Owner’s Equivalent Rent

A question surfacing recently on local blogs and forums has been how to properly value owner-occupied housing. The concept of “owner’s equivalent rent”, the effective rent an owner-occupier pays to carry a property, can be used to justify a property’s value. Such a concept would require setting equivalent rent based upon what other owner-occupiers pay, a slightly unsatisfying exercise for the value investor. A more palatable method would be to find equivalent investment properties and see what rents they command but this is not always easy. It begs the question: how does one ground a property’s value when there is little in the way of equivalent local rentals to do so?

A recent article in the Vancouver Sun had three local pundits involved in the real estate industry give their comments about the local real estate market. While I cannot encourage you to read it fully, I did pick up on a few items Dr. Tsur Somerville from the University of British Columbia has said about his research in how real estate markets behave with a significant portion owned by owner-occupiers.

Q: You said the investment piece is gone: Does that mean that the froth is not going to happen again? (If people aren't buying as investment properties, what would happen with price?)

Tsur Somerville: A couple of issues: No. 1, we don't actually really understand what goes on with investment real estate. When you look at research and studies, it is because home owner/occupiers are such a big piece....

Q: How big?

Tsur Somerville: Since we don't actually 100 per cent know which unit is which. But if you take the Lower Mainland and [calculate] 2.5 million people, 2.6 people per household, that's 800,000 households, 60 per cent homeownership [so] 480,000 households.

The investment piece is still very small in the overall number. It's highly concentrated in certain product types, downtown condos, certain suburban high rise buildings. Overall, it's not a big story. Going forward, we have two things we don't really understand, which is what are those people going to do?

What Dr. Somerville is commenting on is that when owner-occupiers make up a significant portion of a housing pool, it becomes more difficult to determine motivations of marginal players when existing data lump investors and owner-occupiers in one pool, especially when the “investment piece is still very small,” say, 40% of total households.

Joking aside, what I believe is implied is many people place a monetary premium on ownership and motives for buying and selling are not always strictly financial, hence the difficulty in separating true “investors” from the rest. (this blog discussed the concept of the "ownership premium" here.) The “non-investment” focus of marginal owner-occupiers therefore adds uncertainty to the behaviour of the market. He states that there is segmentation between owner-occupied and rental housing, or at least that is the perception, meaning that valuing entire neighbourhoods based upon the whims of investors not heavily involved in the market is questionable.

From a value investment perspective, to determine the net present value, we sum a property’s expected discounted net cash flows. We should also remember that undensified detached housing can justifiably carry a premium over today's rent as the property could be redeveloped in the future so as to increase its utility (as discussed here) and possibly a "gentrification" premium AKA location-location-location in some circumstances (see m-'s great post for some interesting data and analysis). Determining net present value with many equivalent properties with known rents is simple; unfortunately it is more difficult when properties have few direct comparisons. It is possible that in certain neighbourhoods the one or two rentals offering true comparables do not provide enough of a sample to truly gauge what rents would be for other properties. This can even be true for a seemingly normal property with a high finish quality where the neighbourhood's rentals are not renovated to the same degree.

Buyers are therefore left looking at comparable sales in the same geographic location to determine value, in part because neighbourhoods and even adjacent blocks can significantly vary in price. I doubt very much rental data enters into most owner-occupiers’ heads when determining a fair price yet it is an important and almost necessary clue when determining a property’s value ex speculation. Perhaps it is a stigma associated with comparing “the renters” to “the owners”; an admission a property can be rented out at all goes against the concept of “achieving” ownership, or maybe it is just making the buying decision simple: find five comparable sales, offer about that, and Bob’s your uncle. Alas, this is not my idea of value investing.

Believe it or not, even “high quality” houses are rented out. A quick search of Craigslist turns up a few “high quality” rentals, as examples (not sure if they’re “real” or not; these props will likely disappear so maybe do your own search...):

You can calculate how much these properties would be worth as net present value and compare to their rough market values. There are not too many examples of higher quality rentals, however, and we are still left with the problem that a specific neighbourhood will likely reveal few, if any, equivalent rentals for a property for sale.

