In early 2008, the five-year default rate for AAA-rated collateralized debt obligations (CDO) was 0.12 per cent. The Standard & Poor (S&P) rating meant the predicted default occurred only 0.12 per cent of the time, but in late 2008 the default rate came closer to 28 per cent.
This gap between forecast and reality was a gigantic prediction error. In fact, the mortgage-backed securities were extremely sensitive to changes in economic conditions and their defaults triggered the global financial crisis.
At the start of the pandemic, I don’t recall hearing predictions the housing market would be as hot as it is now. In fact, most were pointing in the other direction and there was fear of the unknown.
We expected job losses to drive the economy down, and with it, some adjustment and discount in real estate. Instead, today we see overall debt levels are down (credit card debt and car loans are being paid off and replaced with low-interest mortgages tied to property), and individual debt-to-income ratios are improving while there is a real estate buying spree.
Wrong predictions aren’t new and as the old joke goes, economists called nine out of the last six recessions correctly. So why is it so difficult to make predictions? And what does it mean today for the real estate sector?
There are many reasons why we miss the mark on our predictions – too many to cover in an article, so let’s discuss just two:
– probabilistic vs. fast thinking; and
– failing to prepare to be wrong
Probabilistic vs fast thinking
Daniel Kahneman, in his book Thinking, Fast and Slow (2011), explains two systems of thinking – fast and slow. An oversimplified way of looking at it explains ‘fast’ as quick intuitive gut reactions, and ‘slow’ as analytical evaluations or critical thinking.
Many GameStop investors recently got caught up in the ‘fast’ emotions of seeking quick riches and ignored ‘slow thinking’ fundamentals. They took a risk on the probability that stock prices would continue to rise “to the moon” based on hype that came after the short squeeze had already happened.
We make most of our decisions with heuristics and emotions and then seek to justify our decisions with a logical reason.
What makes it worse is the abundance of information we now have. The internet has exploded our access to information, social media has decentralized media, and we are now more than ever able to be selective in what information we choose to see.
If we believe in something, we just seek to confirm it by reading only information that supports our view and ignoring that which opposes our beliefs. It is known as confirmation bias.
Reddit users weren’t seeking investment advice that was opposite to their position; they were in a social media-fuelled buying frenzy even after the GameStop stock price multiplied many times over, thinking fast, and getting hyped up on becoming overnight millionaires.
I am talking here about those who saw the stock go from $4 to $300, yet still decided to “invest.”
The emotional tail was wagging the rational dog.
Failing to prepare to be wrong
If S&P had assumed that CDOs were correlated, the impact on the financial industry would not have been as profound and maybe there would have been no global financial crisis of 2007-2008.
In retrospect, the assumption that defaults on some housing would not trigger other defaults seems obviously wrong. If the analysts at S&P had prepared to be wrong on this one assumption, their range of probable default rates would then have been too big to ignore.
And if GameStop investors prepared for an overnight reduction to their investment by 80 per cent, many would not have been in a Wall Street Journal article explaining how they plan to pay off loans they took on for an “investment” – gamble is a better word.
Real estate enthusiasm
Across Canada we are seeing an insatiable appetite for real estate, from homeowners to investors and developers.
That appetite is based on predictions and expectations, but does that mean we could be wrong? Of course. But, it is not that simple.
Traditionally, prices increase more at the core of cities due to urbanization, and then the pressure spills out to the more rural areas. In 2021 we are seeing the opposite because of the pandemic. Urban centre condos are not doing well.
Rental vacancy in Metro Vancouver and Toronto has increased for reasons such as low immigration, remote work, and students studying virtually. At the same time, prices and sales are rising in suburbs and we are seeing a migration of people away from city centres.
We need to admit that we do not know the future of real estate prices or what economic recovery will look like. The government doesn’t know, and neither do the economists and analysts. The economy is so complex that when a butterfly flaps its wings in Brazil, real estate prices go up in Vancouver – chaos theory for real estate.
The years 2006-2007 showed us that when locals start seeing real estate as a “sure thing” investment, and the lending environment allows for speculation, at some point it tips the scales, and our “prediction” of rising prices becomes wrong. We see patterns where none exist and have a very short-term view.
Preparing to be wrong
‘Fast thinking’ in real estate would be to follow the herd and just buy anything. ‘Slow thinking’ suggests making a more disciplined evaluation and preparing to be wrong by asking the right questions – questions that help make our predictions more probabilistic and a little less emotional.
– When are the interest rates likely to increase?
– How quickly do we expect to be back to ‘normal’ at the office?
– What impact will an interest rate increase have on real estate in general?
– What leverage can I handle with my purchase under various scenarios?
And the hard question that really needs to be asked right now is do we expect the current de-urbanization trend to continue post-pandemic?
