A new approach to housing valuation:

What a dog with a stick can teach us about house prices

              

Some innate behaviors traverse species

Every weekend I take my dog; Butters out for a nice long stroll at a local off-leash dog park in Ottawa. She is a husky so she loves to run and be chased. Over her short life span of 3 years, Butters has learned that getting a chasing buddy doesn’t come easy and requires some enticing. She has figured out that if she picks up a tree branch from the acres of land with trees and fallen branches, inevitably she is going to draw attention of another dog. The other dogs almost always place a great deal of value in this random stick, resulting in Butters perceiving it as of great value to her. In fact, when she picks up a random stick, dozens of dogs come barreling down towards her, wanting to chase her and play with the stick. A stick that just five minutes ago laid on the ground with no apparent worth suddenly has a dozen dogs vying for it. In this dog society, as fast as the value of this stick goes up, it tumbles down. Being that huskies are borderline ADHD, after getting her chase on, she get distracted and moves on to other important things in life like rolling around in dirt. The stick she leaves behind has no takers, no salvage value, and it lays there until at some random moment another dog decides to pick it up. 

Butters at Bruce Pit, Ottawa

I have learned from dog experts that a dog’s intelligence plateaus at a level similar to a 2 year old human.  Often to the dismay of many parents, I compare things Butters does to their two year old. But I can’t help it; at an age up to 2, dogs and kids are so darn similar. We all have seen kids that want what the other kid has. If a kid picks up a random toy from a heap of toys, the other kid must have it. We all like to think that over time, this innate human behavior leaves us, that somehow we have evolved out of it but the truth can’t be further from that. As adults, we want to dress like those that dress like what we want to be. If our income permits (or in some cases event if it doesn’t) we aspire to drive the cars and live in the homes like the ones that our idols drive and live in. I love my dog, but I am glad that her impulses do not have a huge bearing on major economic decisions in my life. On the other hand, human impulses have implicated not just me but many others over the years. It is these impulses that have mired our history with valuation bubbles.  

Human history is mired with valuation bubbles

The readers of financial history are well aware of the fads that have preceded our time. Human history is mired with valuation bubbles. When one studies the financial bubbles, it appears that humans have indiscriminately chosen a random “stick” to value. From the earliest recorded asset bubble known as Tulip Mania to the recent examples of overly zealous valuation of internet companies, art work, classic cars, specialty tea and coffee, residential mortgages, student loans, it appears that our ADHD is almost on par with the dogs.

The fallacy in real-estate pricing approach

While the real-estate values vary depending on the location, the pricing approach to real estate is uniform globally: based on the approach of relative valuation. An individual that has engaged in real-estate transactions at any point in his/her life will recall that their realtor shows them a list of comparable homes in the neighborhood and based on that recommends a price point. This relative price comparison approach forms the basis of valuation for close to 500,000 home on average that change hands in a given year in Canada and millions in the US. This type of approach is not unique to the retail real-estate market but is in fact mainstream in the non-real-estate world as well. Wallsteet and Baystreet analysts persistently employ relative price valuation to price a host of assets.

In the context of the housing market, the problem with relative pricing approach is that the impulse of another individual to pay a certain amount for a house will for a long duration change the house prices in a given neighborhood.  Because a house is heterogeneous enough (location, features etc.) the lack of comparables mean that the price is not corrected fast enough.  The exuberance of one individual impacts many others in the market for quite some time. When it comes to housing, the dynamics are quite different and it isn’t until we encroach on some key fundamentals – which provide a common sense check -that we realize that the market needs to be corrected.

An alternative to relative price valuation

The next time you are thinking about purchasing a home, think about whether you are chasing after the proverbial stick that Butters has. Reflect back on the moment that first instigated the notion of home ownership in your mind. If you come to the realization that the decision is based on someone else’s decision to purchase a home, stop and think again. In case you made the decision independently and were not inspired by someone else, make sure you do your homework and are willing to treat the stick as a baton in a relay race that can be passed on to the next person with high credibility. Below are some alternative approaches that you should utilize the next time you make the decision to purchase a home.

• Mortgage affordability based on normalized expected income: Make sure your five year projected income can support the mortgage and base it on the interest rate on a five-year fixed term. Instead of looking at your current gross household income, look at the expected income which takes into account the probability of unemployment and use that to calculate the mortgage affordability. In the example presented in the table below, the normalized annual household income is equal to $60,464 versus the current income of $75,580.

