Regulators to probe impact of foreign money on real estate; Reader question- What to do with real estate windfall...
JUNE 05, 2011
It’s been an interesting week. Greece faces a near-certain default of some form in the not too distant future, though reports indicate that a new bailout is in the works. Hopefully this one has a longer half life than the last. And of course the Euro zone bankers are sleeping a little less soundly now that Greece teeters on the brink and new signs of weakness are emerging out of too-big-to-bail-out Spain. A haircut on Greek bonds held by the large Euro banks will certainly ratchet up credit market tensions and risk a second financial crisis. How this will all play out will be the story of 2011 and 2012, though expect the rot to continue unabated and begin spreading from the Eurozone periphery PIIGS nations to the core, testing the will and resolve of the monetary union.
Meanwhile jobs and manufacturing numbers disappoint in the US. In fact, manufacturing is slowing the world over. The stock market is showing signs of stress as investors are increasingly anxious about the looming end of QE2, with risk assets coming under expected pressure while bonds find their bid. Rising bond prices have pushed yields lower this week. This is all good for interest rates as the big banks have started slashing their 5 year posted rate. As I’ve said all along, the bond markets, which are nearly 15 times larger than the stock markets in North America, are far more fearful of deflation at this point than runaway inflation. Deflation is the economic version of the Bogey Man. It’s what keeps central bankers awake at night. The risk of deflationary pressures remain far higher than most realize, despite the speculator led run-up of oil prices.
But alas Canada is an island....insulated from the global storms that buffet other nations. At least that’s what we seem to believe. The Toronto market has found its mojo. You’ll recall that for the past two months I have been warning that if inventory levels don’t normalize, we’ll see the return of bidding wars by the Summer. It looks like that may well be the case as house prices and sales have surged in May.
Meanwhile on the wet coast, giddy buyers happily snap up tear down houses on 50 foot wide lots for 2 mil. Remember, a couple million is a bargain compared to the prices found in other major global cities where incomes are twice that of Vancouver and where there is a real, functioning economy. But there’s a risk that some of these international buyers who find Vancouver’s pricy real estate so sexy might actually pull out a calculator, look just south of the border at a very similar city in Washington state, and realize that they can buy a home for a third of the price and with much better long-term prospects for capital appreciation. What happens then? And far more importantly, what happens to the pie-in-the-sky story that has captivated BCs population and led them to believe that millions in debt is alright as there will always be a dumber, wealthier foreign buyer willing to take it off their hands for more than they paid? This is the great risk and this dynamic, more than the actual buying by wealthy foreigners, that has driven BC real estate to such ridiculous heights. What happens when the effects of the kool-aid wears off?
Well, sales and prices will fall.....hard. At least that’s the concern of the country’s chief financial regulator who is now looking into the impact of foreign capital on real estate markets in Canada:
Canada’s top banking regulator is on a fact-finding mission to gauge the scope of foreign investment in residential real estate.
Industry sources say the Office of the Superintendent of Financial Institutions is sizing up the market, most likely as part of its active campaign to “stress-test” the country’s big banks to measure how they would be affected by volatility in various market segments.
OSFI is taking a broad look at bank exposure to household debt and how the financial institutions are monitoring loan portfolios amid growing concerns over the ability of Canadians to handle their debt load.
In the case of the housing market, sources point to global trends that could affect investment in Canada — such as China’s recent policies to curb speculative real estate investment in that country — as evidence that Canada is operating in a fast-changing market that could be adversely affected by decisions made in other countries.
They suggest OSFI wants to know how big a factor foreign investment in Canada’s housing market is, and how big it is likely to become, so the regulator can measure the potential impact on banks if demand were to dry up.
If the trend of international investment were to continue indefinitely, it would not be a troubling issue for the country’s banks. The problems would come if transient foreign interest were to contribute to the formation of a real estate bubble.
“If demand for residential real estate were to dry up in Canada, it would not be good for Canadian banks...”
It would be great to finally have some real insight (beyond the anecdotes from the real estate industry) into the prevalence of this purported driver of real estate prices. I doubt that it will lead to any significant regulatory changes. I don’t think it really should. Taxpayer exposure to foreign speculation is very minor as CMHC limits mortgage guarantees for non-permanent residents to one owner-occupied dwelling and requires a 10% down payment. I think if we could see the balance sheets of those buying, we’d find that overwhelmingly they are Canadian citizens with terrible balance sheets just like the rest of us. The fact that BC debt to income ratio for all residents is by far the highest in the country certainly argues against the silly notion that real estate prices are being driven by loads of foreigners purchasing property with bags of cash. That simply doesn’t compute.
