Wednesday, September 28, 2005
Banks and Monetary Policy: the Mechanics of Interest Rates setting.
We hear a lot about interest rates, and not only in my professional field of expertise. Interest rates are everywhere to be found in our daily lives: credit card interest, interest on deposits, car loan interest, personal loan interest, treasury bond interest. The other day I received a spam e-mail that said: "Need new socks ? Apply for our Family Loan - competitive interest rates". Since I am single and own approximately fifty pairs of socks - they seem to be the preferred Christmas present in my household - I decided not to push the 'Click Here' button. But just what are the mechanics of interest rate setting? Who decides which interest rate to charge to whom - and how?
Paul Volcker, while chairman of the Board of Governors of the Federal Reserve System (1979-87), was often called the second most powerful person in the United States. Volcker triggered the "double-dip" recessions of 1979-80 and 1981-82, vanquishing the double-digit inflation of 1979-80 and bringing the unemployment rate into double digits for the first time since 1940. Volcker then declared victory over inflation and piloted the economy through its long 1980s recovery, bringing unemployment below 5.5 percent, half a point lower than in the 1978-79 boom and helping Ronald Reagan convert the American people to Reaganomics. Volcker was powerful because he was making monetary policy. Central banks are powerful everywhere for the same reason, although few are as independent of their governments as the Fed is of Congress and the White House. Central bank actions are the most important government policies affecting economic activity from quarter to quarter or year to year.
Monetary policies are technically demand-side macroeconomic policies. They work by stimulating or discouraging spending on goods and services. Economy-wide recessions and booms reflect fluctuations in aggregate demand rather than in the economy's productive capacity. Monetary policy tries to damp, perhaps even eliminate, those fluctuations. It is not a supply-side instrument. Central banks have no handle on productivity and real economic growth. A central bank is a "bankers' bank." The customers of the Federal Reserve Bank are not ordinary citizens but "banks" in the inclusive sense of all depository institutions—commercial banks, savings banks, savings and loan associations, and credit unions. They are eligible to hold deposits in and borrow from the Federal Reserve System and are subject to the Fed's reserve requirements and other regulations. The same relationship exists in Canada between the Bank of Canada and the individual banking institutions.
Banks are required to hold reserves at least equal to prescribed percentages of their checkable deposits. Compliance with the requirements is regularly tested, every two weeks for banks accounting for the bulk of deposits. Reserve tests are the fulcrum of monetary policy. Banks need "federal funds" (currency or deposits at Federal Reserve System) to pass the reserve tests, and the Fed controls the supply. When the Fed buys securities from banks or their depositors with base money, banks acquire reserve balances. Likewise the Fed extinguishes reserve balances by selling Treasury securities. These are open-market operations, the primary modus operandi of monetary policy. A bank in need of reserves can borrow reserve balances on deposit in the Fed from other banks. Loans are made for one day at a time in the "federal funds" market. Interest rates on these loans are quoted continuously. Central Bank open-market operations are interventions in this market. Banks can also borrow from the Federal Reserve Bank at the announced discount rate. The setting of the discount rate is another instrument of central bank policy. Nowadays it is secondary to open-market operations, and the Fed generally keeps the discount rate close to the federal funds market rate. However, announcing a new discount rate is often a convenient way to send a message to the money markets.
How is the Fed's control of money markets transmitted to other financial markets and to the economy? How does it influence spending on goods and services? To banks, money market rates are costs of funds they could lend to their customers or invest in securities. When these costs are raised, banks raise their lending rates and become more selective in advancing credit. Their customers borrow and spend less. The effects are widespread, affecting businesses dependent on commercial loans to finance inventories; developers seeking credit for shopping centers, office buildings, and housing complexes; home buyers needing mortgages; consumers purchasing automobiles and appliances; credit-card holders; and municipalities constructing schools and sewers. Banks compete with each other for both loans and deposits. Because banks' profit margins depend on the difference between the interest they earn on their loans and other assets and what they pay for deposits, the two move together. Thanks to its control of money markets and banks through monetary policy, the Fed influences interest rates, asset prices, and credit flows throughout the financial system. Arbitrage and competition spread increases or decreases in interest rates under the Fed's direct control to other markets including, of course, real estate.
Real Estate Chronicle
Sunday, September 25, 2005
Real Estate v. Stock Market : the Heavyweights Champ !
