Housing Bubble Trouble

Now that real estate prices are climbing by double-digit percentages again, talk on the street is all about bubbles—not only in housing, but also in gold, income trusts and the dollar. Should we be worried?

Now that real estate prices are climbing by double-digit percentages again, talk on the street is all about bubbles—not only in housing, but also in gold, income trusts and the dollar. Should we be worried? Nine years ago, a guy I know (okay, it was me) paid $275,000 for a rundown 90-year-old house in East Vancouver, named it the Munster Mansion because it was a three-storey monster, and the price seemed downright scary. The 2,300-square-foot, four-bedroom Munster Mansion is now worth more than half a million dollars.

In the late 1970s, that same house was on the market for under $100,000 and the buyer sold it a little more than a year later for a 10 per cent gain. The next owner hung onto the place for a couple of years and watched its value soar even more until 1983, when rapidly rising interest rates brought a feverish real estate market to a dead stop. When he sold a year later, it had sunk close to the original price he paid. The Munster Mansion was a real estate investment that perfectly mirrored Vancouver’s most famous real estate bubble—the rocket ride up in 1980-81 and the price crash that followed. And now that house prices are climbing by double-digit percentages again, talk on the street is all about other bubbles—not only in housing but in other hot investment trends (oil, gold, income trusts) that have enjoyed significant price gains.

But are they bubbles? Not really, say the financial experts. Traditionally, bubbles feature mass movements of extreme financial behaviour, when all rationality is abandoned and investors become swept up in a fever of greed that breaks only when the whole house of cards crashes down. We’re familiar with bubbles here in B.C. The famous Vancouver real estate bubble in the early ’80s saw everybody scramble to get in on the action, either out of greed or fear (i.e., “If I don’t get in now, I’ll miss my big chance”). This was the era of the flipper, when, according to the Canadian Mortgage and Housing Corp., nearly half of homes purchased were sold again within a year—the average is about 14 per cent. When that bubble popped, the last people left standing—those who had bought at the height of the frenzy—had to wait almost seven years for prices to recover.

And few investors need reminding of the tech bubble that burst in 2001, with previously unheard of “entrepreneurs” spouting tech gibberish about how technology would transform the world and we’d all be buying our tomatoes and dog food online. Thousands of B.C. investors, like millions elsewhere, bought the visions and gambled with their retirement funds to get shares—at any price and in anything labelled as ‘tech’ —usually without a clue as to what the business actually did. Companies such as Ballard Power and Sierra Wireless were bid up to more than US$200 a share on tech enthusiasm. Then, in a matter of months, it all unravelled and Ballard, Sierra and countless others saw their shares sink to below US$10. Some of the more notorious flameouts, such as 360networks, fled into bankruptcy, leaving investors holding nothing but air.

That’s not to say some didn’t make out like bandits. With hot money, if you can figure out where the stampede is heading and get there early, you’ll make money—get there late, and you could be trampled by the herd. Masses of investors armed with increasing amounts of real-time information react with lightning speed to financial stimulation, creating a huge impact on whatever investment they move to. Money moves at a moment’s notice to wherever the keepers of smart money believe a better investment return can be made. Hot money is old-fashioned investing done at breakneck speed.

Amid the flurry of cash, it’s hard to keep straight the difference between a bubble, which is unpredictable and not based on solid market fundamentals, and simple hot money, which is.

With many investors still nursing wounds from the spectacular tech implosion, are we too quick to cry bubble? The b-word has become a handy term for any scenario in which investors bid up prices—but when is the latest money trend a bubble, and when is it just savvy investment strategy? So, with that question in mind, we’re going to examine bubbles and hot-money trends and, with the aid of some experts in the field, see what’s hot, and what’s chilled out.

Will housing prices collapse?

