World Housing Bubble - All Aboard!

For months, I was clearly the minority in saying that real estate prices in places like China, Australia, Canada, Hong Kong etc are experiencing a bubble. I was also the minority in saying that US home prices are, in fact, undervalued. In recent weeks though, such ideas have become accepted, even mainstream.

By now, I have to admit that I am actually sick of writing about housing bubbles. However, I know from emails I have received that as a result of these articles, at least some people have been dissuaded from purchasing high-priced condos at the edge of personal affordability, and for this I feel that repeating the same message ad nauseum is worth it.

Paradoxically, money tends to flow to assets and areas that are considered "safest," without regard to whether or not they are "reasonably priced." For investors, immediate safety of capital (or immediate gain) is paramount, and everything else is secondary. It is precisely this desire for immediate reward that results in horrible long-term investment choices.

In some countries, such as China, investment dollars are still incoming. In the US, real estate is stagnant water, despite low prices and excellent investment opportunities. In Canada, the flow is now a trickle, and ready to backflow.

The educated media is coming on board. For the masses, the onset of reality will still take several months.

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Video: Bubble Trouble - MSN Money
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See also the previous Frost Report articles:

The World Housing Bubble – Part II

The World Housing Bubble

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Throwing Away Money on Rent

“I want to buy my own place. I don’t want to ‘throw my money away’ on rent anymore.”

As a banker, I hear this sentiment often.

Amongst the reasons renters want to purchase their own place is because it annoys them to “give their money to a landlord” every month, allowing the landlord to get rich.

For most people, buying real estate is indeed a worthwhile and sensible economic decision, to say nothing of the pride of ownership and positive sense of responsibility that comes with owning a home. However, many renters have a twisted idea of how their finances will change once they purchase. To illustrate, I will use “Bob,” a typical renter.

In Bob’s marketplace, he pays $1000 per month for a 1-bedroom apartment with den, with hot water and cable TV included. He hates the idea of throwing away $1000 every month, so decides to purchase a condo in the same area.

Bob buys a $260,000 condo, using a down payment of $30,000 and a $230,000 mortgage. Bob’s monthly mortgage payment is $1234.69. He pays an additional $200 per month for condo maintenance fees and $100 for property taxes, for a total monthly payment of $1534.69. Bob is pleased with his decision. What Bob is not aware of is that he is actually “throwing away” more money now than he was prior to his purchase.

Bob’s first monthly payment will be $1534.69, of which $958.33 will be interest, $200 for maintenance fees and $100 for taxes, with only $276.36 going toward the principle. That is, Bob is now “throwing away” $1258.36 ($1534.69 – $276.36) - a full $258 more than before, not including the utilities and cable that he now has to pay for himself. Over time, more of Bob’s money will go toward the principle, but at the moment Bob is deeply in the red compared to his previous situation. Did Bob make a mistake?

In order to make a wise real estate investment decision, certain rules are best followed:

1) Don’t buy into a declining market (or an exceptionally “hot” market which could soon decline) unless you plan to stay in your home for several years. It is best to purchase when values during the previous 6 months have been roughly flat or rising. There is no point paying $276 toward the principle every month (like Bob), if the value of your property is dropping more than that.

2) Don’t purchase unless you intend to stay in a place for 3+ years, with 5 or more being optimal. During shorter periods of time market values can decline (see Rule 1), and fees (such as moving fees, agent commissions, taxes etc) will take a bite out of any potential profits.

3) Buy something well within your comfort zone. No more than 32% of your monthly pre-tax income should go toward mortgage payments and condo fees.

4) Make sure you have fallback funds. Too many people put all of their savings toward a purchase, leaving nothing for emergencies.

If Bob intends to stay in his property for 5 years or more, has funds set aside for emergencies, and has purchased in a flat or rising market, he has probably made a wise investment decision. Over the years, his monthly payments will remain the same while local rents rise, with more of his payment going toward the principle (and less toward interest) every month. And, he will see his property increase in value while he enjoys living there.

Real estate can be a great investment. Just make sure you do it right.
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“The only difference between a cult and a religion is the amount of real estate they own.”

Frank Zappa, musician

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Bob’s Mortgage

Principal = $230000
Interest Rate = 5%
Amortization Period = 30 Years
Bob’s monthly payment is $1234.69
First year mortgage amortization schedule (click to enlarge):

Is the US Recovery in Danger?