There are out there essentially three places where you can stack up your hard-earned money: the stock market, real estate and under your mattress. If you decide to put the money under your mattress, beware: it will fruit no interest and, hence, it won't grow over time. In fact, it will devaluate. Competition between Stock Market and Real Estate as the top source of investment returns has been going on since the mid 1960's. Typically the Stock Market was seen as the place to invest and Real Estate as the place ... well, to live in. But since the mid 1990's the old axiom has changed more and more every year, and today it is entirely revolutionized. The purchase, holding, renting and reselling of real estate assets - especially residential real estate - is now the investment of choice for the majority of investors. Money is pouring in as a direct and proximate consequence of low interest rates, which favor mortgaging over deposits and low-risk asset holdings over high-risk speculative stocks. Demand for residential real estate throughout all urban areas in North America - and to a lesser extent Europe - has gone through the roof. This affects especially condominiums and townhomes located well inside urban cores, but it extends to single-family assets into suburbia just as well. Real estate has become the psychological equivalent of gold, historically considered a tangible, safe store of value.
Tangibility of assets is, in fact, one of the primary psychological reasons of this financial revolution. Given the choice between the purchase of a piece of paper representing the share into a far-away company over which the Investor has no control, and the purchase of four walls and a ceiling that the Buyer can see, touch and paint, the vast majority of consumers today are not going to hesitate for one second : they'll take the latter. But there is also a very important practical reason: availability of financing. Scandals have scoured both Stock Market and Real Estate circles, but whereas scandals in Real Estate typically have affected one or a few Sellers and one or a few Buyers, scandals in the Stock Market have affected millions of Investors. Lenders, as a result, have become somewhat leery to lend for the purchase of stocks and bonds and are much more comfortable with real estate market values. Banks lend on appraised values, and it is far more likely for an appraiser of a residential condo to determine its true market value with a high degree of accuracy than it is for a stock analyst to evaluate the books of a corporation with the same degree of accuracy. Afterall, it can be said that House A and House B have sold for a certain price in a certain neighborhood so that it is reasonable to expect that House C will sell for a similar or equivalent price in the same neighborhhod. But it is more complicated to apply the same reasoning to Corporation A, B and C because variables are too great: location, number of employees, performance, market sector, technology, politics, taxes and all the rest. Therefore, a financial institution will lend money to a qualified Real Estate Buyer more readily than to a qualified Stock Market Investor.
The type of Buyer has also changed. With the advent of the internet and all other technological advances, Buyers today are more knowledgeable than ever before. As such, they want to see through things thoroughly and, once again, it is easier and preferable for them to determine by themselves whether they like a piece of real estate than it is to believe to a Stock Broker or analyst. More than ever they want sound advice and hot tips, and there is no question that those they can get from either a good Real Estate Agent or a good Stock Broker. But what the Stock Broker cannot offer is a tour of the company. A Real Estate Agent, on the other hand, will show them the house.
And, finally, population growth, density and age are other important factors in today's prevalence of Real Estate over the Stock Market. For instance, here in the Greater Vancouver region population is expected to grow 58 percent to 3.3 million people in the next 25 years according to the Urban Futures Institute. That's 1.2 million more people than are here now. The Institute reports that the Baby Boom generation now makes up about one-third of the population. Their aging will result in a surge in the over-55 population of 146 percent by 2030, and that many baby-boomers today are beginning to look towards their retirement years and golden age as a period of calm, enjoyment and relaxion - free of the continuous buy-and-sell hustle typical of stock exchanges everywhere. They are more and more beginning to question Donald Trump's make-it-or-break-it philosophy for a more solid and long-lasting approach to the management of their own personal wealth and finances.
Real Estate Chronicle
Thursday, September 22, 2005
Prices: where are they headed ?
Money is the source of all evils - so goes the popular saying. Money is also what makes real estate spin around. So the critical question of the year becomes: where are real estate prices headed? Short of using a crystal ball, there are indeed a few considerations that can be made to have a general idea as to whether prices will continue to surge - at the average rate of 15 percent a year for the past four years - or, alternatively, if we are poised for a shift in the market.
Record-low mortgages, pent-up demand and improving consumer confidence have made this the fourth consecutive best year for home and condo sales in the Greater Vancouver area. The sales-to-active listings ratio, defined as the number of sales at any given time relative and directly in function of the number of inventory listings available at the same time, is over 30 percent compared to about 20 percent in a balanced market. If we want to be even more technical, price increases have been rising at about 7 to 8 times the national inflation rate, a sure sign that demand has consistently exceeded supply which, in turn, has made real estate a Seller's market for the most part of the past four years.
