Sunday, February 13, 2011

The trouble with price to rent ratios

Occasionally I get e-mails from readers. I got one not too long ago from a couple who had come across the blog in their house hunt. Its contents highlighted a big issue I've had for a long time in the way we calculate price to rent ratios in our market. I understand, without question, the need to compare apples to apples when we use this fundamental metric to track the market. The trouble I have with it though is rarely does it apply in actual purchasing circumstance.

Case in point, this couple who e-mailed me:
HHV, long-time readers, never posted, but felt the need to share our buying experience with you anyway. If you decide to write about us, please keep our names out of the post.
Done. I'll call these fine young folks Mike and Molly.
We bought a home. We didn't buy it reluctantly, we're really happy now that we've moved in and we've spent our first Christmas in our own place. But we didn't buy a home lightly, we did a lot of research and we looked at a lot of places before we bought. We know we made the right decision for us.
When we started looking we quickly recognized there was going to be a considerable change in our lifestyle. I'm (Mike) a journeyman mechanic and my soon-to-be wife (Molly) is an office assistant in a doctor's office. Together we earn about $65,000 a year. Our families are both on the island and our jobs are here in the city. It's a priority for us to live close to work. 
When we went to the bank last spring, we were both shocked to find out how much money they were willing to give us. We didn't have a lot of debt, Molly had about $4,000 left on her student loan, we had $2500 on a credit card from a Mexico trip we took the previous winter and we have a $350 per month truck payment with about three years left before it's paid for. Our last place we rented was a 3 bedroom home, just the main floor, near the Gorge, for $1250 per month plus utilities of about $150. The bank offered us nearly $350,000. We had just a little over $15,000 in my RRSP I planned to use for the down payment. Molly had saved almost $5,000 in a TFSA for the closing costs. 
So we started shopping. And it was stressful. We quickly learned we weren't going to be living in a house any longer. We tried to find a townhouse, but the only places we liked close to our budget were in neighbourhoods we didn't, out in Langford or Colwood, far away from where we work. We wanted to remain a one vehicle household, so we needed to be an easy bus ride to Molly's office or, better yet, within walking distance. So we started looking at condos.
Here's where I'll jump in to try and turn this long e-mail into a bit more manageable blog post. Long story short, Mike and Molly bought a condo. They bought it in September last year, moved in December 1 and have been happy with their choice. But these lines really caused me to take a step back and consider their circumstances with how we "figure out" market values in Victoria:
We never saw ourselves living in a condo. Quite the opposite really, I hated the idea at first. But after living in rental suites while I was working on my apprenticeship and while Molly went back to school to do her certificate, we were getting really tired of living in places that weren't ours. Our parents were encouraging us, our friends were all buying or had already bought, my boss at work was even trying to convince me to take the plunge. We didn't like that all we can realistically afford is a condo, but that's the way it is here in Victoria and we're not willing to gamble on the market changing anytime soon. We went from a house to a condo, but because it's ours, we're OK with it.  
I don't think Mike and Molly's experience is unique. I think most people don't buy what they rent.The trouble is, is that they end up comparing what they pay in rent against the cost of buying whatever they can get for the same or very similar money. Their next paragraph confirms this theory for me:
We were OK paying about $1400 a month for our rental home. When the banker showed us how the payments would work on the $350,000 they were willing to give us we decided to spend less. We weren't comfortable with $1700 or $1800 a month by the time we included property taxes and strata fees. So we set a budget of $250,000 to $275,000 to keep the total payments at $1400.
See what I mean? While we are here, doing the math on apples, the Mike's and Molly's of Victoria are out there comparing apples to oranges and coming up with the same amount. They know they're not getting the same thing in the end, but that's not what's driving their buying decisions. They can "afford" to buy a home and keep their payments in a range they might be comfortable with today, but they're doing it at the expense of their lifestyles. Some of them may be happy in the long run, others may regret the decisions that led to the changes. But it presents a real issue that makes price to rent comparisons problematic: we isolate apples, compare them with apples, discover apples are X-factor overpriced compared to what someone willing to rent said apples will give us each month versus total cost of apple ownership -- all the while Mike and Molly are out there saying we don't want to rent an apple when we can buy an orange.

24 comments:

Watching and waiting said...

'waiting' re: your last post/previous thread. That article is quite telling. What I thought was interesting was the quote,
"But whenever the market finally does pick up, all those accidental landlords will want to unload, putting another burden on the market. “So many sellers are waiting in the shadows,” said Redfin’s chief executive, Glenn Kelman. “The inventory is going to expand and expand and expand. I don’t see any basis for significant price increases."

I'm starting to see homes that were listed last fall coming back on MLS or usedvictoria. One house that comes to mind is this one:
http://www.usedvictoria.com/classified-ad/CHARACTER---One-Block-from-St-Michaels-University-School_14165097

listed last year on MLS with a price drop to 535k I believe (correct me if I'm wrong), now they are trying to sell for more w/o a realtor. The house (again if I recall) was originally purchased by the present owners in the 470k range.Be interesting to see if the end up listing again with 1% realty and with a lower price. Hard to pay this amount when a house on Forrester which IMO is nicer, quieter and newer can't sell for 529k or the other house on Richmond for 499k across from Richmond Elementary (Blue house on mls with a heat pump)

Bubble 'n Fizz(le) said...

