WTF is a price floor and why does it matter?
Tuesday Jul 16th, 2019
Crossposted to https://heavyweightandrealestate.wordpress.com/ and my linkedin.
I got a response on instagram to yesterday's blog post & subsequent story post about the prominent buyers in the market right now, and why they're dictating the demand side of market equilibrium. The question was:
buy now or wait it out?
My response was pretty diplomatic.
"It depends what you're buying and where, give me some context!"
The inquisitor said they're flexible, and looking for a detached home under $600,000.
I can find this house, and I should, because it's a good investment for my client. The client went on to express concern that things are "high already and the market isn't going to go up much from now."
This blog is designed to explore that logic a little bit. Here's what we're going to go through:
- What is the price floor?
- Why does it matter?
- Why is the price floor moving up?
- How you can leverage the price floor to make a sensible investment.
1. The price floor of the real estate market
The price floor is most easily represented by the place where a property has zero or less-than-zero utility. This could be an unserviced building lot or a condemned property in some markets unexplored by speculators (there are few of these remaining.) In a more exploited market, it is typically represented by the most affordable home you can purchase to avoid rental.
In more urban markets, the price floor is broken by alternative styles of ownership tenure, namely condominiums. This creates a whole subsection of the market, which I'll have to explore in another post.
2. Why does the price floor matter?
The price floor matters because, in a normal market, it's the driving factor of growth. Think of it like minimum wage. As minimum wage increases, (theoretically) wage should increase proportionately to it, ignoring the intimate role of inflation and a host of other factors I'm unqualified to talk about. There are a lot of nuances in the evaluation of this using multivariable regression, all of which play a role. This are worth being aware of, but not worth over-evaluating, because they're completely outside of the scope of control of consumer behaviour as it pertains to supply & demand equation:
- increasing construction costs
- increasing development charges
- inflationary changes as a result of monetary/fiscal policy
- zoning/bylaw policy changes (especially pertaining to servicing land - off-grid living could have a huge impact on this - I'm looking at you, Elon Musk.)
So in regards to that stuff, if you trust your government to make the right decisions, you'll be ok. Although, not much unlike dying, you don't really have a choice anyways, so you might as well operate with independence, awareness, and open-mindedness towards financial policy. Social policy? Do your thing. I digress.
3. Why is the price floor moving up right now?
Honestly, I'd have to guess, because I can't really poll all the buyers, but I think it's because of a variety of factors, both consumer and policy related:
- 2nd-home buyers, and family-home product, dictated the "boom" market. Due to capital mobility factors and jumping from positive equity positions in the asset they exited, they didn't suffer too much as a result of it. (Although the looming 5-year renewals on 2017Q1 mortgages may decide that).
- Buyers who were marginalized by the stress test (policy) and the price surge (consumers) now have a level playing field, and are re-entering the market. First time home buyers.
- As some wise old land banker once told you, "they don't make land any more."
- But realistically, there is a scarcity of serviced land, because servicing land takes time, and is expensive. As mentioned above, off-grid policy and technology will change this.
In a normal growth market (millennials like myself are fascinated by the arrival of such an illusive thing) - the price floor drives growth sustainably for a long period of time, and protects real estate investments against any major blows (policy, economy, etc.). The price floor moving upward looks like a normal, healthy 2-3% year/year growth.
4. The worst house in the best neighbourhood
The price floor moving upward indicates that the value of the land that a home is built on is moving upward. I cannot stress the importance of this statement. If you take nothing else away from this post, let it be that. Here's why this matters:
If you have normal buying patterns like the rest of us, you'll probably stick to a pretty small geographical area throughout most of your lifetime. This neighbourhood patterning would dictate that the land value of your first home will probably be pretty damn close to the value of your second home, so it makes this illustration easier.
Actually, you know what, I may try to make this even clearer by adding a volume element, since the pies being the same size doesn't drive it home. If you're eating the same pie in 5 years then I've failed you as a broker. This is what you want. I tried to make the blue areas similar size for comparison:
So, as the price floor increases, the value of the site improvement on the property (building/house) decreases relative to the value of the land. At a certain point the value of a home becomes so little that the most sensible thing is to tear it down. Ever heard the statement "the worst house in the best neighbourhood"? This is why it reigns true.
Making the assumption that construction costs don't change drastically (they play a role in [replacement cost new] RCN valuation methods) then given this scenario, if the price floor is moving up, the value of land is moving up, and the value of both 1st home (1H) and 2nd home (2H) are moving up. The difference? The return you get from 1H moving up is proportionately larger than the return you'd get from investing the same capital in 2H. 1H is also 37.5% more accessible from a downpayment perspective, allowing you invest less money for the same return, increasing your cash-on-cash return from capital appreciation*. So, in conclusion, if you're considering purchasing an entry-level home as a stepping stone, there is no point in waiting. If the market rises, 1H will rise relatively more than 2H, putting you at an advantage. If the market falls, 1H will fall relatively less than 2H, putting you at an advantage, as long as you don't lose equity.
* Note that in Figure 2 above, House 1 remains.
On a growth plane, it gives you an understanding of why people would rather grow by selling and redeploying their equity from H1 to H2, H3, H4, H5 etc. That being said, if you want to invest and build a portfolio, it's often most sensible to take the equity and leverage into H2, and then repeat that process for H3 ad infinitum.
I HOPE THIS HELPS YOU!
*DISCLAIMER - I am viciously against investing solely for capital appreciation. If you're investing in a home, invest in it for its' homeliness and your ability to service its' mortgage. If you're investing in a rental property, invest in it for a return. Unless you have some market knowledge nobody else does, you can't beat the market on capital appreciation. If you think I'm wrong, talk to 2017Q1.