And the consequence of this all, albeit you may not have directly noticed, is that Canadians are getting richer because of built-up equity. You bought a condo, for instance, in 2003 for CAD $150,000 using a $100,000 mortgage at 4.5 percent interest calculated semi-annually, not in advance. Your condo is worth, today, $195,000 in 2005 Dollars. Your loan has now diminished to an outstanding balance of approximately $97,770 so that, therefore, you have acquired a built-in equity of CAD $97,230. Since you initially invested CAD $50,000 of your own money, your return has been $47,230 in two years or a hefty 47.23 percent per year. Not too shabby. That sure beats the stock market.
Will you be making another 47.23 percent at the end of 2006 ?
You probably will, unless certain economic forces will conjure up against you. These forces - or variables as they are known in economics - are: energy cost, interest rates and affordability. Now, here there are a few clouds looming on the horizon that may make the future look somewhat different from the past.
Energy costs are on the rise. And Hurricane Katrina and Hurricane Rita and the hurricanes that will come afterwards do not help. To be sure, energy prices were on the rise even before the hurricanes that have devastated the Gulf region came around. In fact, most economists still predict no overall long-lasting impact from Katrina. Yet, the same economists also predict that energy costs will not come down to pre-2004 levels. The rises are here to stay, and that applies to all motor vehicle fuels, natural gas, electricity. Everything that affects our capitalistic economies, and not solely in North America. Prices of consumer goods, henceforth, are on the rise as well because it is costing more to produce and to ship them all around. Each and every house component is bound to cost more as well. And the people that are in the process today of building your future dream home or your next real estate investment ... they too will have to pay more to go to the work site. And, taken globally, a rise in manufacturing and shipping costs typically translates in an overall currency devaluation, a noble way to avoid mentioning the infamous i-word: inflation.
Fed Chairman Alan Greenspan - Mr. Monetarist as some affectionately call him - has been saying this all along this past year. Except that nobody wanted to listen. Reality was much rosier than the somewhat gloomy outlook offered by the venerable Chairman. And the Fed has been keeping the steady course of raising interest rates, albeit not hurriedly or in a draconian fashion. And they continue to hold this course.
Which, then, brings us to the third variable: affordability. Let's take a look back at the initial example of you buying a condo in 2003 for $150,000 with $50,000 of your own money. Ask yourself this question: could you, today, buy the same condo for $195,000 with the same $50,000 downpayment ? If you are like the majority of real estate consumers, the answer is probably no. You would need a $145,000 mortgage today as opposed to the $100,000 mortgage you took in 2003. Which means you would have to show your lender that your gross income has increased of $15,000 per year - which probably has not. Bankers say they cannot lower their qualifications standards as they are working on the bare minimum (I still have to meet a banker dying of starvation, but ...). Which, therefore, leads to the conclusion that you would not qualify today for the mortgage. Such being the case, you would no longer be what we in real estate call a 'market participant' . And if a lot of people are or will find themselves into the same situation, the end result will be a lower demand.
So, therefore, what's the verdict? Are prices going to continue to surge or are we heading for Apocalypse Now? Probably neither. But if the foregoing models hold true, it is reasonable to expect a slowdown in appreciation of property values - which in turn implies a correction in prices. Those of us who are involved into real estate on a professional level are beginning to see this already: asking prices are somewhat shifting down, although asking prices are not really reflective of market trends due to their very subjective nature. And it must also be noted that a shift downwards in asking prices is a far cry from the dreaded real estate bubble some people have been prognosticating all along. But it looks more and more that the market is due for an adjustment.
Real Estate Chronicle
Wednesday, September 14, 2005
The Goods and Services Tax (GST) and Real Estate: what You need to know.
When you buy a newly-constructed home, whether it is a single-family unit, a townhouse or a condominium, the purchase price is taxable. If you plan to rent to Tenants, the full seven percent GST is charged on the purchase price. If, on the other hand, you intend to use your acquired real estate asset as your primary place of residence, then you may qualify for a partial GST rebate depending on the sale price. For real estate costing CAD $350,000 or less you will receive a rebate of 36 percent of the GST paid to a maximum of CAD $8,750. This means that you will end up paying approximately 4.5 percent GST on the purchase price, as opposed to the full 7 percent. New housing selling for CAD $450,000 or more does not qualify for GST rebate.
To better illustrate different scenarios where GST is applicable, let's examine the following cases:
GST and the Land
Buyers of bare land such as builders and independent contractors may have to pay GST on the purchase price depending on who owns the land and what it is used for. For instance, when they build a new home on the land they will pay GST on the construction of the house minus any applicable rebate. The rebate would be the same as for a new home. That is, when the total value of the land and house is CAD $350,000 or less, the rebate would be 36 percent of the GST paid on both building and land up to a maximum of CAD $8,750. When, on the other hand, the total value of both building and land exceeds CAD $350,000 but is less than CAD $450,000 a proportional formula for calculating the GST rebate applies. As with the other new home purchases, GST rebates are not available for land and building valued at CAD $450,000 or more.
