Musings on Greenwood

Hello all,

   I promised you a doozy on housing and I intend to deliver. My brother brought a report by Alexandre Pestov of the Schulich School of Business about the Canadian Housing Bubble.

   You can read it here: http://www.scribd.com/doc/28454918/Canadian-Housing-Bubble or just google the guy’s name along with “housing bubble” and you’ll get one hundred different links to the same report.

    READ IT!!!

   I think it’s the final word on the subject. There’s no longer any doubt we’re in a bubble. The only question is how much more will it swell before it bursts?

   The report debunks common myths about real estate. It demolishes the CMHC (Canada Mortgage and Housing Corporation) for delaying an inevitable market correction. As a result, it’s going to be a thousand times worse than it otherwise would have been.

   Here are some excerpts from the report:

INCOME TO HOUSE PRICES: SCREWED!!!

   “An average Vancouver household (that is a family of usually two income earners, not a single person) spends over 70 cents of every pre-tax dollar they earn on house ownership costs. Deduct unavoidable taxes, and this amount would rise to nearly 100 percent of an average household income in Vancouver.

   An average Toronto and Montreal household spends over 57 and 47 of their pre-tax income on house ownership costs, or nearly 80 and 70 percent of their after-tax income respectively”.

   Keep in mind this is at a time when interest rates are at historic lows!!!!
 
   “The innevitable interest rate increase will lead to commensurable increases in mortgage rates. As mortgage rates go up, the cost of borrowing translated into monthly payments will rise about 10 times faster. The effects will be more noticeable for borrowers with short-term loan agreements, such as 1-, 2- and 3-year mortgages who might see increases in their monthly mortgage payments ranging anywhere from 30 to 70 percent.”

   Think back to the previous point. Now try to reconcile that math in your head.
 
   “Today’s median home prices are at or above their peak during the last real-estate bubble of the late 80s and early 90s. Income increases is a good benchmark for evaluating relative housing costs. Over the last 13 years, house prices in Toronto, Montreal, Vancouver and Calgary rose 5-10 times quicker than incomes in these cities.

   Incomes simply did not keep up with the rising home prices. Housing affordability (or un-affordability would be a better term in case of Canada) is significantly above its long-term average now. While it is lower than that at the peak-bubble in 1990, it is expected to skyrocket into the stratosphere once the bank rates rise and the mortgage rates follow.”
 
THE FEDERAL GOVERNMENT’S PONZI SCHEME APPROACH TO REAL ESTATE

   “All these programmes (35-40 year ammortization, 0-5% down) have a common theme – they cannot last forever. The more of them used to stimulate the market to new highs, the greater the collapse will be once they are exhausted. Many will say that by taking drastic measures, the Canadian government prevented the disaster. It must be understood the disaster was not averted, but postponed. The structural imbalances within the system were not eliminated, they were worsened.

   The government of Canada resembles a firefighter who piles a large load of firewood on top of the flames he is trying to extinguish. For a brief period of time the results of his efforts would appear as a success - the flames disappear from view and the fire would seem to be gone. However, in a matter of minutes the blaze will engulf the firewood pile, burning higher and stronger than before.

   By injecting new buyers into the system, the government of Canada temporarily propped the prices.

   However, these buyers were not in the system previously because they were unable to carry the cost of home ownership under the prudent rules. With the new rules, they will be the first to fail once interest rates go up, and they will magnify the problem tenfold once prices begin to drop again.”

RENT VS OWNERSHIP (DON’T BUY A CONDO!!!)

   “In many cases, a real-estate property is viewed as a retirement investment. Over the years, it is gradually paid off, and by retirement time it represents an item of value that carries a very low maintenance cost. This is a true assumption, but the price of the property must be right.

   Let‟s review a 2-bedroom apartment located in downtown Toronto, as an example. Presently, an average rent would be approximately $1,300 in an apartment building. A 2-bedroom, 2-bathroom condo would be priced near $450,000. The monthly ownership cost would be near $3,850 ($3,000 mortgage payment, $625 maintenance fees, and $225property tax). The monthly difference between renting and owning will stand at approximate $2,550, which would translate into approximately $30,000 annually.

   Let‟s assume a highly unlikely event of housing prices in Toronto avoiding a collapse, and increasing at a steady pace of 3 percent a year. At the same time, rents, property taxes and maintenance fees keep up with inflation, and rise at 3 percent a year as well. All savings from choosing a rent vs. owning a condo (i.e. the difference between the rent and ownership costs) are reinvested in safe bonds at 5 percent. There are no transaction fees associated with condo sales.

   After 5 years, the renter will accumulate $176,000, while the condo owner will have $143,710 after selling the unit for $464,000.After 10 years, the renter will accumulate $395,000, while the condo owner will have $298,000 after selling the unit for $538,000.

   Finally, at the end of the mortgage term, the house is fully paid off, and is now worth $838,000. However, by that time the renter will amass $1,438,000 by saving and safely investing the difference between the rent and the cost of ownership.”
 
THE TRIGGER  

“Finally, the most probable cause that will trigger a housing market collapse in Canada will come in the form of a trivial interest rate hike. It was the straw that broke the camel‟s back in the US, and it can take the same role in Canada.

  Canadian homeowners are overleveraged beyond their capacity to carry mortgages under the “normal”, by historical standards, interest rates. The government estimates that 10 percent of home owners are susceptible to defaults once interest rates go up. Once rates go up, the events are likely to unravel just as they did in the US.

   Defaulting homeowners lead to fire-sale prices and excessive inventory. Excessive inventory and price competition pushes down prices. Lower prices dash hopes of investors who find themselves holding a highly leveraged and money-losing asset. It leads to more fire-sales. Once the prices drop 10-15 percent, defaulting homeowners and fearful investors are joined by people with negative equity who have given up on their property.

   This spiral continues for some time, until prices finally stabilize substantially below their starting levels.”

   So, there you have it! That ’trivial’ interest rate hike in July isn’t looking so trivial now.

    Act prudently people! Things are about to get dicey.

Ethan Rabidoux