Monday, October 22, 2007

What could it look like in 5 years if we bought today?

I'm going to revisit a purchase plan on a SFH. I'm going to use an MLS listing that has sold, but I think we'll see more of these types of sales situations so it may be indicative. Or it may not be.

Here it is: MLS# 231005. Original asking was $419,900, it sold after 108 days for $371,000. I picked this one on purpose; if we went after a house we'd be looking for a "motivated seller" so this fit.

Anyway, here's our particular economic situation with it: 5% down, 25 year amortization, 5.85% locked-in over 5 years. It looks like this:

We'll pay bi-weekly rapid. We won't overpay our mortgage because we prefer to max out our RRSP contributions. Any disposable income left over will go into other investment products, not the mortgage. You can debate the intelligence of that, but at relatively cheap money (5.85%), paying down the mortgage isn't huge on our priority list. We anticipate feeling comfortable in this house in this neighbourhood for 5 years.

Assumption Scenarios
Growth continues as it trends right now, roughly 6%/year.
Current value (actual): $371,000.
Future value at 5 years (assumed): $496,481.
Difference: +$125,481.
Mortgage principle paydown: $36,000 (approximate)

Total approximate (possible?) equity at sale time: $160,000 ish.

Now of course you're thinking, $160K, no wonder everyone's getting rich off real estate! It's not that simple though. We have all sorts of other considerations here: taxes, interest, maintenance, months of vacancies etc. Here's the thing: we can afford the monthly payments on this. We can do so without sacrificing our savings, but the days of eating out would be done.

The rental income on the suite (1-bed) we'd calculate at $800/month. That's the high side of the rental market, but it's in a convenient location, we'd clean the place up and replace anything needed. We pay close to that now, so we anticipate being able to have that kind of income come in. That income would go directly towards maintenance of the house and property taxes. Our tax bracket wouldn't change, so our taxes would be based on an additional $9600 to our income, which we can eliminate by maxing out our RRSP contributions--we both have ample room from our years in college and low-income employment. The room is there for five years.

So why wouldn't we do this? It looks like a no brainer on paper. Even for a boisterous bear like me.

What if we changed the assumptions to something like this:

We experience a moderate correction of 6%/year. I don't think even an ardent bull could argue that this is well in the realm of normal possibility and is fairly indicative of the 94-2001 correction which witnessed just modest price reductions. When compounded though, those modest corrections can hurt.

Current value (actual): $371,000.
Future sales value at 5 years (assumed): $245,519.
Difference: -$125,481.
Mortgage principle paydown: $36,000 (approximate).
Approximate loss: $89,481.

Again we've used the rental income to cover taxes and maintenance as a simplistic way to remove those variables out of this complicated analysis. Regardless. When the market increases, you obviously come out ahead. But when the market decreases, you really do get hurt if you have to sell.

If you don't have to sell, you may find yourself living in a place with negative amortization, so you can't go get a HELOC and renovate to make it more comfortable.

It's this possibility that keeps us out of entering into this kind of scenario. It is just too much risk. That 6% decline over 5 years is a compounded 30% correction. That could very well be a reality. It could be less, it could be more, it could be faster, it could be slower. Even if we halved that assumption to 3%, that would still be a $30K loss all things considered. That's my master's degree I want to do over the next few years. That's approximately one-third of our income. That's a lot of money. Did I say a lot?

All signs point to a slowdown in both sales and growth. All signs point towards a looming economic downturn. Dodge is calling on the government to let the market correct the debt crisis, which means some pain is predicted, including raising interest rates. The federal government is trying hard to orchestrate their own defeat because come October 2009's scheduled election there is a highly likely scenario of a less-rosy economic (dare I say recession?) situation.

And this analysis is why we will rent for at least another 6 months. Unless we buy, gulp, a condo; which we'll run over tomorrow.


JMK said...

is well in the realm of normal possibility and is fairly indicative of the 94-2001 correction which witnessed just modest price reductions.

That was 6% correction, total, not per year. Your scenario is more representative of 1981-1985.

Why not include taxes, revenue, opportunity cost and do this comparison properly? The only assumption you need to make is return on investments, which have a nice 100-y time series to them.

Futura said...

Great post HHV.

A mathematical representation of what is at stake is staggering. Thanks for that.

Run, don't walk, to your management company and extend the leases on your rentals.

I extended the lease on my house through to the end of March and look forward to watching the RE market unravel as I save even more for my downpayment.

On a side note I think the rental market is softening. I deal with a large management company and my lease was up and they asked me to sign a year's lease. I said no and countered with 4 months. They tried to say the rental market was tight. I am on good terms with the people in the office so I laughed and said nice try, there are twice an many rentals available on Craig'sList Victoria this month as there were the same month last year. (It's 75% more but whose counting)

Anyways all I know is I am really glad I didn't buy when I first moved to Victoria in Nov 06. I feel poised to take full advantage.

Anonymous said...

great post!

we toured several open houses this weekend. One realtor asked us if we had been looking long - I replied 'yes'. She said that there was no hurry now - things are not moving! I was surprised to get this statement from her with no prodding whatsoever! And this was in Oak Bay!

Frankly I am truly shocked by the overpriced homes out there - many of which are junk.

hhv said...


