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Calgary Real Estate Historical Yields March 25, 2009

Posted by DustinRJay in Calgary real estate, rental yields, risk spreads, valuation models.
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One way of evaluating assets is to compare them to a safe investment.  Arguably, the safest investment in Canada is Government of Canada bonds.  The biggest risk with holding a bond, is that it is subject to inflation over the term that you hold the bond, but virtually guarantees return of your capital.

The following graph compares the historical rent to price ratio for Calgary against historical long term bond yields.  One of the benefits of real estate over bonds, is that the dividend (rent) can be expected to grow over time, and the asset value will appreciate over long periods of time.  A bond does not offer any upside from the coupon rate.  Therefore, it’s usually irrational that real estate, which has more risks in comparison to Government bonds should yield less.  The following graph helps identify some of the recent price corrections including the 1982, 1991 and 2007 corrections.

Calgary Historical Yield Spreads

[click above for larger view]

One interpretation is that given recent rental increases, lower bond yields, and lower house prices that the current rent to price ratio is more competitive than bonds, and therefore offers fair value.

Data:  UBC Centre for Urban Economics and Real Estate, Bank of Canada, CREB, Bob Truman – First Place Realty

Risk Spreads – A Red Light on the Real Estate Market February 7, 2008

Posted by DustinRJay in Calgary real estate, risk spreads.
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Typically, when looking for a good investment opportunity, one expects a higher return than a safe investment like a bond. 

A mortgage product has risk and therefore should have a higher return than a bond.  By an analysis of the spread above the safe investment  vehichle one can determine periods of heightened risk in the credit markets.

Typically, heightened risk in the credit markets has accompanied recessions.  Also, this has proved to be one of several warning indicators for the peak in the housing market cycle.

As you can see in the following graph, large jumps in the risk spread (red zone) have typically accompanied the start of a bear market in real estate.  In addition, a recession has often followed a sharp increase in the risk spread.  Currently, the risk spread is the highest it has been since the early 1980’s bear Calgary real estate market.

This sort of analysis is useful in identifying some of the creamier investing opportunities (green zone) when the risks have been smaller.

Risk Spreads - A Red Light on the Real Estate Market

Reading Tea Leaves – Predicting Canadian Recessions Using Financial Variables February 5, 2008

Posted by DustinRJay in recession risks.
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One of the tools that the Bank of Canada uses for forecasting probability of recessions is the spread between Government of Canada 10 year bond yields and 90 day commercial paper.  This is a leading indicator of slower economic growth.  The benefit of using a tool like this, is that if recessions can be successfully predicted in advance, monetary policy can be adjusted accordingly.

The paper “Predicting Canadian Recessions Using Financial Variables: A Probit Approach” concludes to say:

“Results in the paper show that, in comparison to other financial variables, the spread between Canadian long bonds and the 90-day commercial paper rate is best at predicting recessions in Canada.”

The following graph shows that the spread has been the largest since the 1990’s recession for about a year:

Predicting Canadian Recessions Using Financial Variables

The past two recessions have marked peaks in the housing cycle in Calgary.  As carrying costs are the highest since previous housing bubbles (see this post), it is useful to estimate the probability of a recession as a tool in forecasting the peak in the current housing cycle. 

I am optimistic that Canada will avoid a recession at this point.  However, I estimate that the next period will be the slowest economic growth that has been seen in more than a decade.  I estimate that the probabilities of a Canadian recession are about the chance of flipping a coin three times and having all heads.  Currently,  Global Insight has estimated the probability of recession at 25% in Canada, with most other instutions forecasting less risk than that.

For those that are highly leveraged and unable to cope with an economic shock, there may be difficult times ahead…

Terrain of Calgary Real Estate Valuation – Price To Rent Ratios January 16, 2008

Posted by DustinRJay in rental yields, valuation models.
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In the previous post, I discussed how Calgary rental yields are less than many safe investments like bonds.  I was interested in how the price to rent ratio compared in a historical perspective and what were the valuations like compared to previous real estate cycles. 

A price to rent ratio is similar to the price to earnings concept which is borrowed from the equity markets.  The idea is that house prices can be compared against the cash flow that can be generated from the property.  Ergo, the higher the house price in comparison to the rent, the poorer the value of the asset.

RBC published a report in 2005 called “House Valuations Across Major Cities.”  At the time of the report, it stated that price to earnings ratios for Calgary real estate had pushed “significantly beyond” late 1980’s levels.

The following is a graph of how price to rent ratios compare in Calgary.  As you can see, rental yields are an underlying fundamental of house prices up until 1998, when house prices started increasing exponentially, but the trend for the rent index stayed at roughly the same as inflation.

 Price to Rent Ratios - Terrain of Calgary Real Estate Valuation

The current valuations are roughly double the long term price to rent ratio.  This information dovetails with my previous blog entry wherein I came up with a rental yield of 3.1% for Calgary house prices which is less than safe investments like bonds.  A comparison against the long run price to rent ratio and the current valuations indicates that a more rational valuation would be 6.2% (slightly above low risk assets like bonds).

Therefore, caution may be warranted if buying, as house prices are roughly double traditional valuations.

Mind The Gap – Spreads Between Low Risk Investments and Calgary Rental Yields January 14, 2008

Posted by DustinRJay in rental yields.
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I thought it would be interesting to compare Calgary rental yields against a suite of safer investments.

For one to invest in real estate, one should desire a higher rate of return than other safer investments.

So, how did Calgary real estate stack up against the safer investments?  As you can see in the graph below, not very well…  In general, Calgary rental yields were less than the safer investments yields like GIC’s, savings accounts and bonds.  Low rental yields have led to high levels of condominium conversions as lessors arbitrage differences between renting and owning.

 Calgary Rental Yields

The following is a rental yield calculation for a two bedroom condo in Calgary:

December 2007 Calgary Condo Price = $304,719
Residential Tax Rate = 0.0054614
Annual Taxes = $1,664
2007 Calgary Two Bedroom Condo Rent =$1089/month
Condominium Fees = ~$150/month

Calgary Rental Yields = (1089*12-150*12-1664)/304719 = 3.15%

This compares against:

ICICI Bank Savings Account (4.25%)
ICICI Bank 1 Year GIC (4.65%)
GoC 2 Year Benchmark Bond Yield (4.25%)
GoC 3 Year Benchmark Bond Yield (4.00%)
GoC 5 Year Benchmark Bond Yield (3.75%)
GoC 7 Year Benchmark Bond Yield (5.00%)
GoC 10 Year Benchmark Bond Yield (4.00%)
GoC Long Benchmark Bond Yield (5.75%)

Rental yields would need to increase by roughly 75% in order to be competitive with other safer investments.  Considering current market conditions, a fair market value of $175,000 instead of $304,719 may be warranted for a condo (a drop of ~$130,000).

I find it unlikely that Calgary rent will increase to make rental yields competitive so much as Calgary real estate prices will continue to drop due to:

  1. Calgary has the highest rent in the nation
  2. For the first time since 1994, Alberta had negative interprovincial migration.  This was likely due to individuals arbitraging regional cost of living differences.