Intrinsic Value

I wrote of how the utility of the property is paramount in value of the land.  This is called intrinsic value.  If the lot has restrictions such as access, zoning or size limitations the utility is reduced and so is the intrinsic value.

Size; On a small lot you must build a house with a smaller footprint, you can’t grow a large garden, less room to build a garage, kid play area, solar panels, pools etc.

Access; if there is a park in the back or you are surrounded by neighbours without any laneways you can’t really build a garage in the back, unless there is a way to get past the house.

Zoning; if there are restrictions on what you may build, the utility is reduced.  The art of zoning is to achieve orderly development which suits the city and the citizens without being overly restrictive.  If it is done properly the value of the property is enhanced even though utility is somewhat diminished.  For example you can’t raise chickens in most cities.  Most people find that particular limitation acceptable, and would feel less inclined to buy a home in an area where they are allowed.

Intrinsic value extends to the house and other improvements.  Shelter from the elements, place to keep your stuff, work space etc. are all intrinsic values.  Once we move beyond the basics, everything is optional.  What constitutes the basics has changed over time.  Closets for example; once upon a time, people drove nails into the walls to hang clothes on, and had wardrobes for the rest.  In older homes I have seen, the closets are somewhere around two feet (60 cm.) wide.  I recall the salesperson who sold my parents the house I grew up in, “Every bedroom has a four foot closet, you’ll never fill them up.”  Of course now, we laugh at that.  Kitchens is another place where what was once very acceptable is now seen as very inferior.  It has to do with our present lifestyle, including the sizes of our family members, our furniture, and the sheer amount of our possessions.  The number of kitchen appliances we have today, would overwhelm an old time kitchen, not to mention the electrical system, and the clothing of the average person now won’t fit into a four foot closet.  Our furniture is bigger because we are bigger, so we need larger rooms to hold our stuff, so larger homes are required.

As you can see, what is perceived as constituting intrinsic value changes over time, and that is why older houses lose value relative to new ones; they don’t suit our needs any more.  Once we have achieved the basics, everything else is wants, not needs.  As we move up in price range, the intrinsic part of the value becomes less important to buyers, because all homes will have the basics covered automatically.  When the market suffers a slowdown as it has over the past few years, the houses in the higher price range suffer the most.  High end buyers usually already own a house which has the basics covered.  Buying a different home is more optional, and often depends on selling the current home first.  If the market is slow the current homes don’t sell, so they don’t move up into the higher range.  Listings accumulate in the higher range, prices drop, and only when a lower priced home is sold are any buyers around, even at the lower prices, and only then, if they are staying here.   The lower part of the price range still makes sense from the intrinsic point of view, because the alternative is to pay rent.   At any time, the ‘best’ price range to be in is the top of the ‘affordable’ range.  Currently, that is between $275-300,000.  Over that range, the average buyer is priced out, and much below $200,000 the homes need lots of work.  Properties between $2-300,000 are the affordable part of the market.  At any time, in any market, those properties which are currently in that range will be in demand because of affordability and relatively high intrinsic value.

Anatomy Of A Boom

Real Estate is a local market, dependent on the local economy.  Real Estate, when left alone, is the most pure capitalist market known.  It is almost totally a supply-demand market.  When there are too many houses for the local economy and population, prices fall.  When the number of houses is about right and the economy is stable, so are prices.  When the economy goes through an expansion, often called a ‘boom’, people move into the area to take advantage, the number of houses is no longer adequate, so prices rise.

When people move into an area in expansion, first they take up all the rentals.  Landlords see an opportunity to finally raise their rents, and this pushes some renters into buying their first home.  The renter foresees rent increases and that the differential is very small between higher future rent vs. what he must pay on a mortgage if he buys today.  As the renters move on, more rents rise, and the ‘best deals’ are bought up.  Houses which formerly appeared overpriced become more appealing and begin selling.  As prices rise, more sellers join in, always at higher prices than recent sales, and the trend is set.  As more people move in, some are forced to buy right away which further heats up the market.  As lower priced homes sell, many sellers become buyers of more expensive homes, and the wave of price increases ripples upward through the price ranges.