Yet even from the close to nonexistent comparables, we can still make some assumptions. In the absence of direct data we can look at high quality rentals across the entire region and compare them to lower quality rentals in their respective areas. This will give a rough indication of the premium higher quality demands in the rental market. From this we can look at a larger set of “high quality” compared to “lower quality” rentals and apply a factor to determine equivalent value for a certain “higher quality” property. The concept is simply that there are many neighbourhoods that are effectively comparable, even if separated geographically.

Using comparables from other neighbourhoods is roundabout method of determining value. The uncertainty is higher and my guess is Realtors won’t like the concept one bit; after all isn’t all real estate local? But we need something, even if it’s using deductive inference, or the market is not grounded on anything but sentiment and margins.

Many neighbourhoods have a large mix of both rental and owner-occupied properties so the problem of determining value for the value investor is less severe. For some neighbourhoods, say close to UBC for example, the concept of determining value for predominantly owner-occupied properties I am sure can seem daunting. Even in the face of such high noise, using a bit of deduction, an expanded "virtual" rental market provides us with enough of a tangible signal highlighting how much "high quality" properties are currently priced above what the rents say they are worth.

The Rental Shortage

The Tyee has had an interesting series of articles on the housing market of late and the latest in their installment is The Path to New Rental Homes: One Broker's View by guest poster David Goodman. I encourage you to read the post as it highlights some of the technicalities surrounding building rental housing in the Vancouver area. Certainly it seems, on the surface, to be a bit of a quagmire.

First he starts off by setting the scene:

During my 26 years in apartment sales, I've heard on at least 50 separate occasions developers commenting that "even if the land is thrown in for free, we cannot make the numbers work on a new rental building." As a result, the Vancouver vacancy rates stands at 0.5 per cent, the age of the average purpose-build rental is 50 years plus, and local developers attempting to produce new rental housing are likely to lose money.

So developers cannot "make the numbers work"? Sounds reasonable. But I don't really get it. The vacancy rate is low, apparently signaling low supply. I would expect rents to increase to compensate for the low vacancy rate. I wonder why rental rates aren't increasing -- maybe the vacancy rate isn't as low as he is citing? He continues:

Things changed considerably in the early 1970s when the strata condominium was introduced to the market. This new concept provided buyers, including tenants, the opportunity to purchase and own their own suite rather than pay rent. Prices paid for condominiums were soon much higher than rental apartments. As a result, land quickly increased in value to reflect the fact that building condominiums was significantly more profitable than building rental apartments. Accordingly, except for very few special situations, the construction of purpose-built rental properties ceased. This situation has not changed much since the 1970s.

Ahh now we get to it. The reason purpose built apartments have not been built is because building condos is more profitable. It certainly seems that, given the horrid price to rent ratio in the city, any developer would be batshit crazy to build something with cash flows unlikely to cover debt repayments and other carrying costs (except with a large downpayment of course! haha).

Over many years, the developers of condominiums would assemble single-family lots in apartment-zoned areas or seek to rezone former industrial sites. Unfortunately, we have almost exhausted the conventional source of residential development land throughout the Lower Mainland. As a result, the cost of multi-family zoned land and the resulting new condominiums have increased much further in Vancouver compared to other parts of Canada. This is one reason why we have all heard of some prime Vancouver sites selling at over $200 per square foot gross buildable at the recent peak of the market.

The old faithful "running out of land" argument. Can we be so sure about this? Maybe it seems land supply is tight because there are so many projects under construction? The population didn't suddenly explode in the past 5 years and hit the buildable land brick wall. It is entirely possible what we are witnessing is underutilisation of existing housing and speculation. If we were truly land constrained wouldn't real rents be increasing as well? Strange how they are not.

I have learned to appreciate the important real estate concept known as "highest and best use" in considering the value of real estate.