First, we have to visit the most torrid of hot-money zones: real estate. In the past four years, there’s been a lot of action in this sphere, with what seems like everybody making bets in the market. This kind of action creates its own results, so by last fall, the benchmark price of a detached home in Vancouver had risen 17.1 per cent in the previous year to $564,100, while the price of a townhouse increased 12.7 per cent to $348,000. Apartment prices increased a whopping 20.6 per cent to $280,900. In the suburbs and outlying areas, prices were less mind-boggling, but growth curves were similar.

The prevailing opinion is that prices in the Lower Mainland are going to continue to go up. Certainly, the breathless blandishments of real estate marketers encourage this thinking—you can’t open a newspaper without seeing predictions of a fabulous future for real estate. Keeping in mind that real estate is affected as much by local factors as it is by national events (such as rising interest rates), the reasons for real estate as the hottest of hot-money areas in B.C. are pretty well known: the lowest interest rates in 50 years; pent-up demand, which kicked up prices and so drew more investment; an economic boom and the best job market in 30 years; a lowering of down-payment barriers to near zero; the upcoming Olympics and the building that comes with those kinds of events.

When you see articles about 23-year-old students buying their second 500-square-foot broom closet… er … condo downtown because it’s a “good investment,” it’s time to suspect that things are out of hand. So, with all that cash pouring into real estate during the past three or four years, there is talk everywhere of a bubble with corollary bets on when it’s going to burst.

Stop the talk and start looking at facts: The real estate market goes in cycles (of usually about five years, according to Cameron Muir, senior market analyst with CMHC) so the current market is getting a tad long in the tooth. Also, consider that in Vancouver, it now takes over 60 per cent of pretax income to service the cost of a mortgage, the highest level since the market peak of 1992. But that hasn’t hit the 75 per cent it was in the late 1980s. Overall, it looks like, in the words of real estate observer and advisor Ozzie Jurock, “We’re in the fifth year of a six-year cycle.”

So, hot money but no bubble, OK? But what do the experts say about whether money will continue flowing to real estate? Keeping in mind the old saw that if you laid all the world’s economists end to end, they still wouldn’t reach a conclusion—they are actually remarkably similar in their forecasting. For the most part, they say housing will begin to cool off from its heated pace this year but won’t crash or disappear—apparently there’s still money coming in. Helmut Pastrick, chief economist for Credit Union Central B.C., predicts the cycle’s price climb will continue at least through 2007. Pastrick rounds up all the usual suspects—immigration, increasing job growth, foreigners’ belief that Vancouver is a nice place to live—to support his premise.

Muir also points out that the economy’s strength is relatively new and should last for a while, which means demand for housing will also last. At the same time, constrictions on land and labour are ensuring there won’t be the overbuilding that usually occurs in the last stages of a real estate boom. While interest rates are starting to rise, they’re not jumping, so prices will continue to climb (he predicts the average price of a new home will grow about six per cent in 2006 to $660,000, while the average price of a new condo will leap nine per cent to $350,000). But resale prices in general will start to hit the affordability wall—that vague mental moment when a majority of buyers decide they just don’t have the borrowing power to pay those big prices and start to resist them—and that will eventually spread throughout the market, Muir adds. This wall has already been reached with some of the region’s more high-end developments: Some luxury homes in West Van, for example, have reportedly been on the market for months—one particular development has been trying to sell $2-million homes for more than seven months and has dropped some prices by $50,000.

CMHC regional economist Carol Frketich insists that “from an economic perspective, the fundamentals are still there to continue to support ongoing high levels of activity in B.C.’s housing sector,” but that affordability issues and rising interest rates (to about four per cent by the end of 2006) will throw some cooling water on the red-hot market.

End of the road for income trusts?

Income trusts have been roaring in Canada for several years, largely because so much money has been flowing into them from income-hungry older Canadians. A form of investment trust that holds income-producing assets such as real estate, oil and gas, manufacturing operations—or business trusts that include everything from restaurants to greenhouses—and pays a “distribution” or yield monthly or quarterly, income trusts typically feature distributions that are higher than income-producing investment vehicles such as bonds or guaranteed investment certificates. It’s for this reason that thousands of yield-seeking older Canadians have besieged the income trust market for five years as interest rates fell. They needed income and were badly hurt when bond yields dropped more than 50 per cent over the period. So trusts looked like the perfect solution.

