Investoid

As I did the rent vs. buy math in my last post, I had to make assumptions about the long term annual return for residential real estate. Over the long term this value is typically below equity returns, but around the world these past few years they have typically done as well if not better than equities. So what’s the story going forward? Particularly, what’s happening in Canada’s hottest economy, Alberta?

Let’s review some facts:

• In 2006-07, total returns on homes in Edmonton has averaged over 80%. Since 2000, the total return on a representative neighbourhood in Edmonton has been over 166% (source: Royal LePage historical database). Note that I am using a particular neighbourhood instead of the entire city since aggregate figures were not available for all years. I believe this neighbourhood to be appropriate since it is composed of a mix of low, middle, and high income households.
• Edmonton’s long term (25 year) average annual return on single detached bungalows is around 4.5%. That said, the volatility (standard deviation) on those returns is a whopping 11.1%.
• Prices have been increasing for several reasons, namely (not in any order of importance):
  1. An increase in urban population in Calgary and Edmonton
  2. Higher incomes for the population
  3. An increase in debt-financed home purchases by investor groups
• Alberta’s economy has continued to grow robustly. While Canada’s year over year growth was 2.3% in Q4 2006, Alberta’s growth was well above that. It is expected that Alberta’s real GDP increased 6.8% in 2006 (source: TD Economics via CBC)
• The main reason for Alberta’s growth has been the development of its natural resources, particularly the Oil Sands. The Alberta government derives 35% of its revenue from non-renewable resource revenues, which probably under-represents the overall GDP share of this industry (source: Alberta Budget 2006)

After the sizable runup in the past two years, two camps have developed: real estate bears and real estate bulls. The bulls are ardent that the Alberta economy will continue its high growth, and thus more and more people will be coming to the province and drive up the price of housing even higher. The bears counter that such a high runup in a short period of time cannot be based on fundamentals alone (the population of these cities did not increase by such a large amount in 2 years), and thus speculation is what is causing the ever soaring prices. Bulls are always saying you need to get in now or you may be priced out forever, while bears caution that once the speculators are squeezed (either by higher interest rates, less people willing to buy flipped homes, or an economic slowdown) there will be an inventory glut which will drive down prices.

Here are some blogs (or blog articles) in the bulls camp:

• Edmonton Real Estate Blog
• Confused Capitalist: What housing bubble?
• Money Blogs: 5 signs of a housing bubble

Meanwhile, there is a cottage country of housing bubble blogs. Here are my favourites:

• Edmonton Housing - this one is more neutral than anything but I’ll put it with the bears given the recent press releases it has on its site
• Langley Financial Planning
• Alberta Bubble
• Calgary Conundrum
• Calgary Contrarian

With all this conflicting information, what to believe?

At the end of the day, I believe that Alberta’s real estate rise has been mainly fueled by fundamental economic growth. However, I do believe there is a fair bit of speculation priced in as well, as investors far and wide have put money into purchasing homes to flip or to rent out and then appreciate. I am basing this conlusion from the anecdotal evidence that I encounter in my daily travels. I am astounded at how many people are discussing how they’ve either a) purchased more expensive homes to capitalize on their newfound equity or b) are pooling their money with others and buying homes on spec.

Presently, there are some factors that could affect the fundamentals of Alberta’s economy. There is a perfect storm of issues right now:

1. Possible weakness in U.S. and global economy (next 12 months will be very telling)
2. Environmentalism is because the cause celebre right now with politicians, meaning that strict controls may be put in place in the next 1-2 years (this is particularly more likely if the federal Liberals win the next election), which will place at least some economic hardship on the oil sands producers.
3. There could be significant tax changes at both the provincial and federal levels. The federal government is reviewing the acceleration depreciation schedules given to oil sands capital projects, while the Alberta government is re-evaluating the royalty structure. These could both have a material effect on future oil sands growth.

The Globe and Mail had a good story on this subject yesterday. I would suggest you read it. Any or all of these issues could cause development to halt and even reverse. Those people who were in Alberta in the early eighties remember seeing average housing prices decline by over 30% in three years (and I’ve heard first hand accounts of people selling for half price or worse). Alberta isn’t exactly California - people are here for the money, not for the lifestyle (except us natives who love it regardless).

Bottom line: this is a complex issue with many variables, but I believe that the house prices will start to go sideways as supply and demand reach an equilibrium in the coming months. Should any of the potential shocks mentioned above occur, I believe there might be a healthy correction as speculators are shaken out. But long term, I see growth returning to historical norms (probably with the same amount of volatility too).