The reality is that time will solve this issue. Speculators will be slaughtered and those who jumped in on the advice of the real estate industry will quickly learn the term ‘caveat emptor’. But not all have drank that kool-aid.
Meet ‘J’. Her and her husband recently sold their Vancouver home and now sit on an enviable cash pile of some 800 large. What to do with the windfall?
Hi Ben,
My husband and I have decided to stay out of the housing market in Vancouver for a while. We are not willing to invest more than a million dollars (including a mortgage) in a home that needs renovation or is in some other way not what we want to live in. We are hopeful that in 18 months to 3 years the housing market will correct enough so that we can more comfortably afford what we want.
My question for you is what should we do with our house equity?
We have about $800,000 that we need to park somewhere. This money is ear-marked for our home and not tied to retirement investments.
We want low risk but still want to earn something, ideally about 8% if this is a reasonable expectation. We have considered carving off some of this money to invest more aggressively. With the markets so volatile right now and our investment horizon relatively short we don't know the best course of action.
We have consulted a couple professionals but I wanted to include your advice, and any ideas your readers may generate, in our research.
So far we are considering:
33% cashable GIC's/High interest savings account (OK with locked-in for 1 year but not more), 33% corporate bonds (not Mutual fund bonds)
33% stocks/equity/shares (stocks/equity/shares to be blue chip and posses a low MER. (Avoiding emerging market funds as well)
Would maximize 2 TFSA within this.
Well, I stand by my advice from this post. I’ll let my knowledgeable readers chime in first before responding in the comment section.
Cheers,
Ben
18 Comments
IMHO, anything that will net you 8% return is going to be v.e.r.y risky right now, especially if you are thinking short term. I always like to compare my investments' ROI (and their time horizons) to the appropriate spot on the curve, (plus a little) to see if an expected return is realistic. We are in a low cost of capital environment.
Having said that...I don't know everything, and if you find a security or portfolio that works, let me know.
I'm currently in some cash, some inverse (HXD.TO), I've recently been on a short-picking phase too (Rona as one example).
The problem is that I cant recommend that anyone do this because you definitely do not want to do this long term. ;)
Private 1st and 2nd mortgages provide great income of 8-12% and are usually written for a 1 year term. As long as they are properly underwritten with a good loan to value they are a great way to make money.
I always find it amazing that users of capital get mortgages but suppliers of capital always overlook mortgages in favor of GIC's and stocks.
Hi Dave
Any chance you want to explain this a little more for some of my readers? I'll admit that I do have a bit of knowledge on how they work, but I have never invested in them myself.
How does one go about providing capital for a 1st or 2nd mortgage? What companies allow you to do this? How would you verify the loan-to-value ratio.
Thanks
"sure to foreign speculation is very minor as CMHC limits mortgage guarantees for non-permanent residents to one owner-occupied dwelling and requires a 10% down payment."
I think the FP missed the big story, that OSFI is looking at banks' exposure not only in terms of foreign investment but also in terms of lenders' net exposure in certain markets like Vancouver and Toronto regardless of who has the loan. As the article hinted, the major concern for governments is its future exposure of taxpayers in the event of price drops. That is, if prices drop by 20%, what happens to those with 20% equity previous who try to renew? They will be required to pick up CMHC insurance and the banks offload this risk they effectively took on by lending out silly amounts of money to low ratio customers. In other words, banks have an effective moral hazard when making non-CMHC-insured loans too.
Put another way, CMHC is the eventual resting place for loans (even lower ratio loans) when prices start dropping. Banks know this. Government knows this. OSFI is trying to figure out the best way of limiting future exposure for CMHC. While foreign investment may not be the culprit per se, the PERCEPTION of FI may be a contributor. It's a stretch and my bet is OSFI will go for the root cause, which is curbing loans into overinflated markets. RP1's reference to Carney's paper on countercyclical capital reserves is a hint at where the policy changes might come.
As for what to do with the money, if I were answering this question of an American circa 2005 ex post, I would say bonds. This time ex ante... cash looks good to me. It certainly wasn't a horrible place for an American since 2005 as many Americans can pick up 40%+ more house than they could 6 years ago. Though bonds would have done better.