Fair enough. The MLS # I used is Victoria. The Average for a Victoria, not CRD, home in 1994 was $256K, dropped to $227K by 1999 for a difference of $29K or about 11% compounded.

Regardless, isn't the whole thing kind of moot? Even acknowledging that my numbers assume too much depreciation in the first example, the comparison was an attempt to show apples to apples. Which is arguably impossible when it comes to RE. And it was presented in a what if scenario.

I'm not arguing that it is imminent that this will happen, I'm just saying it's possible. That possibility I interpret as being more likely than continued 6% growth and that makes me uncomfortable with the purchase, both of which are opinions and not facts.

Given that, my assumption in the 2nd case (a loss of $30K all things considered) is still more than we're willing to stomach.

I purposefully left out taxes, maintenance, opportunity cost because of: a) time willing to put into the calculations after work today and b) I'm really not sure I'd even come close to calculating them correctly.

If you want to re-calculate including those factors you suggested, I will post them in their entirety for discussion on the main page. We'd then also have to include costs for selling and re-buying would we not?

I value your insights and your alternative point of view. That said, there is something oddly pleasant about the reassuring voices of bears, who despite their abundance here, seem to be an endangered species out in the real world.

vg said...

great post HHV, somehow I just knew jmk would be the first one here saying you did it wrong.

Even if you bought in the last 2 years and we get a 20% correction only you are still going to be making nothing other than being married to your mortgage and are basically trapped so you better like your place cause when the coming recession hits in the next year it will be far worse then ever experienced in past recessions. Way too much hedge fund money that over extended itself this time around. Throw in the yen carry trade,derivatives, US debt/subprime.China bubble and Canadian household debt hitting the wall that a brief hiccup is highly unlikely.

JMK said...

Well, if it makes you feel better vg, if anything, HHV's calculations are too rosy for the buyer. Not including interest on a 5%-down loan makes a big difference.

Just go to this rent calculator. I'd just put the full rent for the whole unit in there as your current rent (i.e. $800+ whatever you think the upstairs is worth).

JMK said...

Given that, my assumption in the 2nd case (a loss of $30K all things considered) is still more than we're willing to stomach

I guess I prefer to think of these potential losses in these terms: $30k over 6 years is $5k a year or $420 a month extra "rent". Is it peanuts? No, its not, and I'd not like to lose it either. But its not that large compared to your rent for the same property over those 5 years, which would probably be at least 4 times as much. That and the fact that it is a paper loss unless you are forced to sell...

The Average for a Victoria, not CRD, home in 1994 was $256K, dropped to $227K by 1999 for a difference of $29K or about 11% compounded. has Victoria as $243 in 1994 and $227 in 1999 for -6.5%. Unless you are calculating some sort of core number? A quick look indicates the rest of the core looks about the same...

Anonymous said...

Hi Futura,

Can you share your mgmt company's name? I'm debating a move to a year lease on a house, current one OK but not ideal.


Village said...

I wish we were able to calculate the median pricing per sqft from previous times. I think it would give us a more accurate picture of what actually happened.

If I can afford a $300k 1200sqft house now and the market tanks. I can still afford $300k, but now that buys me 1800sqft. I've moved up in size/quality the house without dragging down the median.

Assuming this happens across all the pricing levels. The downward effect on the median is muted.

Anonymous said...

But it can't/won't happen here!

Tony Danza said...

HHV, Thanks for the analysis.

I would suggest that if you're considering an investment that will probably be one of the largest single investments you're going to make in your lifetime, a 5 year holding period is way too short. Even if prices drop 60% over the next few years how do you know they won't drop another 6% per year for five years after that? If you're not sure that you will live in the same locale for more than the next five years you're taking a huge risk with your capital.

Can you name one traded company that you would invest $300,000 in at any point in time that you knew you might need to liquidate within 5 years?

On the other hand if you are planning on living in Victoria for your foreseeable future then who cares if you lose $30,000 in five years, you still have a house to live in. If you wanted to upgrade to a larger home in a nicer neighbourhood chances are that house will also have depreciated by 6% per year as well so the loss on your house is a wash. Just my opinion.

vg said...

"If I can afford a $300k 1200sqft house now and the market tanks. I can still afford $300k, but now that buys me 1800sqft. I've moved up in size/quality the house without dragging down the median."

Exactly why we are waiting 2 years,with affordability near all time highs then whats the point of buying a condo now when you can have a nice bungalow or a 4 bedroom instead of a bungalow now in only two years,how much time is that ? It's not long when you are talking a correction of possible 20-50% depending how ugly the global markets become and especially how hard the Chinese blow up,when they go,we go bigtime.

Anonymous said...

HHV, Did you factor in "surprise" repairs during the home ownership period?

A new roof , siding, or major water damage could force you to cough up serious money, insurance or not. This is rainy BC

vg said...

aren't you being generous with that interest rate ? I see on the RBC site posted 5 year rates at 7.4% the other day and then I know you can get a point off of that for kissing up but another half point is being on the most optomistic side isn't it considering tighter lending rules are in place ?

hhv said...

We have a 180 day locked-in rate at 5.85% guaranteed for 5 years that expires in 90 days.