But, as Vancouver fee-only investment advisor Adrian Mastracci suggests, it’s easy to forget that trusts are really equities that rise and fall in value just like any stock, which often negates the higher yield benefits. Apparently these risks don’t matter. To income-starved investors, yield numbers such as 10 and 15 per cent look pretty damn good and the herd has stampeded to trusts—the S&P/TSX Canadian Income Trust Index gained almost 80 per cent by March of 2005, but has been slipping ever since. As always, when there is a demand, supply follows: the investment community began forming and selling more and more trusts into this new market until late September, when Finance Minister Ralph Goodale, watching the government’s corporate tax take diminish, began musing about changing the trusts’ tax structure. That may have put a chill on the trust-conversion industry, but hasn’t affected demand much because most unit buyers don’t care about some investment banker’s problem.

For this kind of hot money, another more basic factor has come into play: trusts just aren’t offering such great returns any more. As Murray Leith, VP at Vancouver brokerage Odlum Brown, puts it, “Income trusts had a hell of a run because interest rates stayed low for so long. But rates have bottomed out and are starting to rise. At the same time trust yields have been falling, so the spread has narrowed. When we see trusts with yields of six per cent and are looking at interest rates of 4.5 per cent, that’s not great potential. So we think the trust sector will perform only average or worse going forward. It depends on how much interest rates rise.” The hot money, it seems, has cooled on income trusts.

Will energy stocks remain high?

It’s no secret that energy has been the place to be for investors in the past few years, and so consequently has become an ever-growing tub for hot money. Anyone who has pulled up to a gas pump during the past year has probably thought it might be smart to recoup their cash by investing in the companies that produce that gas. The energy industry in Canada generated $53 billion in production in 2002 (when oil was in the US$40-a-barrel range, the last year Stats Canada analyzed it). You can bet that was considerably higher in 2005 as hurricanes and other factors, such as the perception that China has insatiable energy demands, pushed the price of oil over US$60 a barrel and generated predictions that it would hit US$100. Since Canada is the largest supplier of oil to America, the world’s biggest energy hog, it’s been a bonanza in the making.

Hot money, which is always sniffing the wind for an opportunity (or threat), caught the scent of creosote-laden cash in the Canadian energy industry and moved in a couple of years ago. The TSX energy index soared nearly 40 per cent in 2005, while Barclays’ iUnits S&P/TSX Capped Energy Index—a handy measure of general investment sentiment regarding a sector—grew by 44 per cent as of November. In fact, by year end, energy stocks made up 25 per cent of the TSX top stocks index—the one that telecom giant Nortel used to dominate.

So, except for the odd dip, the hot money has flowed to energy. Sure sounds like a bubble. But is it? There has been some consolidation in the field but none of the rampant speculation that usually accompanies bubbles. Analysts have issued conflicting reports, and share prices are bouncing like yo-yos, so the big question is: Has hot money flowed out of energy yet, or is it still sitting there like a big gucky tar pit, waiting to trap the unwary? Hard to tell. The conventional wisdom is that Chinese demand for oil will keep prices in the stratosphere. Most hedge funds, those fleet-of-foot ultimate movers of hot money, are still in oil, so that should say something. Also, oil futures traders recently bought options on Athabasca Oil Sands Project 2007-2009 production for more than US$90 a barrel, which should say even more. Currency experts see a Canadian future painted with oil money. Michael Levy, a VP with CustomHouse Currency Exchange, and a regular commentator on money on CKNW insists the Canadian dollar has become a “petro-currency” and the loonie will soar because demand for petroleum is going to continue to rise.

