Credit where credit is due

I've taken a lot of swipes at the MSM and the real estate industry for their perceived lack of balance over the years. Today I'm not. I'm praising them for this article instead. Here are the highlights:

Caution, not immediate gratification, should be the mantra for buyers looking to buy their first home

It's easy, but financially dangerous to be mortgaged to the hilt based on today's ultra-low teaser interest rates

Mortgage rates are going to increase by two to three per cent over the next two to four years

First-time buyers should be thinking more long term, arranging their financing based on expected rises in mortgage rates that will be a reality in two years

buyers should not expect their real estate investment to make a fast or big payoff when it comes to sell

Younger buyers should be paying attention to the financial restraint of older buyers

Sound advice if you don't want to eat macaroni most of the time while sitting at your granite kitchen island

Credit where credit is due, indeed.

Truth in numbers

Seems there may be a bit of a communications battle being waged between Teranet and the CREA these days.

You'll remember that CREA recently told us that the average home price jumped over 16% in the last month.

Teranet says:

Repeat sale prices for Canadian homes fell for a fifth straight month in April, dropping 6.7 percent from the same month a year earlier, a report on Wednesday showed.

The National Post had an OK discussion of methodology and what that might mean to the numbers:

With the economy in recession and unemployment increasing, Millan Mulraine, an economics strategist at TD Securities, said it was hard to justify a rise in house prices, as suggested by the CREA survey. But he was not convinced prices had fallen as sharply as the Teranet-National Bank survey had found.

Here's what I think: the numbers really don't matter. If you're a first time buyer, you're buying products in Victoria that are clearly in a sellers market, haven't experienced any kind of price correction at all and you can likely only afford them because of hyper-low interest rates. You may think you're getting a deal, but that's only because you're looking at it based on a monthly payment. I wonder how that will end up looking for you in five years time?

Long term planning

Post by Reid:

Let’s look at the long term financial security of two families both aged age 30 that live in Victoria, earn $100k per year and wish to buy a $500k house. The Optimistic family has $25,000 in their RRSP’s and plan to withdraw this to buy that home and finance the rest over 35 years. They have been told this is a sound financial decision as interest costs and property taxes are less than the rent they are currently paying. They will have to pay back the $25,000 over the next 15 years into their RRSP, so they are told they are not robbing their retirement. This family would like to put money into their RRSP, but each year they simply have nothing left to invest given the high cost of living. This family manages to make all their mortgage payments and in 35 years they are mortgage free just as they retire.

The Balanced family is in the exact same situation, but has done a lot of research on financial planning and has decided they will save their $25,000 deposit while leaving their RRSP account alone. They save hard over the next year and learn how to live below their means. With this new found skill they decide they will pay off their house over the traditional 25 year period while maximizing their 18% RRSP contributions each and every year. Once their mortgage is paid off the Balanced family plans to invest their mortgage payment into the TSFA until they retire at age 65.

These families go about their lives and meet all their payments under the following economic circumstances for both:

• Inflation stays low at 1% allowing five year mortgages to stay a 4.25% throughout the next 35 years
• Their houses manage to appreciate at an average rate of 3% per year, a full 2% more than inflation
• RRSP and TSFA investment return on average 6.5% per annum
  

As these families retire, they are both feeling good about their house purchase decision. The Optimistic family never used their house as an ATM machine and managed to get it paid off before they retired unlike many of their friends who took a mortgage into retirement. The Balanced family made a lot of sacrifices over the year, but they feel really good about their retirement.

The chart below shows how the net worth of these two families increased over the 35 year period. Net worth is defines as the value of their house less outstanding mortgage plus the value of their RRSP and TSFA’s.


At the end of 35 years, both families own houses outright that are worth $1.4 million making their investments in those homes 35 years earlier look pretty good. But the big difference is that the Balanced family has investments worth over $3 million and the Optimistic family only has about $150,000 saved in their RRSP’s. The only way the Optimistic family can finance their retirement is to sell their house or take out a reverse mortgage.