Builders sell any houses they hold in inventory, and any houses under construction are sold as well.  Houses built ‘on spec’ hoping for future sales ramps up.  The builders hire more people to keep up, which provides even more jobs, and further stimulates the local economy.  The people who arrive to build the houses must also live somewhere, so there is even more pressure on the housing market.

As prices rise, more buyers enter the market ”Before it’s too late.”  Some homeowners will speculate, buying a property they don’t need, hoping to sell later for more.  Some of the speculation is in the new homes.  The homeowner keeps his present house for the time it takes to build his new home, having nailed down the price today, hoping to sell his present home for more when the new one is done.  This all leads to an overheated market.  The inevitable end result is that the boom ends and the market is overbuilt.  There are too many houses, construction almost stops, the construction people move on, there is an oversupply and the price of homes drops.  Part of this is the renter’s perception that rents will either decline or stabilize but not increase, and the anticipation that prices will be lower next year.  In that environment, waiting is the best option.

As time passes, the market stabilizes; prices and rents are low and remain so.  There is little new construction, only presold custom homes are being built.  The number of builders, sub-contractors and tradespeople diminishes to the point where maintenance work is almost all they do.  As the number of household formations continues, gradually the rental units and the excess of unsold houses are taken up.  Another factor in this rebalancing is the tearing down of older properties which are no longer satisfying peoples’ needs.  Sometimes there is another boom which sets the cycle in motion again, sometimes the market just stumbles along for years, but inevitably the market tightens.  Supply and demand are in balance for a short while, then demand exceeds supply.  This is when the value of housing moves upward, stimulating construction and keeping the market in balance.

That is how the market is supposed to work; the demand fuels rising prices, which stimulates construction which leads to more homes and an end to rising prices.  As the number of homes approaches the balance point, sales of new houses slow, so does construction and we have a soft landing.  There will always be some overbuilding as builders have long commitment times and it is not easy to put on the brakes.  The degree of overbuilding in the previous boom lead to the length of the recent slump, because the more overbuilt the market, the longer it takes to absorb the inventory.  When the slump is excessively long, the market is even more unprepared for the next surge.  When market demand increases there is little serviced land to build on, few contractors and tradespeople to do the building, and prices rise quickly.  When the slump has been very long, the ’snap-back’ at the beginning of the next boom is even larger and more disruptive.   From that point of view anything which contributes to overbuilding makes the next cycle even worse.  The slump is longer and people suffer more, then when the next uptick occurs, the disruptions and problems are that much greater.

What’s the Difference?

There was a Real Estate meltdown in the US recently, and many people in Canada expected the same thing to happen here.  There are a variety of reasons it did not, but they fall under two general categories; their system and their regulatory environments are both different from ours.

First and most important difference is the underlying philosophy; they encourage indebtedness and we have traditionally discouraged it.  They are generally more adventurous and we are more conservative.  They are allowed to deduct the interest on mortgages on their own homes from their taxable income, where we are not.  As a result, Canadians try hard to pay off their mortgages ASAP.  Until recently, the concept of borrowing against equity was very unpopular here.  Last stat I heard was that 54% of Canadian homes are free of mortgage.  In the US they keep their mortgages as high as possible, using whatever they can borrow to buy bling.  When they can’t pay for it any more, they walk away.  In Canada there are repurcussions if you give up your home, in the US less so.  This all encourages Canadians to work hard toward having a clear title, and the USans to work hard to keep their property fully mortgaged.  When things go sour, they suffer, we don’t.