GST and the Resale of Real Estate Assets
There is no GST tax payable on the purchase price of a used residential property. Canada Customs and Revenue Agency (Revenue Canada) defines "used residential property" to include a previously occupied house, apartment, townhouse, vacation property or non-commercial hobby farm. They refer to 'used' as residential property occupied as residence before it was sold. "Used property" also refers to a recently built house that is substantially complete and has been sold at least once before you buy it. For example, if a new condo is purchased and then resold before being occupied, the resale price will be normally exempt from GST. A owner-occupied property is considered a residential property when the owner uses it mainly as his residence - not necessarily his primary residence. So therefore, if you are self-employed and you purchase a resale home that includes an office, the entire home still qualifies for the GST exemption. If, conversely, a owner-occupied home is not used mainly for residential purposes - for example a retail store with a small apartment on the upper floor - then only the residential portion is exempt from GST on resale. The non-residential portion of the purchase price is taxable. If you plan to purchase a resale home, the Seller will supply you with a certificate stating that the property qualifies as used for GST purposes. As with most taxes, there are exceptions to the GST rules regarding resale housing. For example, most sales of real estate property done by charities, non-profit organizations and public service agencies are exemp from GST.
GST and the Rent
GST is not payable - and not chargeable either - on residential rents. If, however, you employ the services of a property management company to rent your property, GST is charged for property management, repair and maintenance services.
To finish, GST is normally payable when the real estate transaction is completed at closing. In certain circumstances, GST is payable after completion on transfer of possession. For more information the Canada Customs and Revenue Agency maintains an extensive website at www.ccra-adrc.gc.ca .
Real Estate Chronicle
Saturday, September 10, 2005
The Streamside Protection Legislation: You are the Bait.
And now, for something completely different: your local government is mingling into your own affairs ! Well, it hardly comes as a surprise for most of us. Property owners are going to be prohibited from developing or redeveloping residential, commercial and industrial properties along urban rivers, streams, creeks, brooks and ... yes ... even ditches. The Provincial Government estimates that population growth and accompanying land development have resulted in the loss of hundreds of kilometers of streamside habitat in the Lower Mainland. To stop this, the Government has ingeniously come up with a brand new and shiny legislation: the Streamside Protection Legislation (SPL) - another example of your tax dollars at work. Under the SPL, streamside and enhancement areas are defined as adjacent to streams that link 'aquatic to terrestrial ecosystems and include both riparian area vegetation and adjacent upland vegetation that exerts an influence on the stream'.
Under the SPL existing permanent structures, roads and other development are grandparented. This means that landowners can continue to use their properties including 'the repair, renovation or reconstruction' thereof so long as it is all done on existing foundations. Likewise, developments that have received final approval including a development permit are allowed to continue. And, naturally, federal land and First Nations reserves are exempt. For everybody else - the vast majority of individual property owners and land developers - any future development, restructuring, remodelling of existing property becomes taboo. This covers an estimated 700 to 800 streams and creeks in both the Lower Mainland and Fraser Valley areas. There is, of course, a need to protect important fish-bearing streams, but the SPL goes too far in that it designates a fish-bearing stream as 'a stream in which fish are present or potentially present' . This definition includes ditches and other waterways that have never been and never will be fish-bearing.
To add gasoline on fire, furthermore, the Legislation impacts property rights without compensation for any loss in value. The real estate industry has been working hard on behalf of landowners to allow compensation when properties are affected by expropriation proceedings under the Expropriation Act and for the setting of a reasonable mechanism to determine the actual loss of market value as well as an appeal process in place for unsatisfied property owners. Under this Legislation, moreover, a typical 10-acre parcel that could otherwise be subdivided into 50 - 60 standard lots will yield just 25 - 30 lots. Which ultimately means that the loss in value will be passed by the developer to the consumer, thus raising real estate costs and contributing therefore to an already very hyper-inflated industry.
Real Estate Chronicle
Saturday, September 03, 2005
Foreseeable Economic Reverberations in the aftermath of Hurricane Katrina
In the wake of Hurricane Katrina that has destroyed and devastated much of the American Gulf coastline, two issues become apparent. The first is the human issue, the tragedy that has involved residents of New Orleans, Mobile and the other Gulf cities affected by Katrina. This human issue is presently being taken care of by the authorities and we certainly hope and wish that the lives of all affected individuals will return to normality as quickly as possible. The second is the economic issue and this will take a while to unfold.