They weren't renting a house--they were renting the main floor of a house. Big difference. I'd say they've moved up since they won't be running into the neighbor on the way from the bedroom to the bathroom.

Leo S said...

Good post HHV. We are in a similar but reversed situation. Paying a small amount of rent for an apartment, but looking at buying a house. For now, renting the apartment is fine, but we have no interest in buying a condo.
At the same time, while a house would be nice, for now the tradeoff of double or triple the rent is not worth it.

So the current "price to rent" is sky high for our personal situation, even though we're warping the definition.

DavidL said...

The original post suggests that Mike and Molly were paying $1250/month. The $150/month for utilities is inconsequential as they will likely be paying a similar amount for utilities with their condominium. However, each month they are likely paying an extra $500 more than before: $150 to the bank ($1400-$1250), $65 for insurance, $135 for property taxes... and what about strata fees of ~$200?

patriotz said...

Interesting but irrelevant.

An asset can only return the income it earns (rental value in the case of RE) to its owners over time. If someone pays more than rental value, he can only make a positive return selling to someone for even more, and that person has to sell for still more, etc.

That's a Ponzi scheme and is the reason why all asset bubbles fail.

In every bubble you get people saying, "fundamentals don't matter", "it's different here (or this time)", etc. The same old, same old.

happy renter said...

I did the exact same kind of math that Mike and Molly did when I bought my condo a few years ago now (I sold it in late summer 2010). I was paying $1350/month in rent for 2 floors of a house and then bought a one bedroom condo where my payments were $1350/month. My $1350, though, included insurance, property taxes, strata fees, etc.. I obviously got a whole lot less space in the condo, but I was certainly treating the two things as comparable. It meant a lot to me that I was an owner who was spending no more than I did when I was renter. It didn't matter to me at the time that I owned an apple and had rented orange.

omc said...

This might sound a bit harsh, but I have owned a condo before and didn't enjoy it.

As has already beem mentioned, we can assume they got a lot less space. I would guess about 1/2. You also have neighbors on all sides of you in a condo, where they would have had only to worry about those below them in am main floor suite. You would also lose access to the outside and pretty much all storage moving to a condo.

What do they see when they look out thier window from a condo? I'll bet it was much better at the house.

I can honestly say I have never known anyone who has honestly enjoyed living in a condo. A realtor once told me that on avergage people only last 2 years before moving on. Guess what, they will lose their shirts; condos never keep pace with houses. When houses move side ways or down, such as right now, condos fall in value. They are aslo very likely to get a special assesment which they can't afford. Condo fees always go up, as the developer sets them unrealistically low to sucker you in.


Pretty much they sound like the sort who has been fuelling the bubble; young, financially nieve and certainly not adverse to carrying debt. They saved money in a TFSA while carrying credit card debt? What is worse is that the credit card debt came from borrowing for a big vacation they could not afford. It just shows that they are highly impulsive and lack critical skills.

He works in construction, and just like I found in the 90s downturn; the good times don't last.

Marko said...

Monday, February 14, 2011 8:00am:

MTD February
2011 2010
Net Unconditional Sales: 195 621
New Listings: 637 1,460
Active Listings: 3,435 3,280

Marko said...

I think we will easily break 500 this month as sales have started to pick up, but anything short of 550 will be a poor start to the spring season.

600 would indicate some stability.

fat said...

I can understand the apples to oranges comparison. Personally I would never want to own in a strata, but the same line of thinking can apply to renting a mansion vs. buying a modest home.

Where I see a huge issue in this story is that the bank is willing to loan this couple $350,000.

I'm glad to hear that they were at least smart enough to decide on a budget first, but I worry that they are in the minority.

How many financially illiterate people walk into the bank, are told that they can buy a home worth X and go out and shop in that price range?

Too many methinks. In my mind, that combination of loose lending and a new social acceptance for massive debt is what has fueled this bubble.

Why aren't more people adverse to carry 4-10x their earnings in debt?

And worse, why do some people think it is the "responsible" thing to do?

axeman said...

Apples to Oranges, what they have neglected to see, is how the emergency interest rates, and manipulation of Mortgage rules, have not only primed the pump, and allowed any breathing body over the age of 18 to buy, it has pushed rentals up too. I rented a 1000sq ft house on Topaz in 2000 for $800.00 that rents today for $1800. Why? lack of rentals, everything had a for sale sign on it. Wait a year when all those condos in langford don't sell, (Bear Mountain comes to mind) renting will start to look cheap.

Affordability has nothing to do with being able to make the payment...

- spaceman

axeman said...

affordability is more than being able to make the payment...

Just Jack said...

Well the young couple has bought, that can't be changed. Now, how can they protect themselves?

It's time to get serious. Pay off all other debts immediately. Cut up the credit cards and only have one or two cards only. Like a Visa and a gas card. Freeze the Visa in a glass of water in the fridge. Pay cash or debit on everything and use the Visa for emergencies only - no impulse buying.