This week saw low sales numbers in housing, lowered (but still rising) durable goods orders, and a generally pessimistic attitude all across the board.

In fact, “pessimistic” may be an understatement. One website effectively summarized the prevailing mood: “Things will never get better. We are all doomed.”

One of many problems with doom and gloom reporting is the resulting dialectical materialism (George Soros calls it “reflexivity”). When people believe something it can become a reality, even if it wasn’t a reality at the time people began to believe it. For example, if people believe there is an increasing chance they will lose their jobs or homes due to recession, they will curtail their spending, thereby causing the recession that they feared. Despite the reflexivity effect, however, I do not believe that this recovery is endangered.

Consumer “entrenchment mentality” is already in full force, and has been for some time. As noted earlier in The Frost Report (The Spending Zone), Americans have been paying off their debts and increasing their savings for seven months straight, and are almost at the point where their free cash flow will increase substantially. As a result of these debt repayments and savings, consumer credit scores are already the highest they have been since 1998.

The corporate world largely reflects the personal one: businesses have vast amounts of emergency cash, have paid down and/or refinanced debts, and have streamlined staff and operations. Corporate America is mean and hungry. With solid balance sheets and low stock prices, M&A activity should rise soon and remain high for months.

The combination of high cash flow, lower debts, higher savings, and excellent credit ratings simply does not match the “we are all doomed” mentality. Similar to cult members who wait for the mother ship, at some point people will realize that the economic apocalypse they are preparing for is simply not going to occur.

Based on the numbers, I suspect that this revelation will strike the US consumer within the next 3 quarters. Regular (if not exceptional) spending will resume shortly thereafter, and corporate America will follow suit with mergers, expansions and hiring.

Though the international picture is deteriorating, it will not be enough to derail the US turnaround.
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“Hysteria has now disappeared from Wall Street.”

The Times of London, November 2, 1929
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Canadian Real Estate: Stick a Fork in It

IT'S DONE.



The Canadian housing boom is officially over.

In addition to the myriad of anecdotal stories from real estate agents and mortgage specialists who tell me that the market “has shifted in favor of buyers,” banks are finally experiencing the inevitable decline.

Back in July, I mentioned that the mortgage pipeline was drying up, and that the results should soon hit the banks. Well, they have. According to my contacts at three of Canada’s major banks, new mortgage and refinance business has fallen off a cliff. Pre-approved mortgage applications – an indication of sales beyond 30 days - are virtually non-existent. Any of this may be confirmed by a casual visit to a local bank or credit union, which reveals empty reception areas and bored lenders.

In an effort to kick some life back into the markets, major Canadian banks reduced their mortgage rates twice in the past two weeks, but it had no impact whatsoever. In light of these circumstances, I suspect the Bank of Canada will rethink its intention to slowly raise interest rates.

At the same time as the Canadian media was announcing that home prices have dropped, sales have slipped, and housing starts fallen, the Canadian Real Estate Association was busy announcing that home prices will continue to rise. I love the CREA. When sales and demand increase, they announce that real estate prices will rise. When sales and demand drop, they announce that real estate prices will rise. You can say a lot about the CREA, but you can’t fault them for inconsistency.

I suspect that several months will pass before the severity of the downturn becomes fully apparent. By then, it should be so obvious that not even the CREA will be able to ignore it.
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Further reading:

The CREA's Use of Spin (The Frost Report)
The Canadian Real Estate Market - Trouble in the Pipeline (The Frost Report)
Housing Starts Slip in July
Shaky Days in the Housing Market
Homeowners Sell, Start Renting Instead
CREA's Resale Housing Forecast

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The Golden Age of Appraisals

“What are you looking for?” the man on the phone would ask me. At the time, I was a retail lender for a major bank.

“Uh, they need 680 thousand,” I would answer. A few days later, the appraisal would arrive on my desk. The home’s appraised value: exactly $680,000.

I miss the golden age of appraisals; the days when an appraiser would ask their banker what value they needed to complete the deal, and the result would neatly correspond. Of course, it didn’t always happen that way. Occasionally, when a client was buying a property that was obscenely overvalued, the appraiser just wouldn’t do it. “The most I can give you is “X,” they would tell me, apologetically.