Because all high ratio mortgages in Canada are insured against default by CMHC or one of several private insurers, all of which operate in exactly the  same way, the rules set by CMHC are critical to the process.  When there is a default here, the very first thing that happens is CMHC goes through the file with a fine toothed comb looking for errors made by the bank in the application process.  If the bank did not perform their due dilligence according to CMHC rules, the insurance is denied and the bank is on the hook for the house.  The bank must deal with disposing of the property and recovering what they can of the money they loaned.  Bankers, being the risk averse types they are, do not want that to happen so they are very careful to do things correctly.  If anything, they are overzealous.  In the US there is a similar mechanism to check for errors by the banks, however I was astounded to learn about spring of 2011 that they had only recently begun to go through the files on the foreclosures.  That’s three years into the process and the regulators were just beginning their due dilligence.  That would never happen here.  Here, the majority of the foreclosures are held by the secondary lenders.  They are the ones used by people who the banks decline.  They accept a higher risk and charge higher interest rates, hoping to offset foreclosure losses through higher earnings.  It is to be expected that they will have foreclosures.  As the recession progressed and things got worse, more foreclosures have appeared with the major banks or CMHC listed as owner.  There is still not the flood as there is in the US, and they are selling, however they are keeping prices low.

Their banks were very active in the sub-prime mortgage market, and our banks were not.  This was mainly because the regulators in Canada are so slow to accept new ideas that they held the banks back for some time before allowing them to play.  As a result, the Canadian banks looked good by comparison, and bankers are strutting around like little bantam roosters, chests puffed out, saying ‘look what a good boy I am’ when in reality they would have had their heads deep in the trough, same as the yankees if they could have.  It’s no credit to either the regulators or the banks here that we didn’t fall into the same trap.  It is just a huge negative comentary on the super-incompetence of the US regulators.

Their government pushed the concept of everyone should own a home, and the administration did everything possible to bring this about.  They encouraged the banks to lend in undesirable areas and to unqualified buyers.  There were stories of regulators landing on the banks that didn’t cooperate, performing audits and other harassments until the banks toed the line and did as the government wanted, even though it was imprudent banking.  Inevitably, the house of cards collapsed. The result was the debacle in which they are still mired.   The reason it is taking so long to dig themselves out is that they have far too many houses in many areas.  The net result of all the stimulation brought about by easy credit was a massive overbuilding of housing.  There are too many houses and not enough people.  Until that oversupply is used up, their market won’t recover.

What can be done to ‘fix’ the problem?  In a word, nothing.  Government interference caused it, more interference will only make it worse.  If the regulators do their jobs properly, making the banks suffer for their stupidities and ensuring that the public is not victimized by the banks in the process, that will be the best that can be hoped for.  Every other approach leads to a worsening not a correction of the problems.  It is time for the government to step back, adopt a laissez-faire attitude and let things find their own way.  Left alone, the market will adjust to a new equilibrium.  Now, just leave it alone.

How Money is Made in Real Estate

Money is made in Real Estate by owning it.  When we buy a property, usually we put up a down payment and take out a mortgage to pay the balance.  We pay on the mortgage as long as we own the house and the mortgage is not paid off.  The mortgage balance is the amount we OWE, and the rest of the value of the property is our EQUITY, which is what we OWN.  At all times in this process, the value of the property is the total of those two numbers.

If we keep the property for long enough, we arrive at a time where the value of the property and our equity in it are equal; we have paid off our mortgage.  This is when the real joy in Real Estate happens.  When we no longer pay a large mortgage payment each month we are less vulnerable to the economy and the curve balls which life throws at us.  The goal is to increase our equity position as quickly as possible.  Anything which interferes with this effort puts us behind.  Anything which increases our equity advances us in our efforts. 

There are three ways to increase your equity; Equity gain through mortgage paydown, improving the property to increase its value relative to other properties, and monetary inflation.  We only have control of the first two, inflation just happens.  As we pay on the mortgage, the balance owing is reduced and our equity is increased.  This is called equity gain on the mortgage.  This gain is very slow at first, because the interest is the larger portion of the payment and the equity portion is the lesser amount.  Equity gain speeds up and the interest component reduces over time, until the mortgage payment is mostly equity gain and very little interest.  If we increase the payments on the mortgage, every penny plus more goes into equity gain.  If we upgrade the property and we make it worth more, the increase in value is all equity.  If there is inflation, the dollar value of the property is increased while the mortgage remains the same.  All these increases in value increase our equity.  If we have deflation the reverse is true; the value of the property is decreased while the mortgage remains the same, and all the loss of value is from our equity position. 

