Time to rethink real estate

'Real estate is always good, as far as I'm concerned," Donald Trump once said.

"It's tangible, it's solid, it's beautiful. It's artistic, from my standpoint, and I just love real estate."

The Donald may be unfamiliar with the architectural atrocity that is the "Vancouver special" or its hometown, which Forbes last year ranked as the sixth most overpriced real estate market in the world.

But the man more famous for the phrase "You're fired" than his roller-coaster ride in real estate was recently worth $3 billion US, and you can't argue with success.

For a lucky few, of course, Vancouver real estate has been a gold mine. Those who purchased a home after the last major downturn in 1990 and hung on through the frequent bumps and dips until today -- or rather until February this year -- hit the motherlode.

Depending on who's doing the math, the value of their investment has more than tripled. And house flippers who snapped up a teardown last year and cashed out near the peak have also made a killing.

The rest of us, lemmings who bought during the frenzy and bid up the price of dumpy asbestos-filled bungalows that are worth less than they were six months ago, rue the day we placed a call to a real estate agent.

A dwindling number of realtors cling to the fiction that we are in a "balanced" real estate market where, since no one has an advantage, everybody presumably gets a fair deal. But remove the rose-coloured glasses and one could easily get the impression that real estate is threatening to become a horror show for sellers -- and it's one we've seen before.

In fact, there have been several episodes of market mayhem, from a terrifying drop in 1981 to more modest declines in 1990 and 1996. But these are early days in Metro Vancouver's latest real estate slump, with prices for a typical detached home down 4.3 per cent in August from May, so it's difficult to gauge whether it will be a mild correction or a catastrophic crash.

It's little comfort that prices of resale homes as of August were up six per cent year over year (new home prices were up eight per cent) because history has a way of repeating itself. And the past isn't pretty.

A worst-case scenario would be a replay of 1980-82 when house prices spiked and sank so fast fortunes were won and lost in a matter of days. The run-up began in 1979 with average prices soaring from the $240,000 range to more than $540,000 in 1981 and almost back again by mid-1982 -- a 125-per-cent gain in real (inflation-adjusted 2008) dollars that largely evaporated within a year. Unfortunates who bought at the peak didn't see a recovery to that price level again until 1995. In nominal dollars, the trough was shorter, just eight years, but no less painful.

A return to those ugly days seems unlikely. Inflation in 1981 was running at an annualized rate of 12.5 per cent and the average five-year mortgage rate reached 18.5 per cent. At the nadir of that recession -- the worst in half a century -- the unemployment rate approached 13 per cent and the economy (GDP) contracted 6.7 per cent in 18 months.

Today, Canada's inflation rate is 3.4 per cent, unemployment is six per cent and a five-year mortgage can be had for under six per cent (if you shop around.) The economy is still growing, although just barely. These conditions do not suggest a housing market collapse like that of 1981-82 is imminent.

Still, a drop of 20 to 25 per cent, which was the range of decline in the 1990 and 1995 slumps, is not unthinkable.

The problem of looking at real estate prices this way is that it fails to capture the complete cycle. Just as investment promoters use timing to inflate claims of stock performance, real estate agents can raise -- or dash -- expectations by emphasizing only the upswing or downside of a cycle.

However, seen from peak to peak or trough to trough, the irrational exuberance of real estate dissipates. Vancouver's annual house appreciation from 1979 until 2008 was 7.6 per cent, from 1981 4.4 per cent, from 1992 5.3 per cent and from 2001 10.6 per cent. These represent fair returns but not a lottery win.

Rather than dwell on historical prices, perhaps we need to think about real estate -- and the notion of balance as equilibrium between buyers and sellers -- in a different way.

A number of analysts, including Tsur Somerville, a real estate finance professor at the University of British Columbia's Sauder School of Business, are doing just that. For them, a balanced market is one in which the ratio of house rents to prices equals the cost of capital for owning a house (the mortgage rate and out-of-pocket costs) minus the expected rate of house price appreciation.

In other words, the dividend payment, being the rent for a house, equals the price of the asset, being the house price multiplied by the cost of holding the asset ( the cost of borrowed funds, maintenance, property taxes, insurance and depreciation) minus the change in the market price of housing.

Applying this formula, Somerville calculates that the equilibrium rent-price ratio for Vancouver is 4.1 per cent, while the current ratio stands at 3.6 per cent. On this basis, Vancouver house prices are about 11 per cent overvalued. Taking the average house price of $754,500 in the second quarter of 2008, prices must fall by about $85,000 to bring the rent-price ratio into equilibrium.

How bad is that? Maybe the real estate storm will blow over without causing too much damage. If a measly loss of $85,000 is all it takes to return to normal market conditions, perhaps we can all breathe a sigh of relief. However, in the event of macroeconomic shocks, like a global recession, or environmental Armageddon, all bets are off.

(Editorial: Harvey Enchin/Vancouver Sun)