Key elements to determine	Value	Explanation
Median current household income (Toronto)	$ 75, 580	This is a gross annual household income. Be conservative and do not include expected bonuses, but this should include reasonable year-over-year pay raises in line with inflation adjustments.
Probability of unemployment assigned to each earner	0.20	The 0.20 implies that both household earners expect to be unemployed for duration of one year in the next 5 year period. The 5 year period is used because in most cases offloading a house in less than 5 years results in less equity being built than paid off in real-estate commission, interest and other related expenses. Your situation may vary greatly. Hint: if you have been laid off from a job, think about how often that has happened in the last five years and how long did it take you to find a comparable position. You can rely on some publicly available statistics to come up with a value but your own assessment will likely be most accurate (see: http://www.bls.gov/news.release/empsit.t14.htm)
Normalized expected household income		= [(median current household income  x  5) x (1-probability of unemployment)] / 5 = [($75,580 x 5)x (0.8)]/5 = $60, 464

• Evaluate the house price using property tax multiple: buying a house should not be an impulse decision. For many it is the largest purchase of their lives, so ample research should be done. Ideally, you should allot one-year to research. Many of the readers may find this to be a ludicrous restraint but there are many benefits to this approach. Firstly, it prevents you from making an impulse purchase. Secondly, it ensures that you have done enough research that when the right house in the right price range comes up, you will have no hesitation in pulling the trigger. Finally, in the one year you may start to notice valuation swings that you are not ready for.

A property tax multiple is the new approach to housing valuation that is proposed here. It is a very useful measure for pricing your house. In the year that you are doing your research, make sure that you retain a realtor and have her send you as much data as possible on the houses being sold in the neighborhood of your choice. From the data provided to you, extract the values of property taxes and the price paid by the buyer. As an example, if the property taxes for the house are $12,000 and the house sold for $1.2 million, the property tax multiple will be 100 i.e. $1,200,000/$12,000. Collect this multiple on as many properties sold in your neighborhood as possible. Get as much historical data as possible. Once you have collected the multiples, arrange them in an ascending order. Exhibit 1 below illustrates a hypothetical outcome from this exercise. It shows multiples from 32 hypothetical property sales. The outcome from your exercise will look different. In order to ensure that you are not overpaying for your home, make sure that the price you are willing to pay falls below the median multiple. In the case illustrated in exhibit 1, that multiple will be in the range from 114-119. Of course, nothing stops you from going even lower but you do not want to be in the upper range of the property tax multiple. At the upper-end range you will be risking your ability to “pass the baton” or sell the home when the time comes. 

Exhibit 1 Property Tax Multiple Approach to Valuation

Since property tax value information is available before the sale – often times provided by the realtor in the property summary document at an open house – prospective buyers can apply the multiple to determine the fair value of the house before closing date. For example, if the property tax assessment shows a value of $5,000, the multiple in the range of 114-119 should result in the fair value in the range between $570,000 to $595,000 (i,e. $5,000 x 114 to $5,000 x 119). The main advantage of the property tax multiple approach is that it does not experience the swings that can typically be experienced through relative price valuation. This is because the property tax assessments are done by a third-party, usually the municipal government and are based on fundamental factors like the location, lot size, property type, age, amenities etc. More importantly, it prevents you from being a victim of someone else’s impulse who either decided to pay a higher multiple themselves and is now unloading the property on you or who is demanding a premium over comparable homes in the neighborhood.

• Balance life style needs: Ensure that the decision does not come at the expense of your other wants. It is stating the obvious but the decision to purchase a home should not come at the expense of your other needs and wants. If you want to spend your disposable income on travelling, eating out, or on a hobby, weigh that against the decision of buying a house and how it may hinder you from doing things that you love.

Crash and burn but still earn: why investing in equities still makes sense

The recent events of the financial market have discouraged many investors from putting their money in equities. Investment dollars are leaving the equity market in droves towards less risky government bonds. Despite the many perils noted by market watchers and investment advisors, this analysis presents a strong case for investing in equities for the long-term. The Canadian equity market as represented by the S&P TSX has performed impressively over the last almost three decades. As illustrated in Exhibit 1, while the herd mentality of investors has resulted in a “crash and burn” outcome for the TSX, the market returns have nonetheless been staggering over the long-term with an accumulated return of 1106% over the 36 year period from 1976-2012 (YTD). This translates to a CAGR of 7.16% implying that if an individual invested $100,000 in an index fund in 1976 that perfectly tracks the TSX, s/he would have funds in excess of $1.2 million by 2012.  