During the Great Recession in the US, property values lowered dramatically and many mortgages are for more than the value of the property.  In many cases this was due to refinancing the property, borrowing against equity, to buy bling.  If these owners had pursued equity gain instead of bling, they would not now be ‘under water’ on their mortgages and there would not be a ‘housing crisis’.  For those conservative investors who own their property outright, the lowering  of values does not matter at all.  It matters a great deal to the underwater swimmers.  This is the perfect example of why it is important to gain equity as quickly as possible.

When you own property, the forces which act to increase your equity are slow, especially at first.  Depending on the market, it takes between one and five years to double your down payment through equity gain on the mortgage.  If during that time you decide to move, then the costs associated with the move will reduce your equity.  In some cases those costs might be so high that you end up with no equity at all.  If you move again and again, you have no chance to build equity.  If instead you  buy and hold, then over time equity will increase, and at a faster and faster rate.  When you buy a property you should always try to buy for the long term.  This will allow these forces to do their jobs.  If you don’t then there is no benefit to buying instead of renting, because you will be constantly paying top dollar for a place to live without any equity gain to offset the cost.

If you buy and hold, then you make all the money; if you buy and sell then the Realtors make all the money.  When choosing a Realtor, this should always be kept in mind; many Realtors engage in the practice of ‘churning’.  They encourage their clients to sell this house and buy that one.  When they do, the Realtor does very well.  Seek a Realtor who does not churn, and he will help you to prosper.  I encourage all my clients to buy for the long term and keep their properties.  Of course not all do, however several people are still in homes I helped them buy 20 to 25 years ago.  I consider them to be my successes; I helped them to buy a home that was so perfect for them that they felt no need to move in all that time.  Note that my successes have earned me the least money per client over time, however I feel that my mission is to do the best for my client so this is mission accomplished and gives me great satisfaction, even though it is not very profitable.

Everything I advocate will lead to benefits for you, not me.  I want to see all my clients prosper.  I hope that they will appreciate my approach, and that they will call me again when they have Real Estate needs, and recommend me to their friends.  If you appreciate this philosophy, call me to discuss your Real Estate needs and how you can prosper even in these challenging times.

The Five Year Plan

The joy in Real Estate comes when you own it outright.  That’s when it really pays off.  You probably will have had some shielding from higher rents in the meantime, so some benefits, but from now on you only pay taxes, insurance, maintenance and utilities.  Suddenly you are less vulnerable.  Now you can really sock away money for retirement.  Now you can enjoy life a little more.  The Five Year Plan is an approach designed to get you there quickly and relatively painlessly.

As you are seeking your first home, you must live frugally.  Eat at home, don’t go out for coffee or drinks, take your lunch to work, don’t buy anything you don’t really need etc.  Sock away money, as much as humanly possible.  You will find that the home purchasing process gobbles money.  You will need it all.  If you have it when you need it, everything is easier.  This also preps you for what is to come.

Once you have your home and have moved in, continue to live as frugally as possible.  There are tremendous resources on the internet on how to live like a king on a pauper’s salary by doing things for yourselves.  Do everything you can to save money.  Look for ways to earn extra money to add to the savings.  Sock away every cent you can, and keep on paying the mortgage.  In six months, look at what you have saved, and put most of it on the mortgage.  Keep a little as a slush fund and continue to save.  At the end of the year, put almost every penny you can onto the mortgage.  Add a little to the slush fund, but keep it small.   If you come into money from any source; income tax refund, gift etc, put all that into the savings account and then onto the mortgage.  Most mortgage companies allow 10-20% annual prepayment without penalty.  They don’t like to take extra payments too often because of accounting difficulties.  I suggest paying extra twice each year, however if it suits you and your bank is agreeable, you might pay more often.  Don’t allow the savings account to get too large or you might be tempted to use it for another purpose.  Once it is paid on the mortgage, it is no longer available to tempt you.