Developers and value investors share this philosophy. But the difference is what "value" means. For the developer it's a very simple and short term calculation: build within one or two years and sell, pre-sold or on spec, to someone else, likely a speculator (in one form or another). This dude either occupies it, using the full brunt of his ownership premium, keeps it dark for a flip, or rents it out at a yield a developer wouldn't touch with a ten foot barge pole. Value investors, on the other hand, look at "highest and best use" more on what cash flow is possible. It may mean re-development but only because doing so generates higher rents to compensate for the construction costs and delay in occupancy. I have no clue the thought patterns of Mr. Goodman's current clients though I would expect, given they are the "dudes" buying the bags, it's not exclusively a value play.

Purpose-built rental housing is not being built because of more profitable alternatives to the developers, namely selling it to someone else to deal with. I laugh when I realise the rental vacancy stats Mr. Goodman cites don't include small time landlords to whom his developer acquaintances sell. I am sure regulation plays some part but give me a break -- even if we remove every shred of red tape surrounding rental units it still wouldn't make sense UNTIL THE RENTS CAN COVER THE THE CARRYING COSTS.

It is laudable Mr. Goodman's suggests to streamline the ability to build purpose-built rental housing again but to think doing so will suddenly swing developers into the rental camp again is a bit too "rich" for me, at least until land values drop or rents increase to where it makes financial sense. I encourage him to keep priming the pump for such an eventuality.

Consumption

I suggest everyone visit http://www.storyofstuff.com/ and watch. This is the mess we have gotten ourselves in as a society and we need to come up with solutions for a more sustainable way of life for our financial well being, our health, and for our environment.

CDN$ vs US$

So I woke up this morning and all I heard and saw on the news was Canadian dollar talk. Insane how the news outlets really can glom onto a topic and really blow it up from something fairly insignificant into a big deal. I'm not saying that the rise in the Canadian currency is not without consequences but the rise we have had versus the US dollar and other currencies to a lesser extent over the past 4 years has been far more significant than the move over the past week.

I guess the attraction to the story is the psychology involved with round numbers or multiples of 10. I don't know why round numbers have such a psychological impact but they do. Maybe we are all just a little obsessive compulsive.

On a contrarian investing note, it is likely that now would be a good time to invest into solid companies the USA (GE, Pfizer, Johnson and Johnson, Proctor and Gamble, Monsanto, Intel, Microsoft for some decent examples), unhedged to the Canadian currency. On a personal consumption note, it is certainly a lot more attractive to go on vacation to Hawaii, Florida or California now than it ever has been in my memory.

The story really should be about the devaluation of the US dollar and not the rise of the Canadian but we have home country bias and see things through a Canadian lens. I remember hearing Marc Faber say that his investment thesis for the next 25 years was the systematic and competing devaluation of currencies around the world. He said that he expected the US dollar to lead and the devaluations will come in fits and starts but that countries around the world, in order to prop up their exports, will purposefully devalue their currency. I don't know whether his thesis will prove true but it is interesting food for thought. The alternate side of that is that every other country around the world could say 'screw off USA, you are more trouble than you're worth!' I doubt the latter.

On crystal balls and market falls

I dug up this old post from the VHB archives from last January.

VHB Post from Saturday, January 14, 2006

The suggestions that the current situation is just a temporary slowdown could very well turn out to be correct. The market certainly did experience only a temporary slowdown in 2004, for example, before resuming high growth. Also, many of the typical indicators of a slowing market (skyrocketing inventory, for example) are just not happening right now. Maybe growth will soon take off again. However, before we take too much reassurance from the experts, let us take a look at the past. I have selected a series of quotes from our 'blasts from the past' series. As you read each quote, it is striking to see how easily it would fit right into a newspaper article in January 2006.It's not easy to predict the future.

