Investoid

I met up with my friend who’s a real estate investor in Alberta. He was bought out of the company he co-founded and is now looking to purchase 20 rental properties with the funds. He is still extremely bullish on the local market, and anticipates housing prices to increase at least 20% annually the next two years. He cites the extremely low vacancy rate (which is project to be 0.5% by 2008), continued low interest rates (and inflation), and the political stalemate over tough environmental laws nationally and globally.

As I’ve talked about before, I think the runup in housing prices has been largely based on fundamentals, although there is undoubtedly speculation in the markets. But I think prices will run into affordability issues soon, and consequently much smaller increases. One mitigating factor to this would be the onset of interest only or adjustable rate mortgages, which would fuel demand even more in the short term.

If prices increased 50% over the next couple of years, Alberta would have housing roughly more expensive than Toronto, which I don’t think is realistic in the short term. Plus, you have investors already diversifying out of Alberta due to opportunities elsewhere, like Saskatoon.

I also think there is some political risk of environmental and/or royalty legislation that could slow down, if not stop altogether, oil sands development. Many of the major producers are already complaining that high costs have forced them to re-think any future expansion. Indeed, one CEO lamented that he would not start the project they are currently working on today if costs were this high when they started. Additional costs could push many to re-think their expansions, given the current price of oil.

It will be interesting to see how the market develops during the peak summer months, which will be a good indicator if the market has plateaued or will continue its run.

Well, within a week of considering buying a place we have now purchased a home. I can’t believe that we moved that fast, but the more time we spent on the buy/rent analysis and the overall market/economy analysis we did we decided that the time was right.

Given the major increases in house prices in Alberta, our options were to:

1. Buy a condominium, either in a high rise downtown or a low rise near family (likely price: $250-310K)
2. Buy a detached home, entry level ($330-375K)
3. Buy a 1/2 duplex unit ($280-370K)
4. Buy a detached home, one step up ($400-430K)

In terms of appeal, the most expensive option was in line with what we had in mind for ‘our house’. This would have meant picking up a fairly large mortgage, but one that would be approved without hesitation by any lender. However, I don’t believe in the 30% ‘GDS rule’ (gross debt service ratio, read Million Dollar journey for all the lingo details). Gross income is a meaningless number, unless you can pay our bills with your tax dollars somehow (please contact me if you know how, I’ll give you half of mine!). A 30% GDS rule implies that for a $100K earning family with a 35% marginal tax rate that you should be spending nearly half of your net income on your house. That doesn’t leave much for transportation, food, yet alone any quality of life things you enjoy. If you max out the GDS rule, you’re nearly working solely to pay for your house, once you factor out the other essentials. That doesn’t sound like fun to me.

Nonetheless, the most price appreciation has happened at the lower end of homes since first time buyers have flooded the market and are trying to get whatever they can. The low end (particularly condos and duplexes) has been historically a good leading indicator of the overall housing market. Thus we weren’t really interested on being part of the rise up and down.

So, we didn’t want a $400K+ house, we didn’t want a condo, duplex, or entry level detached home. What does that leave us?

In the end we decided to look at entry level detached homes with basement suites. There is an incredible demand for additional rental housing right now, and prices have skyrocketed in the past 6-12 months. By renting out a portion of our home, we get to keep our overall housing costs roughly where they are today (20% of net income), while being able to build up our equity. This means we get to keep our current lifestyle, more or less.

We ended up getting a 1170 st foot bungalow with a separate entrance for the basement suite. The suite has 2 bedrooms and 5 appliances. The home went on the market 4 days ago and was listed at $340K. The seller had decided to consider multiple offers simultaneously, so all interested buyers had their Realtors present their offers today one after the other. We knew that there were going to be at least 3 other offers, with the possibility of more. This guaranteed a sale price above list value.

We determined our maximum price using a cash flow analysis based on what the top and bottom could currently rent for. After discussing with our Realtor, we decided to go slightly below this value as he was confident he could ensure that as long as the top offer was not higher than our maximum, we would be able to get the house.

Sure enough, an additional bid was faxed in that was higher than ours. However, our Realtor had made a convincing case and the sellers allowed us to match the offer.

On top of the cash flow analysis, we used scenario analysis to determine the affordability of our mortgage in the worst case (Alberta’s economy tanks, people start leaving en masse a la 1982). We could still pay the mortgage, eat and get to work even if only one of us was working for a period of time and we had no other way to pay for our monthly expenses. Since one of us is in an extremely recession proof job, we feel we are prepared to ride out any economic downtown, which eventually would cycle again (unless inexpensive alternative energies make oil/gas permanently irrelevant).

Conversely, in the best case (strong steady growth continues, population increases), both rent and equity prices will continue to go higher. In this case we will be paying down our mortgage on an accelerated basis thanks to the rent increases, and will also have unrealized capital gains.

Either way, I’ve had a crash course in residential real estate buying (I have had experience on the commercial side before), and in boom-time buying. When I participated in buying commercial real estate in 2004/2005, we had months to analyze and negotiate. Now deals are done in as little as a day.