All of the extra money you pay comes off the principal amount, and reduces the interest component of the ensuing payments.  During the first few years of a mortgage, the payment goes mostly to interest, little to principal.  In the first year of a $300,000, 25 year mortgage you will make $17,000 in payments while only paying off about $8,000. (Based on 2012 rates of 2.99%)  If you can pay off an extra $8000, you save a year of payments, saving you about $9,000 in interest.  If you can pay an extra $16,000 you save two years etc.  The idea is to beat down your mortgage as quickly as possible.

If you have good jobs and are dilligent, you can do it.  You can pay your home off in 5 years.  I know people who have.  If you can pay the house off, you will be $1400 or more ahead of your peer group every month, over $17000 per year in after tax dollars just from not paying mortgage payments.  You also won’t be paying extra on the mortgage so you will have that money too.

Even if you are only somewhat successful, at least you are ahead of the pack.  If  all you do is make your payments for 5 years, you will approach your mortgage renewal with a balance of $256,000.  Your renewal options will be limited, you must renew for 20 years at current rates and keep on making the same payment.  If you have substantially reduced the total, you can reschedule the mortgage to allow for new circumstances.  That way if you decide to start a family, take a new job or whatever, you can simply lower the payments.  If you move into a higher income bracket you might increase the payments.  You might keep them the same to continue to pay the principal off more quickly.  If you then continue to pay extra, the remainder will be gone relatively quickly.

Whether you pay the mortgage off entirely or just reduce it substantially in the first five years, you will be less vulnerable.  Interest rates on mortgage renewal date won’t matter as much.  Whatever curve balls life throws your way, you will be in a better position to deal with them.

One final benefit to the process is that you will develop a strong discipline with money which will be valuable for the rest of your life.

Why We Buy

Most people don’t analyse their Real Estate buying decision on the basis of numbers.  For most people, the only Real Estate they ever buy is the family home, and they buy on the basis of emotional appeal and practicality; do they like it, does it suit their needs, and is it within their budget?  Is the price asked appropriate for the value perceived at this time in this market?

There are, however some over-riding concepts which guide them to choose ownership over tenancy:

First and foremost is establishing a home for their family.  They want to build strong family ties and see the home as a vital part of that picture.  We especially see this in young women bearing their first child, where the ‘nesting instinct’ is in high gear.

They seek control.  As a renter, you have less control over a variety of factors than do owners.  Renters are not in charge of maintenance or upgrades so they may be forced to live in less than ideal conditions.  Their rent can be increased any time or they can be evicted if the owner decides to sell or move his relative in.  The landlord can enter the property with notice at any time, and the renter is not permitted to prevent that.  They perceive renting as less stable in the long term than ownership because the needs of the owners could over-ride their needs as renters.

They seek a step up in the social heirarchy.  Owners are viewed as having higher status than renters for a variety of reasons;  It is a public declaration of financial maturity and purposefulness, because owners tend to be long term thinkers, renters short term.  Owners are seen as having a stake in society, and therefore will contribute to it.  Renters are seen as somewhat transitory and less stable, more likely to be takers than givers.  Because this is a step forward in the social sense it is approved of by others, notably those in business and banking, who view owners in a somewhat more benevolent light than renters.

They seek a hedge against inflation.  They don’t know the exact numbers, but they understand the concept that their payments will stay relatively stable over time if they buy vs. paying rent which will inevitably rise with inflation over time.  They also understand the concept of rising values, so they want to buy now before prices go up even more, and hope that after they buy prices will continue to rise.

They have a long term goal of paying the house off and having no payment at all.   When your mortgage is paid off you are ahead of renters by the amount of rent they pay each month minus your cost of operating your house (taxes, maintenance etc).  In today’s dollars you will be ahead $1000 or more each month if you own an average house.  That money can be used for a variety of purposes; to increase your standard of living, to play or travel, to save for retirement, to do good works etc.