Exhibit 1

 So how should one navigate investments in the future?

The crash and burn scenario has been a norm in the Canadian financial market. However, the severity of drawdown in the market has experienced an uptick in the recent years. As shown in Exhibit 2, the long-term gain in the market has been tapered by periodic corrections.  The typical cycle in the Canadian stock market has been a 4:1 cycle where the market is in the positive gaining momentum for a period of four years and then corrects in the fifth year dropping a significant percentage point.  

Exhibit 2

 

The severity of negative events has increased significantly post 2001. Exhibit 3 shows that whereas the quantum associated with negative events preceding the dot-com boom experienced on average an 8% drawdown, in the post 2001 world the average drawdown has gone up three folds to 25%.  

Exhibit 3

It is expected that due to factors such as increased globalization, financial product complexity, increased participation in the financial markets etc, the new world order of sustained levels of high volatility will continue. For example, increased globalization has meant that now a number of global events affect the Canadian market exogenously. Thus, it is expected that the crash and burn scenario will continue to take place on average every four years. The markets will continue to show resilience, dusting off its shoulder and carrying on for 4 years before getting hammered again.

For investors with a long-term investment horizon, the equity market in Canada will provide an attractive return that will be well in excess of risk free investment. As illustrated in Exhibit 4, a $100,000 investment in the equities market today will easily exceed the risk free return in the long-run. There are four scenarios presented in Exhibit 4: risk free, optimist, realistic and pessimistic. If an investor puts aside $100,000 in risk free investments, he can expect to get almost $380,000 in 35 years. Even in the most pessimistic of outcomes for the Canadian equity market, where the market experiences 15% drop in value in the first 5 years increasing by 6 percentage point every 5 year, such that by year 32, the market drops by 45%, the equity market will still beat the risk free investment by providing almost twice the returns. It should be noted that in the optimistic scenario the market continues to experience its natural cycle, albeit less severe, dropping by 15% in the fifth year and increasing by 2 percentage points henceforth every fifth year. Under the optimistic scenario, an investment of $100,000 of principal in year 1 will yield almost $1.7 million by year 35 which is 4.4 times higher than risk free investment.   

Exhibit 4

 

The next exhibit is a nail in the coffin for a decision between a risk free investment and investment in market portfolio. This scenario contemplates an equities market that performs twice as worst as the most pessimistic scenario in Exhibit 4. The risk free investment continues to earn a 4% return over the 35 year period but the equities market, with its jagged edge route than previously considered still ekes out a premium of 29% over the risk free return. It is important to gain a better appreciation of what is in store for the equities market in Exhibit 5. Under this scenario, the equities market will gain 16% during the four years up-swing cycles in the market, dropping by 15% in the fifth year, 45% in year 10, 27% in year 15, 33% in year 21, 39% in year 25 and finally 45% in year 30.     

Exhibit 5

Exhibit 6 Main Assumptions

Assumption	Detail
Risk free rate	Risk free rate of 4% is assumed over the 35 year period.
Stock market cycle	It is assumed that the equity markets follow a cycle where for 4 years the annual returns are 16% annually and then the market goes down by a certain percentage point depending on the scenario
Optimistic scenario	Market goes up by 16% annually in the first four years, then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and drops by 17% in year 10. This 16% up and 2% incremental drawdown every five year continues on until year 35.
Realistic scenario	Market goes up by 16% annually in the first four years, then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and drops by 19% in year 10. This 16% up and 4% incremental drawdown every five year continues on until year 35.
Pessimistic scenario	Market goes up by 16% annually in the first four years, then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and drops by 21% in year 10. This 16% up and 6% incremental drawdown every five year continues on until year 35.
Worst x 2 scenario	Market goes up by 16% annually in the first four years, then drops by 15% in year 5, then goes up by 16% for subsequent 4 years and drops by 45% in year 10. The market then recovers at 16% annually for the next 4 years and then drops by 27% in year 15, dropping by 6% in every next 5 year cycle. Finally the market drops by 45% again in year 30.
Stock market investment decision	It is assumed that investors either have a highly diversified portfolio of investments that has a Beta of close to 1 or that investors are invested in ETFs that closely tracks the performance of the S&P TSX. This assumption is reasonable considering that most industry reports have shown that investment managers at hedge funds and mutual funds have largely been unable to beat the market performance. This combined with the fact that investment products such as ETFs offer a low cost solution to investing in the market means that it is highly likely that most equity investors will experience the returns and cycles profiles in this analysis.