Present Value of shelter -- part 2

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Here is part two of a post that aims to evaluate housing as an investment ... where owners are expecting to earn an annual return (rent) as well as capital gains due to appreciating property values upon final sale.

in part 1 - I laid the groundwork as to the basic premise which would be used to evaluate the prices of real-estate.

recall -- that basically, the most a rational investor would be willing to pay for an investment is the present value of the income stream of the investment, with all future income being discounted by a corresponding equivalently risked market return. for a re-hash as to what this looks like, part 1 can be found here.

In this, we have to lay some basic assumptions out first.

• housing in Victoria, BC (the CRD) has had an average growth rate of 5.07% per year from 2005 to 2016 based on the Canadian Real Estate Associations Housing Price Index (CREA HPI) which can be found here.
• (For those familiar with the rule of 72 -- this estimates that if this continues, the price of housing will double approximately every 14.2 years.
• Rent prices between 2015 and 2016 in the CRD increased on average by 5.77% although this does differ from a min of 4.9% for a 1 bedroom and up to a 6.8% increase for a 3+ bedroom, as determined by CMHC which can be found here. 
• Recognizing that between 2015 and 2016 there was an influx of people into the CRD pushing up prices, coupled with not being able to have access to a longer time frame of rental prices, I have arbitrarily adjusted the annual growth rate of rental prices down to 4.5% from 5.77% as I feel this 5.77% is not representative of normal rental activity.
• Second, BC tenancy act allows landlords to increase rent at 2% above inflation ... given a targeted inflation rate of 2%, this further seems to fit this assumption
• For reference: Expected return over the last 61 years from an aggressive to a conservative portfolio is as follows: data obtained from here.
• Aggressive portfolio (80% equity, 20% bond): 10.9% per year.
• Moderate portfolio (60% equity, 40% bond): 9.8% per year.
• Conservative portfolio (20% equity, 80% bond): 8.11% per year.

Recall we want to compare our payments from this investment in real-estate versus an equivalently risked investment -- Based on a preliminary search, the consensus seems to be that real-estate is less risky than equities, but riskier than bonds (due to potential maintenance problems, non-payment, periods of vacancy etc.). Thus perhaps around 9% similar to our Moderate portfolio may be good grounds to compare real-estate to (we will, in fact, calculate for an array of interest rates).

Presently we have the following price and rental situation in greater Victoria (CRD):

If we (as investors) were to assume that our annual house price was to continue to increase at 5.07% per year and that our annualized rental payment could be expected in to increase at 4% per year into the for seeable future, then we should expect the following present values if we hold on to the property for 30 years, collecting rent, and then willing to sell it for its market price.

Where if we sum up the present value of the future income streams over 30 years (discounting by the respective interest rates) we see that at the current market price -- If the interest rate is 7% then all real-estate regardless of unit type is a great buy! alternatively, as we move up to an 8% interest rate, one bedroom and three plus bedroom units are over priced. Finally, as we move up to a 9% interest rate, all units are over priced.  

Now perhaps investors are not actually looking to purchase real estate to invest in for a 30 year time period, so perhaps that is too long to consider. Thus, let's graphically look at the present value of each unit based off of its income streams over a 0,1,5,10,15,20,25 and 30 year time period. keep in mind that over a time period of zero, we have the current price of the unit. 

As this would be a bit too cumbersome to display in tables, we have graphs:

Updated: As was kindly pointed out to me, the previous graphs in this post were very misleading - the nature of a line graph seemed to show how the price of real-estate was expected to change over the next 30 years when this was not the case. the graph instead is demonstrating what the present value of real-estate is based on the period of time you hold it for as an investment.

At a 7% prevailing interest rate, all unit types are currently for sale for cheaper than their present value for all holding period.

As we move to an 8% prevailing rate, three or more bedrooms and one bedroom units initially have higher present values (for short holding periods) but quickly decrease.

 Finally, as we look at a 9% prevailing rate, we see rapidly falling present values for all holding periods greater than 1 year -- indicating that all unit types would be overpriced relative to their present value of future income.

As stated at the beginning, real estate as a risk class is considered less risky than equities, but riskier than bonds -- I arbitrarily assumed a rate of 9% based off of historical portfolio returns. It shouldn't however, be a surprise to learn that in recent years we have been in a lower interest rate environment, thus it is under this rationale that I have included a range of prevailing rates. To finish off, for reference, I will include one lower rate of 6% and the corresponding present values.

The takeaway? depending on our view of the prevailing interest rate on a similarly risky investment, current real-estate in the CRD could continue to increase, or could already be over-priced.

Of course -- all of this is extremely sensitive to our assumptions - especially the growth of real-estate and rental prices into the future ... if either of these begins to slow, then we have a very different story!

What are your thoughts -- should real estate be viewed as an investment? or strictly as a means to provide shelter? Feel free to comment below.

Thank you to Francis and Joel for your comments leading to this revision!

Present Value of shelter -- part 1

Here comes another post about the housing market in BC as the news keeps peaking my interest along different avenues of this topic.

This time I began to wonder if maybe the driving demand for housing is not at all for shelter -- but what if the primary consumers of real-estate saw real-estate as an investment. That is, a place to park their capital in order to earn a decent return.

This idea was spurred by a recent article the tyee, an independent online newspaper written by Geoff Dembicki which can be found here.

I'm not sure I fully agree with all the conclusions made in the article, but just the same it made me think. If real-estate is primarily seen as an investment, then we could realistically obtain a price for real-estate based on the expected returns to be had over time.