But the contrarians out there feel that the China syndrome has been overblown, and that high oil prices will have the effect they always have: force consumers and companies to reduce their consumption. It may take awhile, but demand will fall, and so will prices. For instance, Leith points out that U.S. oil consumption peaked during the energy crisis of 1978 and took two decades to get back to that peak. Oil is a cyclical commodity it seems, and the cycle always turns—eventually. “The U.S. economy is going to slow because of high energy prices,” Leith says. “That means that eventually, there will be less energy demand in the U.S. Unfortunately, this is not going to be great news for Canada.” Marry that to fears of inflation caused by high oil prices and corresponding action by central banks around the world to fight it, and the picture looks like this: continued short-term action in oil but hurt all around in the long term and, eventually, an end to the oil rush.

How high can the loonie fly?

Remember when the Canadian dollar was really, really sick? A US$0.65 “Northern Peso” that was the laughingstock and had pundits demanding that we dump the loonie altogether and tie our fortunes to Uncle Sam’s currency? Well, not anymore. The Canadian dollar is now the Western world’s strongest currency. For the past couple of years, the Canadian dollar has been the destination for hot money among the world’s currency traders.

This has occurred, for the most part, because oil prices have risen so dramatically, but also because the U.S. dollar has been in a tailspin for several years. It did gain last year, but the U.S. government has been running up debt—it owes, mostly to European and Asian bondholders, in the neighbourhood of US$8 trillion—and spending like drunken sailors on tax cuts and military forays. Meanwhile, U.S. consumers have been borrowing on the value gained from rising real estate prices to buy ever-growing piles of consumer trinkets. This accumulated consumer debt now threatens the U.S. economy, because when it exhausts the consumer’s ability to pay it back, there will be a mighty reckoning.

In Canada, however, it’s been party time, especially in the West, because our economic strengths—natural resources such as oil and gas and metals—have the economy roaring. As a measure, Canadian stocks have advanced 70 per cent in the last three years, while in the U.S., they’ve gained a meagre five per cent (in Canadian dollars). That’s drawn foreign money, which converts to loonies and adds demand, which increases the dollar’s value. Couple that with the fact that Canada has been attacking its debt, racking up budget surpluses—sure, it’s all about high taxes, but currency traders don’t care—and generally doing a bang-up job of getting its fiscal house in order, and a stampede starts stirring. According to Levy, the Canadian dollar has been “disconnected” from the U.S. dollar and now stands alone as a destination for currency traders around the world. A handy mirror for this kind of action is the price of gold, which has been on an upward curve for some time and was expected to cross US$500 by the end of last year. Gold is priced in U.S. dollars, and that dollar was de facto being devalued.

All in all, it appears that the hot money has turned the Canadian dollar, in Levy’s words, into the “glamour currency.” And it looks like it will continue to flow that way as long as there’s a demand for energy. Many pundits predict further highs for the loonie, currently hovering in the neighbourhood of US$0.85 (a pretty tidy gain from its 2001 low of US$0.65). In November, BMO Nesbitt Burns was calling for a US$0.87 dollar by the end of 2005, with some slight easing in 2006. “With the winter heating season coming and oil prices still elevated, there is still room for the Canadian dollar to strengthen further,” a Nesbitt report said. So it’s all about the “petro-dollar” and the gamble on whether oil prices will stay high or retreat. The bullish, like Levy, see continued growth. He predicts a US$0.90 dollar by the end of 2006, and wouldn’t be surprised to see the loonie at par with the U.S. eagle within two years. Odlum Brown is more contrarian: high oil prices always cause recessions, so a slowdown is coming in the U.S., and consequently in Canada, which is so dependent on the price of oil, it says. This means the loonie will probably settle in the US$0.85 range.

