Real estate asset bubbles, part 1

by Sam Johnson

20 October 2011

These trends have vaulted Vancouver into the rarified company of some of the most unaffordable housing markets in the world, such as Hong Kong, New York, Sydney, and Shanghai.

There are many ways by which the economies of Vancouver and Brazil differ dramatically: a roughly ten-fold disparity in GDP per capita, a stark gap in the rate of economic growth, and the very fact that neither can be accurately compared on the basis of scale alone. Vancouver is a relatively small city of 2.3 million people, bounded by mountains to the east and water to the west – an important feature that constrains the physical capacity for future development. With a GDP of over $2 trillion, the country of Brazil is the seventh-largest economic powerhouse in the modern world, and has a vast landscape ripe for expansion.

Though the regions share few similarities, they have experienced a convergence of sorts with the beginning of a phenomenon that threatens to rock the very economy upon which each depends. The culprit has been a red-hot, unrelenting infusion of foreign capital, a sizable portion of which has been injected directly into the heart of the real estate sector. As we will see in this article, it will take the utmost care and precision of policy makers and market participants to prevent these de-stabilizing flows from delivering a disorderly shock to an industry commonly regarded as an economic lifeline.

My aims are two: to establish the extent to which these two scenarios compare, and, in light of recent property-bubble-related collapses, to examine the extent to which foreign capital flows can damage the local real estate environment.

Vancouver

In Vancouver the overwhelming majority of new capital flow is due to an influx of new Chinese buyers – a phenomenon that Bank of Canada Governor Mark Carney himself has publicly acknowledged.

While these flows are difficult to quantify, the roots of the phenomenon can be traced back to the end of the financial crisis in 2009. As the economy stagnated, property values receded, the BOC forced benchmark-lending rates to rock bottom 1% levels, and Canada’s real estate environment presented capital-rich foreign investors with a wealth of opportunity in which to diversify their asset holdings.

Enter China, who, emerging from the financial crisis relatively unscathed, quickly developed a taste for high-priced Vancouver property.

The drivers behind Chinese demand are broad in scope, and much more ambiguous than factors behind the searing hot growth seen in Brazil.

In the late 1800s, as Canadian developers brought in Asian workers as a means to fuel the construction of the Canadian Pacific Railway, the population of Asian immigrants exploded. As it stands, approximately 50% of the city is of ethnic Chinese origin. Culturally, it thus affords Chinese investors with a natural market in which to deploy capital.

There are still other forces at work. Vancouver has been consistently ranked among the best places to live, worldwide, and the 2010 Olympics showcased this to the global community.

Asian investors have also developed an affinity for the high end of the property market; West Vancouver and its surrounding regions, including Richmond and Burnaby, have become a focal point for this flood of foreign capital. In West Vancouver, where prices have increased 80% over the last five years, and 27% in the first half of 2011 alone, possibly overzealous local estimates have identified mainland Asian investors as representing roughly 70% of luxury-market transactions in the latter period.

Regardless of the exact numbers, the following example puts the investment psychology of these buyers in perspective: in March 2011 one Chinese buyer paid $1.7 million for a 5-bedroom, 3-bath house. This offer price exceeded the asking price by over $150,000. Upon the completion of the deal, the buyer announced that he planned to tear the house down and build a new property on the existing site.

Effects on the real estate market have been staggering. The price-to-income ratio – a measure of annual income needed to cover the value of a home, is traditionally seen as a rudimentary gauge of housing affordability. According to Statistics Canada, the most recent Canada-wide measure stands at 5.2, compared to a staggering value of 11 in Vancouver. Affordable housing markets are traditionally held to have a ratio lower than 3. Sales have increased 80% since 2009, driving the expected price of a detached bungalow to over $1 million, making Vancouver the only property market in Canada where this is so.

These trends have vaulted Vancouver into the rarified company of some of the most unaffordable housing markets in the world, such as Hong Kong, New York, Sydney, and Shanghai.

Brazil

The flood of foreign capital into Brazilian markets has been much broader in scope, with less focus on real estate acquisitions alone. The country, along with the other BRIC economies, has been part of a staggering socioeconomic rise in recent years. These countries – driven by export growth, beneficial monetary policy, and a rising middle class – weathered the financial crisis with relative ease and are now globally-respected economic and political powers. For the first time, they are global players, fuelling a worldwide, if multi-speed, recovery.

The IMF speculates that in 2015 almost three-quarters of global economic growth will come from China and other developing countries, as opposed to the 1990s – when emerging markets accounted for just 40% of growth. Brazil has been no exception to the new trend; its GDP skyrocketed 7.5% in 2010 alone.

There is a distinctly negative implication to all this, as the torrid rate of economic expansion also presents Brazil with a vicious cycle that is nearly impossible to control. As its economy has strengthened, two things have happened.

First, the omnipresent force of inflation has become too much for the government to handle. In March 2011, the inflation rate touched 6.1%.

Second, as prices rise, the natural policy response is to increase the benchmark-lending rate. The results have been a dramatic tsunami of foreign ‘carry trade’ (where investors arbitrage yield differences across global markets) and a 260% spike in foreign direct investment in the first two quarters of 2011.

Backed by an infusion of foreign capital, a windfall of dangerously cheap credit, and an emerging middle class unafraid of leveraging beyond all rational limits (lending rates often exceed 30%), residential housing prices have increased twofold in the last three years. A recent CB Richard Ellis report stated that Brazil’s commercial real estate market has seen a 400% growth in transaction volume in 2011 alone. This bubble has been buttressed by the development of real estate and infrastructure for the 2014 World Cup and the 2016 Summer Olympics.

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Real estate asset bubbles, part 1

by Sam Johnson

20 October 2011