Friday, April 28, 2017

Real Estate pricing is inherently unstable.

Real Estate in Canada has been defying common sense for quite a while now. Especially in Vancouver and Toronto the prices have gone ballistic. I think this is because Real Estate plays more and more the role of investment as opposed to the utilitarian role of shelter.

Most consumption in our economy has nicely predictable pricing, as it follows supply and demand. Higher prices will lower demand, causing lower prices. This means, it is self-regulating.

When it comes to investments, however, lower prices often repel investors, instead of attracting them. Most investors will want to ride a trend. And if the trend is down, they will jump ship. If the trend is up, they are tempted to invest more of their money in it.

When viewed as an investment, or even a simple nest-egg for retirement, Real Estate pricing is doomed to a vicious cycle. So that means that the housing market is likely to be in a boom or in a bust. And it will be relatively hard to stay in a steady-state equilibrium. Because as soon as the price swings one way, investor behaviour is going to reinforce the trend.

How can these cycles be broken? Well, for that to happen, Canadian home owners need to take a serious look at the intrinsic value of their home, instead of the speculative value. Most people do not have a good feel for intrinsic value. But it can easily be calculated based on market rents.

For a stock portfolio it is not unreasonable to expect a 6.25% yield on your investment per year. If a house is viewed as an investment, we could compare its yield to this. Ignoring property tax and maintenance for a moment: if the price is 16 times the yearly rent, it would yield the same 6.25%. So to determine the intrinsic value of your home, just multiply the market's monthly rent by 12x16 (192.) If you can rent out the apartment for $1000 per month, intrinsically, the apartment is worth $192,000. Depending on the city, or even neighbourhood, the actual market price of the apartment may be much different from this. In the United States, the extremes are San Francisco and Detroit.