The Golden Age of Appraisals (and the housing bubble itself) resulted from general human psychology, and a lack of regulation to counteract it. The government wanted a robust market so that voters would be happy. Bank executives wanted stunning results so they could exercise their stock options. Lenders wanted to underwrite mortgages to exceed their targets and get good bonuses. Appraisers wanted to keep lenders happy and get bank business. Clients wanted to be approved so they could buy homes to flip and get rich. And so, everyone worked together to create a royal mess.

At the time, I didn’t even realize that by answering the appraiser’s question, “What are you looking for?” I was contributing to a bubble. I recognized that the question was suspect, but thought I was simply helping them cheat at their jobs by giving them an anchor figure to work from.

Housing appraisals go by either “replacement value” or “the comparison approach,” the latter of which is the most common. In this approach, a home is compared to the recent sales of similar homes in the area, adding or subtracting value for any differences. In the bubble years, the values given to differences were often generous. After all, who’s to say that the $500 of gardening supplies and weekend of sweaty work didn’t add $20,000 to the value of the home? It’s a judgment call.

These days, most appraisers no longer ask their banker what he is “looking for.” They rarely assign a value of $20,000 to a small garden plot, or $30,000 to a new paint job. And, they often anchor their appraisal based on the price of the nearest foreclosure, knowing that foreclosures drag down prices for everyone. The old days are gone. Appraisals are becoming – dare I say it – accurate.

That is, until the next hot economy…
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“Until you play it, St. Andrews looks like the sort of real estate you couldn't give away.”

Sam Snead
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US Foreclosures – The “Las Vegas Index”

In the past few months, foreclosure rates have climbed.



Under any normal circumstances, an increasing rate of foreclosures would indicate that the housing market and economy are declining/struggling/suffering. But, these are not normal circumstances.

As everyone knows, US banks are sitting on large numbers of properties where the owners have not paid in months. Previously, the banks wanted to foreclose on these properties but could not, since any increase in foreclosures would have only added to the already large glut. The fact that foreclosures are climbing means that banks are actually able to foreclose. Put another way, foreclosure rates are climbing because the economy is improving, and banks are able to sell their foreclosed properties faster than they were several months ago.

To illustrate, I give you The Frost Report’s “Las Vegas Index.” I chose Las Vegas to measure the nation’s real estate health because it is, officially, the worst housing market in America - with the highest percentage of foreclosures and the largest peak-to-trough drop in prices. The Las Vegas Index is simple: it measures the number of detached foreclosures and listed properties available for sale between 0-$1 million USD, with 1 bed and 1 bath or more.



There are two things that are clearly evident by studying this chart. First, non-foreclosed properties are simply not selling. Therefore, many of the existing home sales statistics are, at this point in the economic recovery, essentially meaningless. Foreclosures will have to clear before regular home sales will make any meaningful recovery. Secondly, the number of foreclosures on the market has not increased in recent months, despite a larger number of properties being foreclosed upon: this means they are selling.

The increasing rate of foreclosures is a positive sign, not a negative one, for the US economic recovery. The sooner bad mortgages and loans clear out, the sooner bankers (and citizens) can get on with their lives. The US real estate market, though it has a long way to go, is improving steadily.

PS - If you were ever considering purchasing real estate in Las Vegas, now would be a very, very good time.
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"...the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The Federal Reserve, Aug 10th 2010

Reflexivity and the Decline in Home Sales

Recent headlines confidently announced that the 33% reduction in U.S. new home sales for May 2010 was due to the expiration of the new-home buyer’s tax credit at the end of April.

In other words, we are supposed to believe that home sales were robust due to an $8000 tax credit, and now that this credit is over the housing market is bust. Nonsense.

In fact, the reversal in new home sales was primarily caused by an equally large decline in psychological wealth that occurred at the beginning of May - which had nothing to do with tax credits.

Rapid declines in consumer spending are caused by rapid declines in asset values, such as stocks or real estate. While there is much talk about how a drop in stock prices can “predict” an economic downturn, there is little notice that a drop in stock prices, rather than predicting a downturn, may actually be the cause of one.

When people see their net worth decline, they compensate by saving. That is, they decrease their spending and increase their margin of safety, further exacerbating the symptoms of the decline.



The “flash crash” of May 6th 2010 punched the confidence out of retail investors, psychologically forcing them to transfer billions of dollars out of equity investments. So, while April saw inflows to equity mutual funds of $13.89 billion, May saw outflows of $29.94 billion (www.ici.org). Negative headlines caused retail investors to run for the hills - and they haven’t stopped running. These days, the market fluctuates wildly from the trades of hedge funds and volume traders, while those working with retail clients (such as Financial Planners and Brokers) sit at their desks, bored.

