School Closures in Vancouver

The Vancouver School Board has announced (PDF) closures of 11 schools.

As you may be aware, trustees faced difficult financial decisions this spring, and last evening approved a budget that includes approximately $16 million in spending reductions and eliminates 137 positions. We also received a report earlier this month from a government appointed special advisor recommending we consider school closures to reduce our costs.

It is in this context that district management prepared a list of schools that trustees might consider for possible closure. The schools on the pre-notification list were selected because of a number of factors, including low enrolment, under utilization and the availability of space at neighbouring schools.

Without delving into the politics of the matter there has been a general trend towards lower public school enrollment in the past number of years. This is not to say that the school-age population is necessarily dropping -- parents may be opting for private or home schooling instead. Statistics do indicate a dropping school-age population in Vancouver but, interestingly, the number of family-sized dwellings in the city has not commensurately dropped.

Looking at recent birth rates, it is likely these school closures may be a bit premature. But beyond even that, a look at the city's available housing stock shows a strange dichotomy between dwellings designed for families with school-age children and the actual residents of these dwellings. At some point it would seem reasonable the utility of these dwelling should match the residents' needs by way of demographic shift back towards more children or re-development away from the usual family-oriented architecture.

Sauder Housing Predictions

In a previous post I outlined basic theory behind net present value (NPV) calculations as it pertains to real estate and related it to a working paper (PDF) published by Dr. Somerville and Kitson Swann at the Sauder School of Business at UBC. I have read a few online discussions popping up recently regarding this paper, brought on I am sure in part by Dr. Somerville’s many recent quotations in the local media.

The paper claims that Vancouver’s house prices would need to drop 11%, from a benchmark of $754,500, to return to “equilibrium”: $680,000. If we look into the methodology used in the paper, the cost of capital elements such as tax, depreciation, and maintenance are determined by a percentage of current house value. This is fine however, should the house value change, we must re-adjust the figures as I will now do.

The cost of capital was calculated to be, as percentages of the original price: maintenance and insurance 0.5%, depreciation 1.07%, and tax 0.5%. All of course are fixed costs that will not vary significantly with changes in land value so nominally these values are $3773, $8073, and $3773 respectively. Note the $8073 number for depreciation is way too high and should be around $2500-3000 but for now let’s leave it as is.

The REBGV just released their statistics showing the new benchmark price in Vancouver is about $696,000 so let’s re-calculate the cost of capital, assuming as before a 5.4% annual capital appreciation (which I will deal with in a bit). The new percentages are: maintenance and insurance 0.54%, depreciation 1.16%, and taxes 0.54%. The new equilibrium cost of capital is 4.27%.

Uh oh. Now we need to re-calculate a new equilibrium price with the new cost of capital. Plugging in the numbers we get a new “equilibrium” value of $652,000. That is a drop of -13.5% from the paper’s benchmark price and a further -6.3% from today’s market price. If we perpetually plug in the new “equilibrium” prices into the formula, as we now must given prices are dropping fast, the new “equilibrium” converges at $602,000. Put another way, the true “equilibrium” price, given the property’s nominal costs and expected capital appreciation, is -13.5% below today’s benchmark price and -20% below the number used in Somerville et al’s paper.

It unfortunately does not stop there. I must take exception with the purported 5.4% annual appreciation numbers cited as the long term expected average appreciation in Vancouver. While this may have been true in the past there are at least three good reasons to believe this level of appreciation is far too optimistic.

The first way that prices appreciate is by rising incomes however Vancouver’s real incomes are flat. This means that in terms of long-term affordability, dwelling prices cannot increase much faster than incomes are rising, roughly at the rate of inflation. There is little in the short term to believe that incomes will be rising faster than inflation; in aggregate with falling employment and a looming recession the opposite is far more likely to happen in the medium term.

The second way prices appreciate is by densification; that is, the anticipation of using a piece of land to produce higher future incomes. Here there is a good argument that some property prices can appreciate faster than incomes are rising if they have not fully densified yet. However some quick deduction can show that there is a limit as to how fast average densification can occur: the population growth rate (around 1.2% in Vancouver area). From a practical perspective the actual densification will occur less because new land (farmland and forest) is being turned into residential dwellings, easing the maximum densification potential.

The third, and the most striking, way prices appreciate is through a waning of inflation expectations that has resulted in perpetually lower mortgage rates over the past generation and this has, through a perpetually decreasing cost of capital, caused unusually high capital appreciation. We are at a point where inflation expectations are unlikely to decrease much more. The best scenario is for mortgage rates to stay flat; the worst is for them to increase.

Taken all three together, the maximum nominal appreciation I would expect from Vancouver detached housing going forward is around 2.5-3% annually. Condos, due to the fact there is little possibility of densifying further, will likely appreciate at inflation, say, 2%.

Coming full circle, using my newly expected capital appreciation estimates, we can further adjust the cost of capital up by 2.4% and re-calculate “equilibrium” value. Astonishingly the new price drops to $270,000. Note this is too low, mostly because the depreciation number used in the paper is too aggressive. Using a more realistic annual building depreciation of $2500 we can re-calculate “equilibrium” at approximately $400,000. You can make other assumptions – perhaps a lower mortgage rate – and arrive at equilibrium a bit higher, however it will be difficult to justify anything but a significantly reduced outlook for the long-term appreciation of property prices compared to Somerville et al’s estimates.

Edit: Commenters here and in other places in the local RE blogosphere have raised questions about depreciation as a line item in a DCF (discounted cash flows) calculation. While I agree depreciation is not a cash flow, in this case depreciation represents an expected decrease in future cash flows below headline estimates. In terms of the formula's framework, for what it is, depreciation does account for decreased future cash flows but is not explicit enough to really know what Somerville is modelling. Read the comments for an alternate approach.