I'm surprised CMHC even insures loans for non-residents. Their vision is "Committed to housing quality, affordability and choice for Canadians", but maybe it was more lucrative to expand their scope?
Well CMHC can provide "affordable" housing by limiting their insurance cap at $400K or less IMO. That they removed the cap seemed more to do with lobbying from banks than good long-term policy. If any family is having trouble affording property in any region of the country, $400K is more than enough, even in Greater Vancouver. They might need to buy a bus ticket and settle for a smaller space like townhouse or condo but that's all that's needed to render housing "affordable".
I think one thing OSFI can do right away is impose blanket qualification under the 5 year fixed rate instead of variable. Right now if you're under 80% LTV banks will often qualify people at variable prime (or less!), unlike insurable high ratio loans where they need to qualify at the 5 year fixed rate. That's a big risk in terms of renewal if the variable prime rate goes up substantially because, under that scenario, banks may simply refuse to lend and governments will have to pour in with guarantees again, not to mention that they may have to step up anyways if prices fall. I think we'll see more heavy-handed requirements for lending going forward. Was talking to a mortgage broker tonight and she's concerned banks are qualifying people willy-nilly at the lower rate. Oh and most of her loans are low-ratio. She said "you'd be surprised" how many people have large downpayments these days. Defo -- if a place is $1MM you kinda need a big DP on average income...
It appears they even insure purchases of (smaller) rental properties, how do they explain that?
Would be very interesting to see how this expansion happened.
"how do they explain that?"
If it's the same mantra as the US it's enabling housing supply by providing subsidies to investors. I expect the reason is somewhat historical: governments were funding larger-scale rental developments to meet housing demand, through larger subsidies for block rentals ("projects") as well as smaller-scale cooperatives and other grants for affordable housing. So some bright light suggested why not get rid of that burden altogether and turn over management of rental stock to the "free market" by offering insured and preferred financing rates? They are effectively passing on housing subsidies, in the form of government guarantees on financing, to investors. Greenspan thought this to be a free lunch because he surmised that looking at the data people are more responsible in aggregate than lenders were giving them credit for. Turns out he was wrong.
If CMHC tightens access to credit for small-time landlords, the government will be paying anyways through housing grants and other rental-based subsidized housing, so goes the argument. I can't say one way or the other but I do find it odd that small-time landlords are accepting yields so low that larger investors simply balk. That doesn't sound healthy to me.
And one might ask the question: if there is a large number of foreign non resident buyers, how do their purchases affect the long term economic prospects of the regions they purchse in? Do their purchases inflate prices and therefore negatively affect Canadian citizens who live and work in the regions affected? Do their purchases effectively remove housing and potential rental stock from the market exacerbating rental and lease values? Does their " investment" offer long term value to the economies of the regions in which their purchases have been made in terms of spending, tax revenue and job creation?
Tw:
Of course non-resident foreign buyers inflate real estate prices, rental prices.
Let's ask a better question: Why are they buying? SO THEY CAN PROFIT. China curbed their speculative activities, so they moved their speculation here.
Let's ask another question: Who benefits? Well, the foreign buyers do, if the prices keep escalating. The real estate industry, the building industry, other speculators, people who already own homes, etc.
Who loses? People who are not in the market.
Interesting post, as ever.
I have been focusing personally on a similar conundrum. We sold our house, in a Vancouver suburb, just ahead of the amortisation changes in March, and as a result we now have a packet of cash to deal with instead of a collection of mortgages and HELOCs. Whoopee!
I read Ben's post (linked above) and I like the 'conservative' (safety oriented) approach that he has taken. This is particularly so as I am convinced that QE and QE2 have resulted in global asset inflation across the board, which will be correcting sooner rather than later; and also that the Euro crisis appears as if it will explode into a new Lehman's situation, also sooner rather than later. This means, to me, that paper assets will correct back sharply, as well as Canadian housing; and also that we are now facing the prospect of either an interest rate shock or else a hyper-inflationary episode of some kind. Why? Because the Greeks (and the Irish and the Portuguese, and possible also the Spanish) can't conceivably pay their debts; and therefore the European Central Bank, which holds vast sums of these country's bonds, is essentially broke. Its only available recourse in terms of 'fixing' this will be to print vast quantities of Euros to recapitalise the ECB. This may trigger a bout of hyper inflation, and it will certainly undermine faith in fiat currencies.