Start shopping at Value Village. Bake your own bread. Take advantage of cheap movie nights or go to the University to see shows. Get rid of cablevision and your telephone line. Walk and bike to work. Go to auctions for your furniture.

Hunker down until your renewal comes up, putting every penny into your TFSA.

Get serious about the TFSA. I don't think the TFSA will ever grow enough in order to pay down the mortgage at renewal, but you can dip into the TFSA after the next renewal rate to offset the higher monthly payments. Because if your payments go up by $400 at renewal, you may need a $100,000 in cash to bring the payment down to your current level.

At 65K, you don't have much wiggle room. Hopefully you can rent out the condo. Because, you may need more space if two becomes three. And if you owe more than the condo is worth, the bank may not let you sell the condo. That means you would have to rent out your condo and find a house to rent for yourself.

The really easy part of real estate is buying. The really tough part is paying for it.

jesse said...

While I get the apples-to-oranges comparison, as patriotz stated, it's irrelevant. Unless the entire market is made of owner-occupiers the fundamentals will set the price in time.

What has been happening recently is a significant shift in home ownership rates, from 64% 10 years ago to around 70% today. This shift has meant that people have been willing and able to pay a premium to own rather than rent the same property. But they are paying a premium -- overpaying -- and while Mike/Molly are indirectly admit they are paying more for a lower quality product they never truly admitted they are overpaying. The desire to own instead of rent seems to obliterate any straight investment comparison.

If you want the reasons for bubbles in a nutshell, families like this one, with their personal preferences to own, are a big piece of the puzzle.

Just Jack said...

I think people are willing to pay 4 to 10 times their income for properties because it has worked for them and others in the past.

Not until, we have a decline in prices will people understand the risk of real estate. That 32 to 40 percent of their income going to housing means severe belt tightening on all other expenditures. Fast forward 2.5 years and your six months away from renewal and the interest rate has gone from 4 to 7 percent.
In six months you might not be able to make the new mortgage payment and because you owe more than the property is worth - you can't sell.

Leveraging worked fine when prices were going up. But man, it really sucks on the way down. Too bad the CMHC insurance pays out the bank and not you. Because if there was anytime that you personally needed insurance it's in today's market.

markoj said...

"The desire to own instead of rent seems to obliterate any straight investment comparison."

Same applies to a lot of desires in life...otherwise we would all be driving a Toyota Yaris getting from point A to point B in the most economical manner with the least amount of depreciation.

a simple man said...

Millenium Water condos in Vancouver (soon to be renamed) will be slashed in price by an average 30% on Feb 17th.

Source: TC

HouseHuntVictoria said...

Patriotz & Jesse,

I understand completely about apples to oranges being irrelevant for those of us who are simply tracking the market. But I think it's safe to say the majority of people aren't tracking the market, so apples to oranges comparisons may well be the norm for them. I think we need to dig a little deeper into how apples to oranges comparisons by the masses effect our apples to apples comparisons no?

Mr.4AM said...

Interesting anectdotal email from Mike & Molly. I have pretty much the opposite approach. Renting a place that is significantly less in almost all aspects than what I eventually plan to buy. The logic there is that I prefer to sacrifice 2 or 3 years of renting something smaller so that I can take the extra savings and purchase something bigger.

Mr4AM

Waiting said...

Mr4AM
I'm on the same page as you. I'm renting what can only be described as mediocre at best in a lousy location. I would never consider buying it, but as a rental I'll tolerate it because I'm saving a lot.

patriotz said...

I don't really believe that people buying today are actually willing to pay more to buy than to rent the same property over the long run. I think they believe that they will come ahead of the renter due to capital gains, i.e. that they think RE always goes up.

That's called a "speculative bubble".

jesse said...

"I think we need to dig a little deeper into how apples to oranges comparisons by the masses effect our apples to apples comparisons no?"

What I think you're stating is that it is possible to have an owner's premium perpetuate high price-rent ratios. Looking at it another way, why would a landlord be willing to pay a premium along with an owner? Answer, he's not unless there are above-rental-inflation cap gains to compensate. When that illusion is outed, it's all about returns from rents and that sets marginal prices back to lower price-rent ratios.

While owners may be willing to pay a premium, the returns eventually demanded by investors ensures that, in time, they don't have to.

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SecretAgentSells said...

Cash stuffed duvets, are you kidding me. I think if it is so easy maybe you ought to get yourself a license and try it out, if you have the guts to leave your secure J O B or maybe visit payscale.com to see what the average 5 year veteran realtor here in Victoria makes annually. If I can manage to be in the top 150 or so realtors and not be rolling in bundles of cash like you infer maybe just maybe you ought to check your facts. My partner brought your little blog to my attention, and I didn’t have to read more than the first paragraph to know you are misinformed, and most certainly a glass is half empty kind of guy. I would gladly share my T4 with you, and let you know how many calls, how many appointments, and how many hours of my year it took to make it. While I love helping my clients, and earn a decent living doing so, my earnings are a smitten of what is possible for those brave enough to make their own way and trade results for dollars not hours for dollars.