You may say that this example is extreme, but if you research how much average families actually invest in their RRSP’s, the Optimistic family is like many typical Canadian families and most will have to sell their homes to support retirement. A key message here is that you have to save a lot more money for retirement than one thinks and it needs to far exceed the value of your home. Although three million dollars may seem like a lot of money it is actually about what a 30 year family will need in 35 years to properly support themselves under the above economic assumptions.

Proper financial planning will not stop you from buying an overpriced house, but only make you realize that you must factor in proper retirement and other financial matters into the overall buying decision. For most it takes many decades to generate real wealth, but it can be achieved.

Value in relation to rent

We know there are two common values typically associated with houses: the market value obtained through a current market analysis (CMA) evaluated by a REALTOR® and the BC Assessment value which is largely obtained by a less-than-accurate averaging/evaluation based on like/similar property transactions within an immediate area.

Most home owners likely have an expectation of what their house is worth that is as accurate as either of the two previous estimates through browsing MLS for a few days. Ultimately, market value is determined by the buyer, who either agrees to pay a given price or doesn't.

But what is fair value and how can we calculate it in real estate? What ratio should a home sell for comparatively to rent? Is the ratio static or does it change with market conditions? Can we learn from fundamental analysis of stocks and apply the same criteria to homes?

One of the keys to fundamental analysis is revenue. After all, who wants to own the shares of a company that doesn't sell anything (risk taking speculators do). How do we easily measure revenue as it relates to what we own? In the world of stocks, we use the price to earnings ratio: market price per share divided by earnings per share.

Here's a quick example: ACME Corp. has 10 outstanding shares. ACME Corp. earned $200 in 2008, or $20 per share. ACME's share price closed today at $400 per share. To calculate your earnings per share ratio today you divide $400 by $20 to get a price to earnings ratio of 20.

Determining what is a good price to earnings ratio is easy: the answer is the lower the better. Determining what is a fair price to earnings ratio is open for debate and depends on the stock you may be analysing and how its share price compares to peers.

Can we use a similar metric for housing to determine fair value?

I know I can rent a 3 bed 2 bath home in Victoria for about $2500 per month. I know that same house will sell for about $550,000 depending on the area of town. But let's keep those numbers simple for explanation's sake only here, OK? To calculate the price to earnings ratio I divide $550,000 by [(12 x 2500) - costs*] to get the price to earnings ratio. Remember that reported earnings in relation to a stock are accounted for after expenses--earnings are what the company returns to shareholders.

In our housing case, costs* are the key part of calculating value. Do costs, once accounted for, leave anything to report as earnings? Or do costs result in a loss?

For simplification's sake, let's assume you're buying with cash and renting the house out; your costs should be minimized here. Property tax ($200), income tax on the rent collected ($750), maintenance ($250) and insurance ($75) are added up ($1275) and subtracted from $2500 to get earnings of $1225 per month. The price to earnings ratio is then calculated as $550,000 divided by $14,700 to get 37.4.

I would not use a price to earnings ratio to determine fair value in the residential real estate market, it's just too problematic and open to too many variables that can greatly skew the importance of the numbers. Besides those problems, a price to earnings ratio is a weak analysis of true value if you don't have a historical or side-by-side comparison to use. But if you're working on your financial literacy, hopefully this post has provided you with another term to add to your vocabulary.

Your home: the investment you think it is?

Note: edited on June 19 to fix formula, H/T to Just Janice and NanHousing in comments for corrections, added two future assumptions below

Many people consider their home to be their primary investment. There are a number of financial and other reasons for long term home ownership including:

• "fixed" cost of shelter
• pride
• perception of security
• historical market value growth

But is your home the investment you might think it is? The classic definition of investment goes something like this: you take something you have today (money) and create something with it (business, consumer good, income producing asset) to cause a return on investment. Simply put, a return on investment (ROI) is calculated as gain from investment minus investment cost divided by investment cost.

For example: you give me $1 (cost) I agree to give you back $1.10 in 1 year (gain) = $0.10/$1 = 10%.