They see home ownership as a component of a comfortable retirement.  If you are a renter when you retire, a large portion of your pension income will go to just pay for a place to live.  Even if your pension is generous, if you don’t have other investments or savings the housing component will take a large bite out of your standard of living.  If you own your own home outright and it’s in good shape your pension goes a lot farther.   When you are older and the house no longer suits your needs, you can sell it and take that large sum of money and use it to suplement your pension and pay rent.

These are powerful motivators to buy.  Homeownership proportions vary within a narrow range; between 60-70% of Canadians are owners at any given time.  This is a very high percentage when you consider the number of youth and aging who are renters because they have few choices, youth because they are not yet ready to own and the aging because they are unable to properly care for a home.  Even among the aging, many own condominiums because the desire to own and control their own place is so strong.  When I talk to older people many can’t even think about renting even though, looked at objectively, it might be their best choice.  These powerful motivators also cause people to view the investment in a home differently than other investments.  This is one of the reasons Canadian default rates are so low, and why we did not suffer the same harm to our housing market as the US did in the great recession.  Canadians don’t put home at risk.

The Three Legged Stool

Just as a three legged stool is the most stable platform, so Real Estate is the most stable form of investing, because it has three sources of returns.  The sum of all of these returns outperforms all other investments over time.  The three sources are 1. Equity Gain, 2. Cash flow, 3. Inflation.

Equity gain is the paydown part of the mortgage payment.  Each payment is blended; part is interest, part is principal.  The principal part is equity gain.  As time passes, the part of each payment going to principal increases, and interest decreases.  Eventually we have the mortgage paid off.

Cash flow is that part of the income of a property that exceeds the costs to own it, which the owner gets to keep.  Even when we talk about our own home, there is cash flow potential;  Payments on the mortgage are stable over time, while rents rise.  When the rents rise they exceed our payments.  The difference is a form of cash flow, because if we hadn’t bought the house we would be paying more, so the difference is cash in our pocket.  If the property is an investment, the cash flow is return on this investment, and it should be viewed as such with our own home too.

Inflation is a persistent devaluing of money.  When we buy we pay for the property with today’s money, and pay it off with devalued dollars in the future.  When we sell the property, we receive more of the devalued dollars in exchange.  This is why Real Estate is called a ’Hedge Against Inflation’.  This is only partially true, for though we might receive three times as many dollars for the property, the dollars we receive in 25 years might be worth only 1/4 of their value today, thus we are receiving less buying power in the end.  The difference between the buying power of the purchase today and the sale of tomorrow equals the depreciation of the property over the 25 year period.  Even though Real Estate does not totally protect us against inflation, it protects us more than any other investment.

The other component of Real Estate investing which is important is leverage.  Leverage is the principle of buying something with a down payment and financing.  Real Estate requires the smallest down payment of any investment, requiring as little as 5% down.  When we analyse our return on investment, we compare with the down payment.  Because the DP is so low, our return is magnified.  Example:  5% down, 95% mortgage paid off over 25 years.  Total return is 1900%  (95/5 X100).  1900%/25 years gives a simple rate of return per year of 76%.  Even if we use compound interest rate calculations, we return far more on our own homes than any other investment.

Other investments such as stocks etc. also allow leverage, (usually 50% down payment), however the difference is that the balance of the price is paid by the owner of the stocks, whereas Real Estate is paid off by tenants.  This can be a tricky concept when applied to our own homes.  If you view yourself as a tenant, renting your house from you, the landlord, you can visualize it better.  The tenant you pays ’rent’ and the landlord you pays the mortgage.  The tenant you is paying off the mortgage, just as you would if you were renting from someone else.  Seeing as you must pay to live indoors anyway, you just pay your own mortgage instead of someone else’s.  The landlord you is the investor; he doesn’t pay the mortgage, you the renter do, just as regular tenants do.