there seemed to be a lot of media attention around the last two Urbanation rental reports, which described steep increases in Toronto rent costs. However, I seriously question the reliability of these reports, particularly when it comes to their sampling.

Ideally, when looking at any population we’d have the full set of data to analyze. But you can’t measure the length of every fish in the lake without draining the lake to catch them all, and for large populations even if you could measure everything you’d end up with a massive amount of data to crunch. It would be nice to have the rent rates of every rental agreement everywhere, or to run an appraisal on every property every year so we could analyze the data as we see fit. But that wouldn’t be worth the cost and effort of doing so, so realistically we have to sample: pick a few fish out of the lake, phone up a few potential voters, or get information on some rental agreements out of the city and find out what the average of those are, estimate how our sample differs from the overall population and go on with our lives. A good sample should be representative, random, and appropriately sized.

Urbannation doesn’t provide their raw data (indeed, they charge an arm and a leg to get at the report), but the information in the press tells us that with several thousand data points it’s likely large enough. You could probably get a good sample with just a few hundred representative rentals. However, it is not representative. Their report is based on the sample of all rental agreements that go through the MLS system. When you’re talking resale housing transactions MLS is a great sample — it captures almost the entirety of the market, and there isn’t necessarily an obvious bias to what’s missed. For rentals however, MLS is a small slice of the market and is definitely not representative. Many landlords advertise their rental using low-cost methods such as ViewIt, Craigslist, Kijiji, or the local hospital/university bulletin board. The standard charge for an agent to list a rental on MLS is one month’s rent. For a 1-year lease that might get renewed for 2-3 years that’s ~3-8% of the gross — quite the cut for advertising and an illegal “custom” lease on what is already a loss-making “investment”. So we can’t really expect any old random landlord is going to go and get an agent to list their rental on MLS with some equal probability. In my anecdotal experience, the MLS listings are largely from cases where the landlord already has a relationship with the realtor, either a recent sale (“now that I’ve sold you the place, how about I get a tenant for you?”), or a current listing that’s failing (“geez, 45 days and not a single bid, how about I help you rent it out and we can see if the market improves in the spring?”), or is completely out to lunch/out of town.

The Urbannation rental report might say less about the increase in rental demand than it does about the increased use of MLS for rentals. The headline could just as well have been “rental demand unchanged in Toronto; Sales collapse means more people with more expensive units resort to renting out via MLS.” We don’t know how the represented areas and units changed over time (perhaps a few years ago cheap CityPlace units were over-represented while it was newly flipped; now maybe more inherently expensive developments are dragging the average up).

Now I don’t personally track the downtown condo lease market so I can’t say what correlation there is between the Urbannation report/MLS data and what’s actually happening with like-to-like rents. I can say that it does not look like the outskirts of the 416 (North York in particular) are experiencing anywhere near the same level of rent inflation as they suggest. Indeed, anecdotally I’ve heard a few cases of landlords voluntarily freezing rent north of the 401, as even the 2.5% rent control increase can’t be justified by the market rents that could be sought if a tenant left (which is likely reflected in the 2014 cap of 0.8%).

* – the 2nd figure is across the GTA, so perhaps closer to 40,000 units under construction in Toronto proper.
** – I wasn’t able to find the data in a spreadsheet for ease of analysis, so I had to manually parse a few months and build my own spreadsheet. I wasn’t going to go through that for more than a few sample months.

I’ve mentioned speculative holding before as something that underlies a bubble, but haven’t really gone into any depth on the subject. Basically, it’s a speculative behaviour that isn’t as obviously speculative as buying something purely in the hopes of future appreciation: instead you hold something you may have bought for other reasons on that hope.

One of the more typical examples is to hold on to an old property to rent out after you buy a new place to live in. The purchase you make at the time may not be speculative, but often the decision to hold on to excess property is — if you weren’t counting on large future gains, you would have sold off the old place, rather than take the risk and hassle of becoming a landlord.

Less obvious is buying preconstruction while owning. Even if you plan to sell as soon as the new place is finished, you have double the real estate exposure for the duration of the construction, which could be a few years. When people are advised not to time the market, that means they should be selling a their old place as soon as they buy a new one — even if the new one isn’t built yet — in order to limit risk. Many may chafe at that advice, in which case they shouldn’t speculate in the preconstruction market unless they have the capacity to take on the risk, and instead shop around for homes that are already built.

One of the more subtle effects on supply is the decision of whether to buy first and then sell, or go the other way around. Deciding to buy first then sell has a small effect on supply and is like a minor version of buying preconstruction (for a time you are exposed to double the risk). It is a small effect, and the market adapts to whatever way is accepted as the norm (or even some mixture of methods). But when the shift happens from one scheme to another en masse, it can sway the supply. Take the case where everyone considers that the way to transact in real estate is to buy your new place first, then go out and list the old one. If then everyone changes their mind, perhaps deciding that the market is softening and the old way was too risky, and sells first, it could shift months of inventory over all at once: suddenly new houses are coming on the market while inventory sits. If “the” way to transact is different in a “buyers'” market than in a “sellers'” market, then once the shift is proclaimed, it could lead to a short-term swing in inventory and put pressure on prices.

I think one of the largest effects of speculative holding is the shift that occurs in the supply curve under the influence of rising prices, the holding on in the face of steady price increases. Imagine if someone comes out of the blue and offers you $1M for the house you paid $500k for just a few years before. Many of you would be all over that deal, telling your neighbours about it who would rush out to list their houses and take advantage of the opportunity. You’d think the buyer was nuts and that it was a one-time, not-to-be-missed opportunity. Hey, you could go move to the next town over (where houses were still $500k) and practically retire on that kind of money. But if you got to the $1M offer via a succession of offers: one at $550k that you turned down, then again a bit later the buyer comes back to you offering $600k, then again a few months later with an offer of $650k… by the time you got to $1M in a few years, you would have been expecting that price, and possibly even projecting out to the $1.2M offer you were sure was in the works for you. The price itself was still just as insane, just as much of a windfall, but because of the path to get there you’re less likely to actually put your house on the market and take it. You were inoculated against the crazy, so it seemed right.

And finally, the incarnation of speculative holding that made me think to write this post: taking the house off the market for “when it recovers in the spring”. Sales in Toronto and Vancouver dropped double-digit percentages over the past year, to the lowest levels since the financial crisis. Prices barely budged, but were down a bit in many sectors. Thus it’s quite common to hear on the subway, in the restaurants, the newspaper articles and the chat boards that famous idea of trying to relist later when the market looks better. That is perhaps the baldest speculative holding of all: the person wants to sell, but will hold on in the hopes of higher prices later.