There are a number of factors that go into determining the quality of an investment, not the least of which are:

• ROI rate
  
• liquidity
• risk of capital loss
• ROI factors (interest, dividend, yield, capital gain etc)

Usually, the higher the risk, the bigger the gain or loss. Stable, liquid investments historically offer low rates of ROI as a trade off for security of initial capital. If the only source of ROI achieved by a particular investment is capital gains, the investment is usually labeled speculative.

Clearly, a home you own can fit the classic definition of investment. There are two classic ways to achieve ROI in your house: growth of its market value over time concluded with a transaction and rental income (no transaction necessary).

Here's the wrinkle: most people today see this as the calculation that makes the home they've owned over the past 7 years such a great investment: sale price ($500K) minus purchase price ($250K) divided by purchase price = 100% over the ownership period or 10.4% annually.

What happens when you calculate the real--and keep in mind this formula is very rough--ROI as: sale price ($500K) minus [down payment ($12.5K) + interest paid ($72K) + principle paid ($11.5K) + taxes paid ($14K) + maintenance paid ($17.5K) + sales costs paid ($20K) + mortgage balance repayment ($228.5K)] = $124K/$24K = 516%.

The above formula doesn't account for inflation of 2%-3% per year and guesstimates the interest, maintenance and taxes (conservatively).

There are costs associated with "investing" in a house. The over-simplified model of ROI used by the media and the real estate industry typically ignores those costs. Even my simplified model formula doesn't include all of the myriad extra costs that homeowners pay that renters don't. Ignoring the costs associated with home ownership clouds the true ROI, even in so-called boom times like we've just experienced. If housing only stays flat year-over-year for the next several years, ROI diminishes then disappears as time goes on. Here's a couple of examples (ownership costs * = sum of above list):

Buy today, flat market for 5 years
Purchase price = $500K
Down payment = $25K
Principle payments = $31.5K
Sale price = $500K
Ownership costs* = $601K
ROI = loss of $101K or -178%

Buy today, falling market for 5 years
Purchase price = $500K
Down payment = $25K
Principle payments = $31.5K
Sale price = $450K (10% loss over 5 years or approx. 2%/year)
Ownership costs* = $601K
ROI = loss of $151K or -267%

Assumes a 5 year 30 year amortization mortgage at 4.5%.

Market movement

Up to date stats for June in Victoria from Tim Ayres on Twitter:

New sales - 433
New listings - 710 (sales to new listings ratio is 61%)
Total active listings - 3773 (sales to active listings is 11%)

I'm seeing chatter all over the place of multiple offer scenarios and price gains. The market is once again in full frenzy at the low end (did it ever stop?) and first time buyers are drunk on cheap money and the prospect of pre-approval time limits ending. I don't think this will end anytime soon and we may see a record summer for sales volume (prices may peak above April 2008 too).

So, you're sitting on a 5% down payment for a $400K house. There's currently around 71 houses for sale priced below $425K within the CRD. Pickings are slim, you've got a down payment burning a hole in your pocket, a pre-approval time limit weighing on your mind, and the feeding frenzy atmosphere at every open house you attend. What's a savvy buyer to do?

If you haven't already, perhaps you should start acting like you've already bought? That means start saving the difference between owning and renting right now, every month. Here's a quick, back of the envelope calculation for you:

(Mortgage payment amount - current rent) + property tax amount + utility payments + house insurance payments + estimated maintenance costs = ($1800 - $900) + $125 + $200 + $85 + $200 = $1510.

You've got a $20,000 down payment, and you're adding $1510 to it every month. In 3 month's time, you'll have almost $25K to put down. If you keep this up for 6 months, that will grow to almost $30K. Should you wait a year, you'll have a 10% down payment, not a 5%, should you still buy a house for $400K. You will also have a very real understanding of the true costs of owning a $400K house in this city.

There is a time value of money calculation that needs to be worked out here. You need to sort out whether your money is better served in a cash savings account/money market fund (where else are you holding your down payments?) or actually spent on real estate. Considerations include mortgage interest rates (are they headed up or down in the next year?), interest account rates (what's the best you can get?) and the future value of the house (will prices be the same, more or less, in a year?).