Once again, we don’t have a crystal ball but if we look at history, we can learn some lessons and make informed decisions. According to economist Ed Glaeser’s comments in Six Hundred Atlantic’s ‘Today, Tomorrow, and COVID-19’ podcast episode (September 2020), despite plagues and pandemics, urbanization has been a constant since the 14th century:
“Urbanization proceeded despite the reappearance of the Black Death in the 1350s. Urbanization proceeded despite the Great Plague of London in the 1660s. All of the great diseases that spread in 19th-century America, cholera, yellow fever, the urbanization just chugged along.
“Even the influenza pandemic of 1919-1920 was followed by a tremendous decade of city building. So, I think our cities have proven to be remarkably resilient.”
As a developer, I am biased toward real estate and think it is the best asset class for my own investments.
We are constantly making predictions, and to make better decisions we rely on detailed pro-forma financial forecasts. This is how our business decides on a “go” or a “pass” for a development project.
For personal investment decisions, I recommend the same analytical approach – whether we are in a pandemic or not. Ask questions, consider many scenarios, base decisions on your financial abilities and, just in case, prepare a downside analysis.
Budget Tips Canadians Should Consider Before Renovating Their Home
The decision to undergo a home renovation project should be exercised with an equal amount of excitement and caution. Most renovations require dealing with the foundation, plumbing, or electrical within the home, producing significant costs.
Canadians should approach each renovation with a firm understanding of their finances, especially if the project will involve a contractor or paid professional. To make sure you’re on the right track, these budget tips can help.
1. Estimate Your Costs
If you’re considering a renovation on your home you’ve likely come up with temporary plans and dreamed-up colour schemes and design ideas. The next step is evaluating the costs for each renovation to determine if you have the financials you need to get started.
When it comes to budgeting for a home renovation, it’s important to overprepare — creating a spreadsheet outlining each project and your projected costs will help you visualize your expenses. Once you have your costs in front of you, you’ll want to pad your budget slightly. Renovations are synonymous with surprises and inflated costs, and it’s always better to be overprepared.
2. Find Savings with DIY
One of the simplest ways to lower your renovation expenses is to take on specific projects yourself. The DIY approach can range from construction-based projects to simply painting the walls or re-furnishing your old furniture — it all depends on how handy you are and the time you have to contribute to the project. If you can manage to save money on professional painters or lessen the number of construction workers on any project, your chances of saving money are far more significant.
3. Know Your Financing Options
Ideally, you’ll want to have as much money saved as possible before undergoing any projects in your home. Every household is unique, which means your financing options may vary from your neighbours. What you’ll need to ask yourselves is, how much money will you require to complete this renovation and will you be able to pay back potential loans?
Homeowners are looking for alternative lending options that don’t require the stress and time that can come with traditional lenders — extensive interviews, paperwork, and the time it takes to receive any cash is unfavourable for most.
These days, homeowners are looking at online-only lenders like Flexmoney.ca for a faster, more convenient way to access the money they need to complete their projects. The new wave of lenders is focused on helping borrowers access the cash they need quickly and without the added stress of waiting and wondering if they’ve been approved. It’s easier to focus on what needs to be done in your home when you have the funds you need to get the job done.
4. Shopping Second-Hand
The idea of second-hand is still new for many homeowners, who are hesitant to purchase things for their homes that have been previously used. The reality is that second-hand goods are a beneficial tool for anyone looking to save money on their renovation. With some time and patience, you could find great deals on appliances, furniture, and home decor. With the extra savings, you can focus on the areas of the home that need the additional capital — or, if you’re right on budget, any money you’ve saved could go into a savings or investment account.
The housing boom, central banks and the inflation conundrum
By Sujata Rao
LONDON (Reuters) -A multi-year boom in global house prices which even a pandemic has failed to halt is forcing central banks around the world to confront a knotty question – what, if anything, should they be doing about it?
The surge in property values from Australia to Sweden is often viewed benignly by governments as creating wealth. But history also shows the risk of de-stabilising bubbles and the high social cost as millions find home ownership unaffordable.
The irony is that while the cheap money created by low or negative interest rates has driven the price rises, they barely figure in central banks’ calculations of inflation, one of the key drivers of their monetary policy.
While housing costs, whether rent or home repairs, are assigned varying weights in inflation indices ranging from 40%-plus in the United States to 6.5% in the euro zone, house prices themselves are left out. As they spiral higher and higher, many argue this is no longer tenable.
“The debate of whether we actually are reflecting inflation properly will come up more and more. House prices will start getting a lot of attention,” said Manoj Pradhan, co-author of a book called The Great Demographic Reversal, which predicts a global inflation resurgence in coming years.
Global residential property prices have risen 60% in the past 10 years, according to a Knight Frank index. In 2020, even as COVID-19 choked the world economy, they climbed an average 5.6%, with 20%-30% jumps in some markets.
While low interest rates have long been the main driver of the rally, existing government subsidies for home ownership and more recently pandemic-era support such as suspending property taxes have been factors too.
