I discussed a number of factors that have driven up prices in my last post, but not all of them. I decided that before discussing what to expect in the medium to long term, we should explore a few other factors that have definitely played a role. This is important as many of these have changed, so we should be able to understand better what to expect moving forward.
Now that we have discussed that the credit cycle has played a major role in the drive for high prices, we should narrow down on Vancouver. The credit cycle we discussed applied to all of Canada, but the big boom in prices was unique to Vancouver (and to some extent Toronto). Why? Why is Vancouver different?
An analogy I can think of is that of a forest fire. For a big fire to happen, I once heard a firefighter that they need three factors: high wind, low humidity and high temperatures. (He called it the 30/30/30 rule, that is, winds >30km/h, humidity <30%, temperature >30C). But even if you have those conditions, a fire does not take place everywhere, you need an ignition.
Think of cheap credit, and government guarantees as the low humidity, and high temperatures. The rest of the country had those too, but Vancouver also had high wind, and finally the fire hit in 2014-2015 as we will discuss below.
Irrational exuberance – New era thinking
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and, in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.
Shiller, Robert J.. Irrational Exuberance: Revised and Expanded Third Edition (p. 2). Princeton University Press. Kindle Edition.
In every speculative bubble, people build new era stories. For example, in the 1920s, people believed that the recent introduction of automobiles, telephones and electricity would mean that productivity would go up a lot, and the high prices of the stock market were justified (there was a boom in the stock market up to the 1929 famous crash that put the world into deep depression). In the late 1990s people thought that the invention of the internet would change the world, and again justified the exorbitant prices of “.com” companies by the new era thinking. Again, eventually prices came back to reality with a large stock market correction. More recently people have built stories to justify buying bitcoin (it’s supposed to replace normal money) or marijuana (legalization will make it a big product). Both stories again produced some nice speculative bubbles that are still being corrected as we speak. These stories are like the high wind, a very important factor.
New era thinking – Vancouver is a world class city, and everybody wants to live here.
What’s the story to justify the high prices in Vancouver? An excellent recount of the history of Vancouver popularity growth can be found in the CBC podcast SOLD episode 3. It is explained that Vancouver started to get world recognition at the Expo 86. Then prior to 1997, when Hong Kong became part of China, a number of people moved to Vancouver (In 1994, at the peak of the migration, 48,000 people moved to Canada from Hong Kong, with 16,000 settling in B.C.). Of course, we had the Winter Olympics in 2010, which again showed the city to the world. This adds to the constant top ranking of Vancouver in the most livable cities . The story that has been built is that Vancouver is a world class city and everybody wants to live here. This story has been used by many local and foreign investors as justification of the recent high prices for real estate in the city. This made for high wind in Vancouver.
In my analogy, the government guarantees was the low humidity. But there’s another factor that let’s say made the humidity much lower than 30%, that is the tax structure for real estate. The capital gain exemption for primary residences and the lax rules that existed for a while made for VERY low humidity.
The capital gain exemption allows you to buy a property, live in it for a bit, and then sell it, without paying taxes on any profit! This is a very generous policy. Many other countries have some way of capping the exemption. In the US, it is capped to $250k per person ($500k if house is owned by a couple). In the Czech Republic and Finland you need to live in the property for 2 years. In Portugal, the exemption only takes place if the total profit on sale is reinvested in the acquisition of another home, own residence or building plot in Portugal. See some other variations here.
You can see how great this exemption is. If you make a profit from other investments, you need to pay taxes on it, but not for primary residence! But this exemption has been there prior to the price increases in Vancouver. So why am I discussing it? Well, it turns out that the government was not tracking who was claiming it and people did not have to prove it to the CRA. That was until 2016, when they finally realized that it is a big deal and they need to start tracking it: See article . We simply don’t know how many people claimed it fraudulently prior to 2016.
Now, if you sell a property that was used for investment, you always have had to pay taxes on the capital gain. However, again, it’s not so straightforward for the government to track this down. Thanks to the amazing journalistic work of Kathy Thomlinson from the Globe and Mail we now now that a lot of people flipped properties in condo presales and never reported the profits. See her investigative work in this great article: Flipping of condo units by insiders fuels hot Vancouver market. Her investigative work led to the creation in late 2018 of a registry for condo presales (See article). Again, we simply don’t know how many people fraudulently did not declare capital gains to the CRA prior to 2018.
It was windy, hot and very dry. What started the fire then?