First, this will be long enough to describe the methodology, the basic concept by which we will attempt to measure the present value of housing. Thus for this post, part 1, I will strictly be discussing one way to determine the price of an investment, while in a follow-up post I will apply this method to the housing market to explore the effects.

The way I normally teach this premise is to introduce the idea of some magic machine that you can buy and put in your house. This machine then regularly creates money, such that it generates $1000 a year. Now this machine is only capable of doing this for two years, then runs out of its magic. Despite the loss of the magic, the machine is still worth $5,000 for the scrap metals and parts - thus it can still be sold after it stops producing your money.

Based off of this -- I ask, "What is the absolute most you are willing to pay for this machine?" typically the answer is $7000 ($1000 from each year and the $5000 you sell the machine for) The rationale being that if you paid $7000 for this machine, you neither made or lost money -- thus it would be the most you would be willing to pay.

Well, the problem with this answer is - If I offered $7000 today or $7000 in 2 years - which would you take? Most rational individuals would take the $7000 today because they to a degree discount the future.

Alternatively, they know that even if they have no need for the money today, but might in 2 years time, if they take the $7000 today and invest it at a market rate of return they will have more than $7000 in two years.

In this same way, the $1000 we earn from the machine at the end of year 1 is less than $1000 today, and the $5000 we sell the machine for at the end of the two years is less than $5000 today. Thus we need to discount these values based on the market interest rate.

Thus we say the present value (maximum we are willing to pay) for this machine would be equal to:

Thus in each year, we discount the payment (and the final sale price) by the equivalent interest rate we could have earned, had we instead bought an equivalent risk-adjusted item in the market.

Thus if we assume a similar case would have held an interest rate of 5% we have the following maximum willingness to pay for this magic machine:

Thus the absolute most you would be willing to pay for this machine is $6394.56 as this is the amount that if you had today, would yield $7000 in over 2 years time at the given interest rate.

In this sense - If the current price of this machine is anything less than $6394.56 then you buy this machine without hesitation because it will be making some positive amount of money for you.

That is, to put it a different way -- $7000 in two years is worth $6394.56 to you today ... thus if you could pay $6200 in order to get this machine, you have instantly made $194.56.

In a follow up post I will take this basic premise an apply it to the real-estate market.

"Why Trumponomics fails"

link to an interesting blog piece by Robert Reich called "Why Trumponomics fails".

Specifically great are the comments Trump recently made about the new Boeing being made in the US (realistically assembled). but more relevant to the topic at hand, the situation of the workers who do the majority of the manufacturing of the components which are then assembled in the US.

To quote Reich below he states the following when speaking about the workers in the countries where a good chunk of the production takes place:

Notably, these companies don’t pay their workers low wages. In fact, when you add in the value of health and pension benefits – either directly from these companies to their workers, or in the form of public benefits to which the companies contribute – most of these foreign workers get a better deal than do Boeing’s workers. (The average wage for Boeing production and maintenance workers in South Carolina is $20.59 per hour, or $42,827 a year.) They also get more paid vacation days. 

These nations also provide most young people with excellent educations and technical training. They continuously upgrade the skills of their workers. And they offer universally-available health care. 

To pay for all this, these countries also impose higher tax rates on their corporations and wealthy individuals than does the United States. And their health, safety, environmental, and labor regulations are stricter.

Not incidentally, they have stronger unions.

All of this initially seems like it would result in much higher costs (higher wages, high taxes, more vacation days, etc.) so why doesn't Boeing manufacture these parts at home (America) using their cheaper American labour who take fewer vacations?

to answer this with another snippet from Reich:

The way to make the American workforce more competitive isn’t to put economic walls around America. It’s to invest more and invest better in the education and skills of Americans, in on-the-job training, in a healthcare system that reaches more of us and makes sure we stay healthy. And to give workers a say in their companies through strong unions. 

In other words, we get a first-class workforce by investing in the productive capacities of Americans  – and rewarding them with high wages.

It’s the exact opposite of what Trump is proposing.

That is - despite the higher wages, taxes and vacation days being enjoyed by workers abroad, their high level of education and technical training translates into high quality, and high productivity work, allowing these workers to produce a superior product at a cost that must meet if not be below the cost which would be incurred domestically.

Again this simply reiterates the point made during an earlier post that the liberalization of trade (free trade) is not in itself the problem being faced by the US. Instead, the problem has been decades of misplaced policy resulting in a lack of investment in education and technical skills, leaving a vast amount of the American labour force unable to compete against global labour pools. Where this is no longer a case of being unable to compete due to lower wages being paid to workers in Asia, but rather unable to compete due to the higher skill sets and levels of productivity of workers in Europe as well other developed countries.

What are your thoughts on this, what are the solutions? protectionism? or evaluating some alternatives which pay prove the be quite costly in the short-run in order to play catch-up?

Feel free to comment below.

Unoccupied houses

In a past post, I made a statement that when looking at household formations and the rate of new households being built it seemed that supply was outpacing demand, thus we should expect to see falling prices. Clearly, we are seeing the opposite with home prices.

I speculated that this may be due to investors purchasing houses for speculative capital gains, leaving them vacant. At the time this was pure speculation - then today I began noticing a number of news articles on the subject pulling data from the latest census.

it appears my speculations was not entirely wrong!

You can read my previous post here. Or view some of the related news articles here and here.

Keep in mind -- real-estate investing is not a bad thing. If those investments are being rented out to provide shelter, then shelter is still being provided. It is only when the price is being pushed up and shelter is being denied when we potentially have negative consequences and overall falling affordability for both owners and renters.

Keith