I’m sure I’m in for a lot more education in the coming months as we prepare to take possession as well.

My wife and I have been unexpectedly thrust into the real estate frenzy in Alberta. We were given three months notice from our place today, as the owner is looking to sell, as her returns on capital will be higher with the money in hand than renting the place, given the current housing prices. I don’t blame her, and her analysis makes a strong case for us to continue renting, since renting prices are once again below the equivalent housing costs.

However, rent has been increasing dramatically in Alberta right now, and barring some rent controls (which the Alberta gov’t is looking into), rents will likely catch up to housing costs once again given current growth trends.

As I’ve stated before, I think Alberta’s housing boom has been driven by a mixture of fundamentals and speculation, the proportion of which is extremely hard to determine given the data available. In the past I’ve been slightly bearish about the future prospects for home prices, but have been proven wrong so and continue to be as we approach the peak buying season.

Future housing princes in Alberta essentially boils down to energy prices, so as long as cold fusion or another cost effective alternative energy source isn’t discovered tomorrow, things will not drop immediately. There are risks that China’s economy could face a hard landing (they had another 4% correction yesterday, amid fears of the enormous number of newly minted equity investors. Oil summarily dropped in sympathy), which would directly affect world energy demands.

Another interesting aspect is the high amount of debt lenders are willing to give to consumers. We were preauthorized for over $600K without any documentation (although there was a credit check), which makes me wonder how many people are taking as high of mortgages as possible.

In the end, we are leaning towards buying a home, one that has a basement suite so we can partially recoup our mortgage payments. We are looking for something that we can afford even with no renters, and in the extreme case only one of us has a job (although we’d be eating KD every day in that scenario).

This is a huge undertaking and has come about in the past 72 hours, but we know that we must act quickly and smartly. Any house in our range that’s half decent will have multiple offers on it, so we must be prepared to pay higher than asking price, or go after a home with issues and fix it up. We have some houses to look at tonight and if there’s one we like we will have to put an offer on it within 48 hours or it’s likely gone.

I am getting a crash course in home buying the hard way. It’s definitely not the way I expected to learn, but you never know what life will throw at you.

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).

It seems like a lot of the personal finance blogosphere thinks home ownership should be a given. I don’t think I’ve seen one blog where someone is advocating renting, or that the bloggers themselves are currently renting. While this conventional wisdom is well known and widely practiced, is it always appropriate?

A home is an investment asset that you must analyze like any other. You need to look at the costs of acquiring and maintaining the asset, as well as estimate its future return. Since you need to live somewhere, you need to compare the asset’s future value versus taking the excess costs of servicing the asset over renting and investing the money in alternative assets. While doing some digging, I’ve found a couple of decent rent versus calculators:

• Strategis (Industry Canada) Website
• Genworth Financial Website

Genworth’s is more of a fluff piece since they don’t take into account alternative investments. I’d like to know how they arrive that their ‘mortgage capacity’ calculation too.

To take into account more variables, I created my own rent versus buy spreadsheet which you can download here. It incorporates assumptions for increases in rent, property taxes and utilities, and I include a field for insurance costs. I also calculated future value either 25 or 35 years out. After playing around with these calculators, I found the following:

1. The end values are extremely sensitive to changes in assumptions for the growth rate in housing values, alternative investments, mortgage rates, and rent increases. Adjusting these values even half a percentage point can affect end values by several hundred thousand dollars.
2. Term does play a factor. Depending on the variables, a buy decision may be appropriate at 25 years but not at 35 years. Thus, the affordability of the home (can you reasonably amortize the mortgage over 25 years) comes into play.
3. The ratio of monthly rent to initial mortgage size is a decent gauge of whether to buy or rent. I found a ratio of over 300 (for reasonable long term growth rates indicative of my area) to be a pretty good threshold to determine whether renting or buying is the right long term choice.

Using my calculator, I’ve plugged in some values that represent the current Edmonton, Alberta market. I’ve used a mortgage of $330,000 with a down payment of $30,000 (this is around the average house price in Edmonton as of February 2007). I’ve used a rent calculation of $1300 per month all inclusive, which I think is roughly equivalent. I assume an increase of 5% annually in rent and a growth rate of 4.5% in real estate value over time (which was calculated based on the long term compound annual return for a representative region of the city between 1981 and 2007 using data from Royal LePage). Taxes and utilities increased on a blended average of 6.5% per year, while the estimated return on alternative investments (eg. North American equity ETFs) was 7.5%.

Using these figures, the ending value in the buying option ($1.68 million) was about $460,000 more than the value in the renting option. So, it seems as though buying may still the appropriate choice in Edmonton, despite the huge runup in prices in the past year.

When I plugged in values for my situation the return is nearly identical. I’m at a point where I need to evaluate what’s the best option for me. Which leads to the obvious questions about the long term viability of the Alberta housing market. Will Alberta’s real estate boom continue? Or are we in a bubble situation? That will be the topic of my next post.