Many of these one-off support measures will start to be wound down, but governments often fight shy of politically tricky measures to keep a lid more firmly on prices, such as banning multiple property ownership or easing building regulations.
That raises the question of what central banks can do.
New Zealand’s government fired the first salvo in February when it told its central bank to consider the impact of interest rates on house prices, which soared 23% last year.
Others are considering the question too. European Central Bank President Christine Lagarde said last week that measuring housing’s role in the rising cost of living had emerged as a key point in a strategic policy review due to be unveiled this year.
If real inflation is higher than the official consumer price index is measuring, it could imply that central bank or government policies are more expansionary than they should be.
“If housing does not signal inflation via the CPI, then the economy is more likely to run hot, and what you get over time is generalised inflation pressures,” Pradhan said.
At present rental inflation is subdued due to pandemic hardship, or because low interest rates and remote working are encouraging home-buying.
Morgan Stanley’s chief cross-asset strategist Andrew Sheets said this may be giving a misleading signal. “The rental market will be weak and the housing market will be strong and that (rental weakness) could show up as a disinflationary force.”
There are strong arguments for excluding headline shifts in house prices from inflation indexes. Housing is, for most people a lifetime purchase rather than an ongoing expense, which they are designed to gauge.
Including house prices in the inflation measures central banks use to guide policy is also widely seen as impractical, given their extreme volatility.
More central banks may however consider adapting inflation indices to include a measure of the costs associated with living in one’s own home, such as maintenance and home improvements.
At present, inflation measures used by the Fed, the Bank of Japan, New Zealand and Australia include so-called owner-occupier costs. But the gauge employed by the Bank of England does not, and they are also not factored into the main inflation measure used by the ECB.
The ECB has argued for their inclusion, but collecting timely data from 19 countries and differing home ownership levels across the bloc would complicate the task.
Crucially, economists believe including these costs might have lifted euro zone inflation by 0.2 to 0.3 percentage points, taking the ECB nearer its elusive inflation target of close to 2%.
Ultimately, such policymaking shifts may be risky amid uncertainty created by the pandemic.
Adding property prices to CPI indexes just as long-dormant inflation finally awakes could send readings soaring, heaping pressure on central banks to tighten policy even as economies nurse pandemic-time wounds.
Some analysts, such as at ING Bank, predict that with some exceptions housing rallies may anyway start to cool as support measures introduced during the pandemic are unwound.
Voters’ anger may even goad governments into slugging property investors with higher taxes – as New Zealand did at the end of March.
Those who argue against extending central bank remits further into housing say tighter policy could even exacerbate the problem by crimping property supply.
George Washington University professor Danny Leipziger argues housing markets are more effectively cooled by regulation and measures outside central banks’ scope, such as raising capital gains taxes and increasing the supply of housing.
“I have no problem with the ECB adding rental or home-owners’ costs to its basket,” Leipziger said. “But if I am concerned about house prices in Berlin or Madrid, asking the ECB to deal with it is not the right way.”
(Additional reporting by Dhara Ranasinghe and David Milliken; Editing by Mark John and Jan Harvey)
Canadian home prices on fire and policymakers using ‘squirt gun’
By Julie Gordon
OTTAWA (Reuters) -Buyers are turning up the heat on Canada‘s searing hot housing market, their frenzy leading to record sales, prices and starts, but in a budget unveiled on Monday the federal government did little to tamp down the fire.
The Teranet-National Bank Composite House Price Index showed home price gains accelerated 1.5% in March from February, data released on Tuesday showed.
The index was up 10.8% on the year, with a record 81% of the broader 32 markets surveyed posting annual gains above 10%. That far exceeds the last peak in 2017.
On Monday, Finance Minister Chrystia Freeland, presenting Canada‘s first budget in over two years, fleshed out a previously announced tax on foreigners parking money in Canadian homes, along with limited investments in affordable housing.
“The idea here is that homes are for Canadians to live in. They are not assets for parking offshore money,” Freeland told reporters.
For those watching, it was nowhere near enough.
“It’s like a squirt gun next to a towering inferno,” said Doug Porter, chief economist at BMO Capital Markets.
“We need to break the psychology that real estate is this can’t lose investment that only goes up,” he added. “Before this turns into a full-on bubble.”
March was a record month for new housing starts and home resale prices surged 31.6% year-over-year.
New Zealand, facing a similarly red hot market, introduced a raft of cooling measures including new taxes on investors and stricter lending rules.
And most measures that would cool the frenzy are up to the provinces and federal government who remain cautious as a third wave of COVID-19 rages.
Real estate agents say more listing are now coming to market, but they still see a massive long-term shortage. They expected more than the 35,000 units pledged in the budget.
“It’s not going to do much to intervene in the activity level we’re seeing now across the country,” said Christopher Alexander of RE/MAX Ontario-Atlantic.
(Reporting by Julie Gordon in OttawaEditing by David Gregorio and Alistair Bell)
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