[daveto]

I was wondering about the sensitivity of prices to the BoC mortgage rate over the past year. Here are some back of the envelope calculations:

Some assumptions:
1. Mortgage interest has dropped 30% over the past 12 months (fixed from 6% to 4.2%, and variable from 5% to 3.5%).
2. Carrying costs (ie condo fees) for a $300k condo or house at $300/month
3. Property taxes at $1800/yr
4. Rent cost for equivalent property $1800/month
5. Avg down payment at 1/3 (ie $100k).(ie downpayment presumably not sensitive to BoC rates)
6. Fixed/variable split 70/30
7. I exclude the various intangibles (ie. emotional comfort of ownership vs loss of liquidity, etc)
8. I include the downpayment in the cost of interest below because it represents lost investment income
9. I presume principle paydown of $6k
10. These are all approx figures. I understand that rents will increase by a couple percent a year , and ownership interest will decrease as the principle is paid down.

A-Annual Ownership Cost Mar 2008:
(.7x.06 + .3x.05)x$300k=$17,100 interest
plus $3,600 carrying costs plus $1,800 property taxes
equals $22,500k annually

B-Annual Ownership Cost Mar 2009:
70% x (.7x.06 + .3x.05)x$300k=$11,970 interest
plus $3,600 carrying costs plus $1,800 property taxes
equals $17,370k annually

C-Annual Rental Cost:
$21,600k annually


Conclusions:
1-Ownership vs Renting
A year ago was a financial toss up.

2-Ownership vs Renting
Now is a $4,230 winner. $4,230 is 1.4% of the purchase price. So over the 5 years of the mortgage, the "savings" are aprpox 7%. Thus if one believes the property value will decrease by less than 7%, then owning for the next 5 years is a financial winner.

3-Prices sensitivity to BoC Rates
From A above, the total annual costs would be
2/3 x $17,100 + $3,600 + $1,800 + $6,000 = $22,800

From B above, the total annual costs would be
2/3 x 11,970 + $3,600 + $1,800 + $6,000 = $19,380

(note "2/3" refers to the mortaged portion, net of down payment, as per assumption #5)

Thus annual costs are now $3,420 cheaper than last year (ie 15% cheaper). Thus one can safely conclude that marketwide prices would have "inflated" by an amount between 0 to 15% due to increased "affordability/purchasing power".

I don't see how one can reach a conclusion on the actual price "inflation" deriving from the BoC rate. One presumes that a buyer would be aware that this is only a 5 year mortgage and rates will increase in the future. So I would suggest the effect would be at the lower end of the 0 to 15% scale.

Personally, I'd pick 5% as my guess. Thus in looking at the price decrease in the last year in the Toronto market, I think an apples to apples comparison would have seen decreases of an additional 5%.

Now that the Boc has no more room to move on the prime rate, I think we'll be able to see the real effect of what is happening in the market.

 

[cdr108]

3-Prices sensitivity to BoC Rates
From A above, the total monthly costs would be
2/3 x $17,100 + $3,600 + $1,800 + $6,000 = $22,800

From B above, the total monthly costs would be
2/3 x 11,970 + $3,600 + $1,800 + $6,000 = $19,380

Thus monthly costs are now $3,420 cheaper than last year (ie 15% cheaper). Thus one can safely conclude that marketwide prices would have "inflated" by an amount between 0 to 15% due to increased "affordability/purchasing power".
.

What does the 2/3 refer to?

Although I understand what you mean by monthly costs, would it be more appropriate to call it the 'annual' cost?

 

[fieras]

You are underestimating the condo fee costs and overestimating the cost of renting. You can rent a comparable 300K condo for $1300, for $1800 you can get 2 bedroom/2 bathroom which is hard to find downtown for 300

 

[daveto]

CDR, the "2/3" refers to the mortgaged portion. The other 1/3 was a downpayment (as per assumption #5). Also, yes, I should have written "annual" costs.

Fieras, sure, one can easily plug in other assumptions. Although I've seen downtown 600 sf 1-bedrooms listed at $300k for sale, and $1700 for rent, with condo fees at $0.50/sf (ie $300). My bias is in favour of renting rather than buying in the present environment (as is yours I believe) , so I tried to err on the side of caution and remove any bias in my figures and give the buying option the benefit of the doubt.