Here's my personal assumption: mortgage interest rates will be higher, likely by 1% on a 5 year term; home prices will be the same or less than May median price of $525,000 (but the low-end will be the same regardless). Here's the scenario crudely:

Buy today
Mortgage amount: $380K
Interest rate: 4.5% (5 year term)
Monthly payment: $1788
Principle paid in 12 months: $4615
Interest paid over the term of the mortgage: $82,044
Mortgage balance at term end: $354,728
Interest paid over the remainder of the mortgage (after the first 5 years): $338,846 (assumed 25 years, 6.2% avg interest rate)
Total mortgage interest (est.): $420,890

Buy in one year
Mortgage amount: $360K
Interest rate: 5.5% (5 year term)
Monthly payment: $1918
Interest paid over the term of the mortgage: $95,365
Mortgage balance at term end: $340,245
Interest paid over the remainder of the mortgage (after the first 5 years): $325,012 (assumed 25 years, 6.2% avg interest rate)
Total mortgage interest (est.): $420,377

Financial literacy redux

We have an opportunity with this blog, should we choose it. I've long since given this place up as my own little recording of a house buying journey to the collective voice it may represent, but more importantly, to the collective intelligence it definitely does represent.

NeedsAnalysis made a suggestion to me last week: "why not use the collective knowledge shared at HHV to help readers improve their financial well being?"

Should this blog evolve into being more than tongue in cheek commentary on the MSM/industry marketing speak and stats analysis? If it is, I will need the help of readers. I won't claim to have a wealth of knowledge to draw from, but that reminds me of the days I started writing here.

So here's my proposal: we'll tackle a topic a week or so, basic financial stuff, taxes, calculations, money management, budgeting etc; essentially all the boring stuff we don't talk about at dinner. I hesitate to discuss particular investments, but we could probably talk asset classes.

Of course, we will still talk real estate. What say you readers? You game? Willing to contribute like Reid has? Please leave your thoughts in comments. I'll keep this thread going for a couple of days, then hit the first topic after a bit of research: the time value of money. I'll need suggestions for future topics, but I'd encourage you to consider contributing--I've learned a lot during research for writing here, I bet you will too.

My sincere hope for this shift is a positive one: I've learned a ton from the regular participants here, I think there is a wealth of financial knowledge to be gained, I really hope you will continue to contribute your experiences, knowledge and ideas.

If we do go down this path, should the name of the blog change to better represent the discussion here? If so, I'm keen to hear your suggested names.

Financial literacy

Content by Reid:

I would define a person as truly financially literate when they can apply a holistic approach to making a key financial decision. By that I mean they can factor in the implications of a financial decision on other aspects of their financial life both short and long term. In order to be financially literate someone has to have a good handle on the following knowledge or skills:

• Budgeting and cash flow management and then apply these principles to their daily lives
• Retirement planning and sheltered retirement investment tools
• Understanding of assets allocation and basic investment approaches
• Understand the time value of money
• Understanding of economics and how changes impact their life
• Decent understanding of personal taxation
• Ability to look out and plan for the long term (as financial success only really comes over the long term)
• Can assess potential risks/opportunities and factor these into possible scenarios and outcomes

The problem is that to learn and apply all of what I describe above will take most people a long time to master. Given that we teach basically none of these skills to our youth in school or at home or even in our universities, it is no surprise that few people in our society are truly financial literate. Even if someone knows all of this, it does not mean they will apply it to their own lives. My father worked in the financial industry, made a great living and had all of this knowledge, but he had no discipline and died bankrupt.

Although most of us are not financially literate, we can do extremely well financially if we only understand and can apply the first point above. Do you know how to budget and does one understand that getting ahead financially requires you to spend less than you earn? If one understands this simple rule and you live to it, then you have a real opportunity to live a financially rewarding life.

The people I refer to as financially illiterate are those do not apply that first rule above and live beyond their means. In terms of buying a house, these people will assume that if the bank is going to lend them 5 times their income, then they obviously can afford a house and will typically buy to the maximum of their debt capacity. There will be no longer term consideration as to whether higher interest rates will impact them or if they can properly save for retirement. These people often look to their realtor and mortgage broker for advice on the home they should buy and mortgage they should take on, but do they understand the problem with their biased advice?