Our situation is a bit different. We leveraged our first house to buy a wonderful home in the Okanagan Valley, which we rent out to tourists in the summer months. This has now become our principal residence, which we vacate in the summer for a rented apartment in 'the big smoke'. So we don't need to think in terms of a 'house account'. Our solution so far, which is more long term, has gone like this:
1. We paid off the small remaining mortgage on our new principal residence, which is therefore now an established, revenue earning business, as well as the home of our dreams;
2. $30 k in a TFSA with ING, by way of parking some cash (paying 2%). Per Ben's post, I will be looking into inflation protected bonds as a new vehicle in which to place this;
3. About 18% of our nut is in a spread of physical precious metals. This (I hope) will be a good long term play, and also an insurance policy against either a hyper inflationary episode or a crashing Loonie, which might be part of the fallout from a housing correction (metals are priced in US dollars);
4. And the balance in cash, so that we can buy distressed assets going forward.
So that was the best that I could figure out to do. I hope I got it right.
Great Article Ben! You have such a insightful point of view. I can't wait to read your book!
I'll add a few comments on the end here.
With 800K, I would actually avoid using ETFs for your bond exposure (as I had suggested in the post on building a portfolio). My advice is to take 300-500K and set up a laddered government bond portfolio consisting of bonds that mature 1-5 years (1/5 in each year). This gives you a very similar structure to XSB and CLF, but without the management fees. This is fairly easy to set up with the help of a fee-for-service advisor or a discount broker if you know what you are doing.
I also think that 33% in equities is taking on far too much risk given your narrow time horizon. I would avoid them altogether, or limit them to no more than 100K. With that 100K, I would stick to high quality fixed and floating rate preferreds. I would avoid common stock altogether.
With the remaining money, I would stick to cash (at least 25%), real return bonds, or high quality corporate bonds.
It's not sexy, but the name of the game for you right now is to preserve your capital and avoid the temptation to chase higher return by taking on imprudent risk given your very short time horizon. Remember that your purchasing power will be compounded in the likely event of a correction in Vancouver house prices.
Hope that helps
I think that you should lower your expectations of getting 8%. There is really nothing that is not overpriced out there. Bonds are expensive too, and good corporate bonds are even more expensive.
Cash holders are being repressed by central banks.
There is no greater temptation than to do smth with your cash when interest rates are low.
You must resist this temptation and should know that low rates = overpriced assets.
If you are into more risky things, I would suggest:
1- buy 2 year greek bond, it is paying more than 20%. Despite all the noise, Germany and France will come to greek rescue because thy do not have other choice unless EU unravels with unpredictable consequences. If you know smth about EU politics, you will understand that in the end ECB will start printing and make the PIGS solvent. You must hedge for Euro depreciations as I expect it to happen during this process.
2- convert your cash into USD at the current rates. Especially if you live near the border, your currency risk is low as you can shop in the states and save in shopping as well. I expect the CAD to depreciate by 30% against the USD
3- Short commodities if you can.
With the exception of nb 2, the other strategies are risky. But if you want to be safe, your expectation should be in the 2% yield rather than 8%. Zirp environment sucks for cash holders.
CMHC is a hybrid entity meaning it is not regulated by the government or OSFI. The CMHC has stated (somewhere on the website) that it regulates itself by rules set by OSFI for other institutions.
So if OSFI suddenly required banks to -- I don't know -- qualify borrowers at the 5 year posted fixed mortgage rate, CMHC should have nothing to worry about!
The idea that CMHC will do smth to pop the bubble is not credible. If anything, they will relax the rules more to keep the RE values "stable".
If the bubble pops it will be from buyer exhaustion. The government will try to mitigate any substantial price decline. Given how much control the government exerts through the big five and CHMC , it is possible that a soft landing will be engineered in our RE market while inflation stays consistently above the interest rates.
"soft landing will be engineered"
What's a soft landing? Is it 5% decline per year? Flat? Will it be uniform across the country? How about Vancouver and Toronto?
Maybe there will be a "soft landing" nation-wide but it would require the government to forgo its balanced budget pledge. And it won't preclude certain cities from taking it over a barrel. I don't think Canadians already facing austerity measures will be too keen bailing out liberal elite enclaves and (purportedly) foreigners from profligacy and gambling addictions.
Conservative, meet speculator.Speculator, meet sledgehammer.