The economic issue can be broken down into three parts: the cost to the insurance industry in terms of forthcoming claims, the reconstruction phase that will necessarily begin once the situation is normalized and which will involve real estate and the handling of interest rates and, last but not least, oil and the cost of gasoline.
The insurance industry tracks catastrophes to monitor claim costs, assigning a number to each catastrophe. Each claim arising from the event is tagged so that total industrywide losses can be tabulated. The term catastrophe is often used in the property insurance industry in a narrow way to mean a catastrophic event that exceeds a dollar threshold in claims payouts. This figure has changed over the years with inflation and the increase in development of areas subject to natural disasters. The term “catastrophe” in the property insurance industry denotes a natural or man-made disaster that is unusually severe and that affects many insurers and policyholders. An event is designated a catastrophe when claims are expected to reach a certain dollar threshold, currently set at $25 million.
Before the 2004 hurricane season, the 9/11 terrorist attacks ranked as the most costly U.S. catastrophe in terms of property damage alone at $18.8 billion — more when liability claims are included. The insured losses caused by the four hurricanes that struck Florida and other East and Gulf coast states in 2004 is estimated at $22.9 billion, exceeding 9/11 property damage. The 2004 hurricane season resulted in more than two million claims, far more than the 750,000 claims filed after Hurricane Andrew in 1992 which is the industry’s single most costly natural disaster to date. By comparison Hurricane Katrina, the 11th storm of the Atlantic hurricane season, hit South Florida as a Category 1 hurricane on Thursday, August 25 and headed out to the Gulf of Mexico. There it gained strength and turned northward, at times generating winds in excess of 160 mph. It hit the mainland early in the morning of August 29 just east of Grand Isle, Louisiana, as a Category 4 hurricane. High winds and the wall of water caused by the storm surge completely destroyed large sections of commercial and residential development along the coast and left hundreds of people dead. Initially it was thought that New Orleans had been spared but some dikes caved in and water has flooded the city. It is too early to estimate insured damage. Estimates so far have ranged from $9 billion to $30 billion with some projected estimates topping $60 billion. States with the most damage are Louisiana, Mississippi, Alabama and Tennessee.
How does the insurance industry deal with extraordinary costs such as the $30 billion bill for Hurricane Katrina? The insurance industry is intertwined nationwide in the United States and Canada. It is estimated that 65 percent of Homeowners Policies underwritten in Canada are carried by insurers in part or wholly financed by American underwriters. The 2004 hurricane season generated a turmoil in the industry with premiums in Canada increasing between 20 to 30 percent depending on the Province. It is projected that the aftermath of Katrina will cause an even higher premium increase in the forthcoming future.
Real estate and the reconstruction of the affected areas will take months to unfold and years to complete. The flooding has displaced about one million workers in the Gulf Coast region, many of whom will not be able to resume their jobs anytime soon. Rough estimates indicate to 200,000 the number of single-family dwellings that need to be gutted and remodelled, if not re-built outright from scratch. In a sign that the recovery could make the sprawling construction sector even busier than it has been during the recent housing boom, the price of lumber jumped last week. The normal pattern is that after the negative consequences the economy gets into a rebuilding mode, and that rebuilding mode takes to higher G.D.P. levels. If this model holds true, the Gulf States are going to be the next real estate Mecca in the forthcoming future.
And what about oil ? Economists say that the storm and its aftermath has raised the risks of a downturn. One major question is whether the damage to oil refineries aggravates what had already been a growing burden caused by soaring energy prices. No forecaster knows how consumers will react to seeing gas lines reminiscent of the 1970's and hearing the President urge people to drive less. If oil production or refining does not return to pre-storm levels for months, a spike in energy prices could prompt households to cut their spending and cause other hardships. Most predict a slowdown in growth during the rest of this year and a pickup next year, as New Orleans and southern Mississippi are rebuilt.
Taken altogether, the three parts of the economic issue make the Fed's job really difficoult when it comes to interest rates. The Fed has been raising its benchmark interest rate since the start of last year to ward off inflation, a policy that will probably continue. But talking about economic models, the problem is that every recession since 1971 has been preceded by two things: 1) higher oil prices and 2) an increasing Federal funds rate. Consumers also have less of a cushion than they have had at many other points. In fact , with the nation's savings rate falling practically down to zero in 2005 in both the United States and Canada, households have little ability to absorb higher oil prices without cutting other spending. Converging forces are, therefore at work to pull the Central banks to either raise interest rates to cool a hyperinflated reconstruction economy and to spur a downturn fueled by rising oil prices. It is going to be very interesting to see which direction will be taken in forthcoming months.
Real Estate Chronicle