Where to stash your cash in ’06

When prices climb rapidly, talk turns to bubbles and everybody starts focusing on prices, figuring to get in on a good thing. But remember that guy (me) who bought the Munster Mansion and saw its value soar over nine years? He didn’t exactly make a killing. The Munster Mansion was sold two years ago for $425,000, a $150,000 gain that works out to a 55-per-cent raw return. Although that might sound pretty good, it only works out—if you include costs—to a return of a little over seven per cent a year over seven years, which is hardly an investing home run. The new owners have probably earned a little less than 10 per cent over two years—again, hardly a rocket—but a heck of a lot better than the average real estate return of about four per cent a year. But that’s how cycles and hot money work: quick, sudden and perilous in terms of timing.

So, now comes the million-dollar question: What’s the next flavour of the month for hot money? When it comes to predictions, of course, you pay your money and takes your chances. But we asked a few experts to go out on a limb and do some forecasting.

• Vancouver financial advisor Adrian Mastracci sees the beginning of a stampede to the growing private equity market such as venture capital, angel investing or funds that invest in companies that are held privately and are not listed on stock exchanges. He may have something there: 2005 was a record year for private investing in Canada (about $3.5 billion was raised for buyouts and venture capital investing), and American private financiers moved into Canada by the carload because they saw value in Canadian companies. Also, Canadian pension funds began dabbling deeper into the high-return (but riskier) private investment market in an effort to balance the drop in their income investments. And the National Angel Organization, a group of early stage private investors, has begun lobbying for tax incentives to pry loose some of the $5 billion in investable money it estimates is held in private hands. Here at home, those incentives already exist in the form of a newly revamped and very popular Venture Capital Corporation program, which offers investors a 30-per-cent provincial tax credit on private investments.

• Murray Leith usually avoids running with the herd but does watch its movements. Like most contrarians, Leith looks for depressed sectors that might be ready to come back in favour. He thinks he’s found one: large-cap U.S. companies such as Wal-Mart, Home Depot, Pfizer and Anheuser Busch, all of which have rock-bottom multiples (price-to-earnings ratios) and so are cheap. “The valuations of America’s biggest and best companies are a fraction of what they were five years ago and the Canadian dollar has significantly more purchasing power today, which makes the case for investing in the U.S. market compelling,” he says.

• Everybody is warming up to gold, which languished as hot money chased everything else under the sun. Currently hovering in the US$500 range, gold is at 18-year highs. Although in Canadian dollar terms, the rise has been relatively flatter, gold has apparently detached itself from all currencies and formed its own momentum. Famed Canadian money manager Eric Sprott of Sprott Asset Management thinks gold is “one of the most promising areas of investment” because it always does well in the financial crises that follow market manias such as the U.S. real-estate bubble. Other forecasters like former Goldcorp chief Rob McEwan believe gold will eventually hit US$850.

• Well-known Vancouver financial advisor Diane McCurdy thinks the next destination in the short term will be nice and simple: cash. Sure, it doesn’t pay more than a couple of per cent but there isn’t much else out there right now that’s attractive to hot-money herds. So they’ll probably park for a while, graze on rising short-term interest rates and wait for their next opportunity.

The Pattison Approach

Take a tip from B.C.’s biggest investor, Jimmy Pattison, who is generally pretty conservative and seeks out solid buys but also admits to taking an investment flyer regularly. Even with his billions, Pattison recognizes that you should never invest more than you can afford to lose. So he designates a certain small percentage of his money for hot but speculative investments—though there was that time in 1980 when he wanted to jump on bouncing silver prices, but his loyal assistant Maureen Chant went against his wishes, didn’t buy in and saved his butt when the price sank—and never wavers from that ratio. How much is that percentage? Well, he won’t say, because how much you’re willing to risk is a personal thing. But the traditional advice from financial portfolio managers is no more than 10 per cent—and that’s for only the most risk tolerant of investors. Five per cent is probably the average Jane’s ceiling, and less if that average Jane has many demands on her money, like financing a business, paying off a mortgage or raising kids. Click here to read Tony’s blog.