The point of this post is not to make fun of some predictions that turned out to be wrong. Instead, I simply want to emphasize that we should not turn our brains off simply because some person quoted in the media reassures us that everything is A-OK.Here are 10 quotations. After each in italics you'll find the source, timing, and a link for the quote. Enjoy:

1. "Price stability, rather than decline, would be expected for most of the housing stock . . . since underlying home ownership demand remains strong due to continued high immigration." (Frank Clayton, January 18th 1981 in the Sun. link The market crashed by about 50% over the following year. )

2. Renaud said he thinks that the trend to prices for houses has been broken by a temporary lull and that by [next year] or so prices will be equal to or greater than peak prices. (Claude Renaud, VP of Mortgage Insurance Canada on April 14, 1982. link The market took 26 quarters (over 6 years) to regain its peak in real terms.)

3. "To those who are waiting for Vancouver house prices to collapse, I can only advise them not to hold their breath . . . Unless there is a major recession or significant depopulation, house prices are unlikely to drop significantly." (Jerry Jackman, VP Royal Lepage, November 18, 1988 in the Vancouver Sun. link In 1989, prices started to drop - with an eventual 30% or so drop. Real prices did not attain these heights again for 58 quarters, or around 15 years.)

4. "We are definitely in a transition market in areas such as the West Side, Vancouver East, and Burnaby . . . it is too early to tell if the market will stall." (Jerry Jackman, April 20th 1989 in the Province. link Prices did not recover in real terms until 15 years later.)

5. "It is unlikely that prices will decline significantly." (JJ again, July 18th 1989 in the Sun. link)

6. "The whole world wants Vancouver because everybody is moving here now and everything points up, up, up." (Realtor David Goodman, December, 1989 in the Sun. link The market did not reach these heights again for 15 years.)

7. " . . .no one is panicking over the west side housing market and he insists that it has simply 'normalized'." (Jerry Jackman, January 27th 1990 quoted in the Sun. link West-side prices fell by 40% in the next 2 years.)

8. "I can't see prices reversing themselves there [in the west side] because it is still a very desirable place to live." (Same as above.)

9. "The market is entering a more 'normal' phase." (REBGV president Brian Calder, Feb 2, 1990 in the Sun. link If normal means that it takes 15 years to recover, then 'normal' it was.)

10. "A BC Central Credit Union newsletter released Tuesday said BC's housing market is currently experiencing a contractionary phase but the worst of that phase should be over by late summer or early fall." (BC Credit Union economist Richard Allen quoted in the Sun, July 5th 1995. link The decline in the late 90s was slow, but it took 28 quarters to bottom out and 33 quarters to recover to the previous peak. Some 'phase', eh?)

posted by Van Housing Blogger at 9:55 PM

Bill Good Talks Real Estate

I was in the car this morning and I caught 10 minutes of the Bill Good show on CKNW and from what I could gather the entire hour between 9:00 AM and 10:00 AM was talk about housing affordability in Greater Vancouver.

Mr. Good had all the usual suspects on the show:

1. Obligatory real estate industry "economist" - Cameron Muir from the BC Real Estate Association.
2. Obligatory 'objective' acedemic economist - Tsur Somerville from the UBC Sauder School of Business.
3. Obligatory 'entrepreneurial' real estate investment guru - Don Campbell, who has written books on real estate investing in Canada.

My impression from the 10 minutes I heard was about enough to make me lose my breakfast and spit up my coffee. All the usual junk about how Vancouver is such a nice place to live and that the market perfectly determines prices, downplaying the US housing market situation, Vancouver is different, residents are making it work somehow, low unemployment, Olympics, hot economy, real estate agents are wonderful, Olympics, real estate offers fantastic wealth generation opportunities, and on and on and on.

Anyone else listen to the entire show and have some different impressions. I usually find Bill Good fairly informative and balanced but his choice of guests today was far from balanced. He is also a notorious Vancouver Olympics pumper so that may have played a part in his choices.

My theory here is the Bill Good show may represent the 'magazine cover indicator' for the Vancouver market in 2007.