 

[fieras]

and you are also assuming everyone has 100K for a downpayment... the numbers tell a different story if someone only has 5% or even 20% down.

 

[daveto]

Fieras, indeed, different assumptions will lead to different results. But market wide I think 1/3 downpayment on average is not unreasonable.

One thing I think you are alluding to is the effect of the BoC's rate decrease on the more vulnerable buyer. Someone with a small downpayment is likely someone who has less financial/realty experience. That person is more likely to be influenced by some marketing about the present affordability, but not understand what might happen when rates go back up.

Notwithstanding the above, I think it is relevant when one looks at a 7% YOY decrease in the City of Toronto marketplace (as per the TREB Feb 09 report) to consider that with a consistent BoC rate the decrease would certainly have been much greater (whether 1%, 5%, or more).

 

[cdr108]

Interesting analysis, but I do believe several assumptions have been over/under estimated:

1. downpayment - 20% would be more reasonable, and I think that's even a stretch for many.
2. maintenance fees - add another $50/m > $4200/annum;
3. property taxes - additional $50/m > $2400/annum.

 

[simuls]

Nicely done and fair math all things considered.

 

[cabbagetowner]

the rent v. own debate always pops up. in the end, it usually depends on a variety of factors many of them are not math related.

drop in rates, definitely a helps with affordability for financing. but it won't be enough to prop up prices. it's a small drop in the ocean of bad news.

 

[Jarrek]

Our variable rate mortgage is 1.75% with Scotiabank!

 

[daveto]

Our variable rate mortgage is 1.75% with Scotiabank!

Goody gum drops for you!

 

[Therion]

One point that is often missed in these discussions: the eventual retirement of the mortgage. Ie. after a certain amount of time (could be as little as 10 years, which is what I'm aiming for), you have paid off your mortgage and your housing expenses extend to the condo fees and property tax only. For the next 40 years of your life, you're paying about half of what renting would be, plus you have something worth a rather large sum of money.

In the long run, the only time it is not worth buying a house is right at the peak of a property boom.

 

[cdr108]

One point that is often missed in these discussions: the eventual retirement of the mortgage. Ie. after a certain amount of time (could be as little as 10 years, which is what I'm aiming for), you have paid off your mortgage and your housing expenses extend to the condo fees and property tax only. For the next 40 years of your life, you're paying about half of what renting would be, plus you have something worth a rather large sum of money.

In the long run, the only time it is not worth buying a house is right at the peak of a property boom.

That is true; however, the idea is to compare a 'typical' mortgage vs. rent.

Accelerated payments, large downpayments, etc are all great to shorten one's mortgage but if that was the norm do you think there would have been such a large market for the 0% down / 40 year mortgages or the other non-traditional products out there (ie. not 20-25% downpayment 25 year amortization) ???

 

[daveto]

One point that is often missed in these discussions: the eventual retirement of the mortgage. Ie. after a certain amount of time (could be as little as 10 years, which is what I'm aiming for), you have paid off your mortgage and your housing expenses extend to the condo fees and property tax only. For the next 40 years of your life, you're paying about half of what renting would be, plus you have something worth a rather large sum of money. .

Therion, if someone owns a home worth $300k with no mortgage then they are sacrificing the extra income they could have received from another asset worth $300k.

If someone owns a fully paid home and they have $500/month carrying costs, then the cost of their home is the $500/month PLUS the lost investment income on the $300k. Of course, real estate does itself appreciate at an historical rate of 2% above the rate of inflation. However that is one of the poorest rates of return on any asset class.

 

[Yossi Kaplan MBA]

Making the banks pay for a change.

As my finance prof. used to say "a little debt is a good thing", cash-rich investors that have substantial capital portion available as stored value in the form of real property, take a loan against the property, write-off the interest and re-invest at higher yields. Most of us here are young and can't do this right away, but this is how I've seen it done:


examples:

1 - you own 50% of a 300k property. the bank loans you a portion of that value at a lower then prime rate (say 2% in today's rates) b/c their risk is minimal and they want your loan.

2 - you pay cash at interim closing for the property (we negotiate that with the builder), skip the occupancy fees and skip paying all kinds of admin fees for the mortgage. now go back to the bank and get a low-rate mortgage and negotiate no upfront or back fees. chances are they'll agree.

Another technique is to try and tie-up the sale of your property with the date that your mortgage retires, save the 3xmonths interest.

etc etc.