Stocks are reasonably priced, with little room for a disastrous collapse like the one from the peak. Home prices are low. Interest rates are low. Despite problems in Europe and Asia, the U.S. economy has all the logical conditions which make it ready to rise from the ashes. However, retail investors and consumers are anything but logical.

Until the chat-room anger and gloom subsides, both stock and housing markets will linger - and the buying opportunities for rational long-term investors will be sublime.
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“…the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.”
The Federal Reserve, Press Release, June 23 2010

“Housing cannot lift the United States from its new state of Marxist depression, you bunch of morons. The American Dream is just that. Rest in Peace, USA.”
Anonymous comment on a financial news website, June 24 2010
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See also: Reverse Attribution

Spin City

In recent days, both the Canadian Real Estate Association (CREA) and the Canadian Mortgage and Housing Corporation (CMHC) have been coordinating the same message to potential homebuyers: sales have dipped slightly, while listings & housing starts are rebounding, which is leading to an “improved balance between demand and supply.” The result, we are told, will be stable or modestly increasing home prices, simultaneously proving that the bubble everyone was whispering about was false. We can all breath a sigh of relief, and go out to buy that condo.

Personally, I find this spin-doctoring offensive. The CREA argument about supply and demand is rather like arguing that the Nasdaq was not overpriced in 2000, since there was a balance in demand for Internet stocks. In fact, one characteristic of bubbles is that demand suddenly plummets when people realize that there is no one left who wants to buy. So, to know the real story, we have to talk not about supply and demand, but rather about valuation.

By financial standards, a home is considered “comfortably affordable” if monthly mortgage expenses are 32% of pre-tax monthly income or less. As this number increases, one’s standard of living becomes increasingly tenuous. When monthly debt payments reach 40% or more of income (including mortgage payments, car payments and others), financial survival becomes a struggle.

The facts about Canadian housing are straightforward. According to RBC research (November 2009), if a median-income family bought an average 1200 sq ft bungalow in Canada, their monthly payment would be 40.2% of pre-tax income -- well above the 32% recommended, and in fact already above the monthly limit for total debts. In major cities, the numbers look even worse. In Toronto an average home requires 48.6% of pre-tax income: in Vancouver, 66.8%. This effectively means that if an average couple bought an average home in Vancouver, they would pay their income taxes, make their mortgage payment, and have nothing left.

And, the above statistics are the case today. Canadians, normally known for financial prudence and common sense, have actually been increasing their personal debts – not paying them off -- since the credit crisis began. The Bank of Canada stated that, “overall risks to financial stability arising from the household sector have continued to increase.” If current interest rate and savings estimates remain unchanged, Canadian debt payment levels will reach record highs by the fourth quarter of 2011. By the middle of 2012, roughly 1 in 10 Canadian households will have debt payments that leave them “financially vulnerable.”

In order for home prices to remain at current levels, one of the following must occur:

A) All homes and condos built from this point forward must be bought by foreigners/immigrants (since locals are already incapable of safely purchasing homes at today’s prices).
B) Wealthy investors must buy -- and continue to buy -- multiple homes for speculation, and keep them for years.
C) Wages in major cities must increase by approx. 8-30% (depending on the city) within the next 12 months, with no rise in unemployment.
D) Home prices must drop.

I can’t blame the CREA for their rosy interpretation of the numbers; after all, their mandate is to represent “more than 98,000 real estate Brokers/agents and salespeople working through more than 100 real estate boards and Associations.” With such allegiances, it seems unlikely that the CREA would ever say, “we think homes are overpriced and that you should wait to buy one.” Still, for the CREA to pooh-pooh the notion of a real estate bubble by citing supply and demand is either foolhardy or immoral.

Ockham’s Razor states that for any given problem, the simplest explanation is generally the best one: Canadian home prices must drop. For the record, my educated guess (it is only a guess) is that this drop will begin sometime between the 3rd quarter of this year and the 4rth quarter of 2011. And it will be nasty.
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“There is virtually no risk of a national housing bubble based on the fundamental demand for housing and predictable economic factors.” David Lereah, former chief economist of the National Association of Realtors, 2005 U.S.A.
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