Also the "densification premium" awarded to detached properties is further reduced when one accounts for capital costs associated with making land more productive. More bad news.

This One is for the Kids - RESP

From HRSDC:

A Registered Education Savings Plan (RESP) is a special savings account that can help you, your family, or your friends save early for your child’s education after high school.

The Government of Canada allows savings for education to grow tax free until your child named in the RESP enrolls in education after high school. The child named in an RESP is known as a beneficiary. A parent, grandparent, other relative, or friend, can open an RESP for a child. The person who opens an RESP is called a subscriber.

Benefits of Having an RESP

When you have an RESP, you can start saving immediately for your child's education in the future. Many parents wonder how much to save. They also wonder how soon they should start. The answer is simple. Save as much as you can afford. Start today. By starting early, tax-sheltered earnings on your savings can grow surprisingly quickly.

Further, if you are saving for your child’s education, the Government of Canada will help you with special saving incentives that are only available if you have an RESP, including the Canada Education Savings Grant and the Canada Learning Bond.

Your RESP Provider

You can open an RESP through an RESP provider. RESP providers include most financial institutions, such as banks and credit unions, as well as group plan dealers and financial services providers. It is important to choose an RESP provider carefully. Your provider has a role to play throughout the life of your RESP, which can remain open for a maximum of 26 years:

At the start, your RESP provider will help you decide on the type of RESP that best meets your needs. You can choose from three general types of plans: family plans, individual plans, or group plans.

After you decide on the type of plan that meets your needs, your RESP provider will give you advice about making your money grow with wise investments.

When it is time for your beneficiary to start using the RESP, your RESP provider will administer the payments and ensure that they are made according to the terms of your plan. If the beneficiary does not continue education after high school, your RESP provider will ensure that your contributions are returned to you and tell you how much income you made on those contributions. Your provider will also see that any additional money paid into the RESP by the government is returned to the government.

Some RESP providers charge service fees. Some may also limit the amount of money you can put into your plan and tell you how often you can contribute. Before you open an RESP, ask the RESP provider to explain any fees, limits, penalties or requirements to make regular payments that may apply.

Steps to Opening an RESP

Opening an RESP is not difficult. In fact, you just need to take a few simple steps:

• Get a Social Insurance Number (SIN) for anyone you name in your RESP as a person you are saving for. There is no fee to get one, however, certain documents are required.
• Apply to the Canada Revenue Agency for the Canada Child Tax Benefit if your family net income is $75,769 or less. This form is generally provided at the hospital where your child was born.
• Decide on the type of RESP you want to open.
• Decide on the type of investment that will make your money grow.
• Put some money into your RESP.

Making Your Money Grow

Ask your RESP provider about your investment choices. Some RESP providers offer a variety of investment choices while others have a set investment plan.

It is important to take your time. Ask your RESP provider questions about your investment choices, including the advantages and risks of each. Some of your investment choices may have service fees or penalties. It is important to ask for a list of the fees or penalties that may apply.

Type of Plans - Choosing the Right RESP For You

You can choose from three general types of RESPs: family plans, individual plans, or group plans.

Family Plan

In a family plan, you can name one or more children as beneficiaries of the RESP, but they must be related to you. They may be your children, adopted children or grandchildren.
A family plan may be a good choice if:

• You want all, or any one of the children named in the plan, to be able to use the money;
• You want to decide how to invest the money, either on your own or with the help of a financial advisor; and
• You don’t necessarily want to make regular monthly payments.

Individual Plan

An individual plan is for one beneficiary and the person does not have to be related to you.
An individual plan may be a good choice if:

• You want to save for a child who is or is not related to you;
• You want to decide how to invest the money, either on your own or with the help of a financial advisor; and
• You don’t necessarily want to make regular monthly payments.

Group Plan

A group plan is offered and administered by a group plan dealer, and each plan has its own rules. Usually, group plan dealers must invest the money in low-risk securities such as bonds, treasury bills and guaranteed income certificates (GICs). Generally, you have to sign a contract agreeing to make regular payments into the plan over a certain period of time.

In a group plan, your savings are “pooled” with those of other beneficiaries (or children) of the same age. The amount of money each child gets is based on how much money is in the pool, and on the total number of students in the pool who are in school that year.
You can name only one child in a group plan and the child does not have to be related to you. If the child does not continue with education after high school, your group plan dealer will tell you what will happen.

A group plan may be a good choice if:

• You can make regular payments into the RESP;
• You prefer to have someone else decide how to invest the money for you; and
• You are fairly sure that the child you are saving for will continue education after high school.

Since each group plan is different, it is important to ask your group plan dealer for details.

Using Your RESP

As soon as the child named in your plan is enrolled in a qualifying educational program, he or she can start receiving payments from the RESP called Educational Assistance Payments (EAPs).

Qualifying Educational Programs

Usually, a qualifying educational program is a course of study that lasts at least three weeks in a row, with at least 10 hours of instruction or work each week. A program at a foreign educational institution must last at least 13 weeks.

Qualifying educational programs include apprenticeships, and programs offered by a trade school, CEGEP, college or university.

RESP funds can be used for full or part-time study in a qualifying program.

When Your Beneficiary Does Not Continue Education After High School

If your child decides not to continue education after high school, you may be able to:

• Wait for a period of time, he or she may decide to continue studying later;
• Use the money for a brother or sister who does continue education after high school;
• Transfer the money into a Registered Retirement Savings Plan (RRSP) to help you save for your retirement.
• Withdraw your personal savings, tax-free.