Looking backwards the financially illiterate in Canada were generally spared from despair in retirement because most Canadians retired with a defined benefit pension plan which gave them a secure post employment income. Looking ahead twenty years, few outside of the public sector will retire with these types of pensions and therefore it is far more important today to understand financial concepts and apply them.

A good monopoly?

There was an interesting discussion in the BC twitterverse yesterday regarding some recent news about the CREA, the MLS system and the Competition Board of Canada--an independent consumer protection watchdog type organization. The discussion, as far as I can tell, originated with influencer-in-chief, NeedsAnalysis. As I read it, Roger was asking whether or not the CREA exercises monopolistic control over the RE market and more specifically the MLS system. Roger provided many great links to foster discussion:

1. Competition Board speaking notes
2. US Blog about CB visit for learning and professional site of blogger
   
3. Another blog explanation
4. Monopoly defined
5. And a VanSun article written by a paid PR person to influence the consumer to fight back against the rising cover-your-butt-ism in the RE industry (I can only assume since it's mostly poor us fluff)

When I engaged in two tweets last night with the agents most active in the discussion, I garnered two truths:

1. It is a monopoly--but as suggested by the agents, it's a monopoly that benefits everyone involved
2. The CREA does exercise monopolistic control over the MLS system

CREA rules prohibit home sellers from purchasing just a listing in the Multiple Listing Service from a real estate broker. If a seller in Canada wants to list their property in the Multiple Listing Service they must also purchase a bundle of services including negotiation and contract assistance. This, of course, affects the price that sellers must pay for real estate brokerage services.

In observing the real estate market over the past two years and more as closely as I have, there is one conclusion above all else that I have arrived at: The real estate industry has won the communications battle:

• Media repeats their press releases as truth without much investigation, if any
• The consumer has accepted that commissioned sales peoples opinions are expert
• Dissenting voices in the public realm are marginalized or chilled through threat of libel wherever possible (see what agents can and can not say about themselves and their industry organization)
  

I don't believe that we can change the outcome of the communications battle. Not without significant funds and coordination, which the consumer doesn't have, and the CREA has plenty of. Nor would I advocate consumers down that path.

If Canadian consumers want the situation to change, I see two definite paths:

1. A new paradigm where the buyer pays a commission (the buyer pays the commission anyway, but the fog of words and literal truths used to confuse everyone means they "literally" don't)
2. An open, competitive MLS system whereby any seller, be they agent represented or not, can PAY a fee (I'd be fine with agents paying less fees than non-agents) to have their property listed
3. An open and transparent statistical data system whereby any private actor can PAY a fee to access a detailed statistical database of real estate transactions (I'd love to see a crown corporation like BC Assessment start tracking this and charging interested consumers for detailed databases)
   

Edmonton Housing Bust has an interesting post on the demise of ComFree in the downturn. Would my suggestions above provide greater competition and choice for the home buyer and seller? Will they level the playing field for competitive services like ComFree and ZooCasa? Is this making a mountain out of a molehill?

VREB stats

Preliminary:

Month end Victoria Real Estate Board stats:

New sales: 879

New listings: 1362

Total active listings: 3789

Full release on VREB.org later.

H/T to Tim Ayres for stats posted on Twitter

I'll add to this post once the full release is out. No surprises. Won't be seeing any price reductions this month or next. Inventory down slightly from last month.

UPDATE: Release is out. Here's the price data:

The average price for single family homes sold in Greater Victoria last month was $573,442, up from $550,736 in April. The median price also rose to $525,000. The six-month average was $550,756. The overall average price for condominiums was $306,971 last month, up from $292,252 in April. The average for the last six months was $292,766. The median price for condominiums rose in May to $279,500. The average price of all townhomes sold last month was $400,788, virtually unchanged from $400,695 in April. The median price dropped slightly to $375,000. The six month average was $397,224.