It appears that a very significant stimulus in China produced a huge credit boom in that country starting in the early 2010s (source):
This big stimulus made Chinese investors increase significantly their investments overseas over the years, this was until recently, when a crackdown has slowed the trend (see more at the source):
It is unclear how much money from China came to Vancouver, as our government was not tracking it very well. Andy Yan, a professor at SFU found that in the West Vancouver neighourhoods (Point Gray area), Chinese names dominated the titles, particularly for expensive properties (Study was from Nov 2015, source):
Shortly after this study, the BC government started tracking the money and the finance minister at the time, Mike de Jong said recent government housing data indicate foreign nationals spent more than $1 billion on B.C. property between June 10 and July 14, 2016, with 86 per cent on purchases in the Lower Mainland area (source). This led to the introduction of the foreign buyers tax in July 2016.
So once all this money from overseas came, the fire started, and a positive feedback loop took place.
In feedback loop theory, initial price increases (caused, for example, by the kinds of precipitating factors described in the previous chapter) lead to more price increases as the effects of the initial price increases feed back into yet higher prices through increased investor demand. This second round of price increases feeds back again into a third round, and then into a fourth, and so on. Thus, the initial impact of the precipitating factors is amplified, resulting in much larger price increases than the factors themselves would have suggested. Such feedback loops may be a factor not only in the historic bull and bear markets for the aggregate stock market but also, with some differences in details, in the ups and downs of the housing market and of individual investments as well.
The theory of feedback is, as I have noted, widely known, but most people do not use the term feedback loop to describe it. The phrase is a scientist’s term for what might popularly be called a vicious circle, a self-fulfilling prophecy, a bandwagon effect. Although the term speculative bubble has more than one meaning in common discourse, it usually appears to refer to such feedback. In the most popular version of the feedback theory, one that relies on adaptive expectations, feedback takes place because past price increases generate expectations of further price increases. In another version of the feedback theory, feedback takes place because of increased investor confidence in response to past price increases. Usually such feedback is thought to occur in response not so much to a sudden price increase as to a pattern of consistency in price increases.
Shiller, Robert J.. Irrational Exuberance: Revised and Expanded Third Edition (p. 84-85). Princeton University Press. Kindle Edition.
As sales soared in the 2014-2016 period, prices started to escalate, people would sell with big profits, and more foreign and local investors jumped to the wagon to try to profit (typical of Ponzi schemes), creating a positive feedback loop. As an example, Kathy Thomlinson reported just such a scheme with the so called ‘shadow flipping’ (she reported it in early 2016), where properties would be flipped even before the first buyer registered the property. Realtors got rich, and the bag was passed multiple times bringing up the price each time:
Again, she reported something similar with the condo flipping.
As people realized that it was profitable to flip properties, the intention of the purchasers changed. From buying properties to live in, to buying properties as an investment. This graph illustrates that perfectly (from Saretsky’s blog)
This positive feedback was very powerful, and as we already discussed in the previous post, resulted in a fear of missing out, and more and more people bought properties.
What has also become clear in recent months is that in the housing boom also encouraged a number of illegal activities. The CBC podcast discusses some of these activities. More recently, Global News reported that $1 Billion was laundered with Vancouver Real Estate in 2016. “The study of more than 1,200 luxury real estate purchases in B.C.’s Lower Mainland in 2016 found that more than 10 per cent were tied to buyers with criminal records. And 95 per cent of those transactions were believed by police intelligence to be linked to Chinese crime networks.” This video shows the scheme that was uncovered:
Why would criminals want to hold Canadian Real Estate? Well, you can think of many reasons, but one of them is that they can be used to further laundered money. Kathy Thomlinson discovered a money laundering scheme that is summarized in the following image:
It is unclear the magnitude of all the money laundered through Vancouver Real Estate, but it was definitely a significant factor
In our previous post we saw that speculative bubbles are like avalanches, they require a lot of different factors to combine for the perfect avalanche to take place. In this post we found another analogy for the Vancouver Real Estate price boom: a forest fire. The cheap credit, tax structure, government guarantees, the new era thinking of Vancouver as a world class city provided the perfect conditions for a fire. Once foreign investment and illegal activities took place in the 2014-2016 period (in conjunction with a drop in interest rates), the conditions were perfect for a strong positive feedback loop, and the result was a big boost in home prices in the region:
But it is Vancouver after all, and rain eventually comes to cool down the fire. In my next post I will go and discuss what has happened recently that has made the market cool, and maybe for our fire to be estinguished. What should we expect? Next week, I’ll write what I have gathered by looking at history and other places.