Juggling Dynamite

There’s an old saying: the best days of owning a boat are the day you get it, and the day you sell it. The sentiment is especially true when people borrow to buy recreational items. While usage of the lifestyle item is periodic, related expenses tend to be continuous.

Recreational properties and equipment saw a frenzy of buying during the first two years of the pandemic. Now, schedules are normalizing, money is tighter and reducing expenses is the new dream. As motivated sellers outnumber buyers, the available supply of nearly everything rises. For more, see: For Every Vacation Home Fantasy, There is a Harsh Financial Reality:

Sales of second homes are way down from last year’s boom, dipping below pre-pandemic levels (February 2020) for the first time in two years, due in part to high prices and rising mortgage rates, said Daryl Fairweather, chief economist at Redfin.

Many Americans [and Canadians] still envision a second home as a source of family memories, wealth, rental income and tax benefits, if everything goes to plan. These buyers don’t always grasp the risks such as trouble renting the home, family squabbles over the property and unexpected costs.

Well before the rate increases this year, many would-be investment properties had rents insufficient to cover expenses, and owners were subsidizing the negative carry in hopes that capital gains would more than repay their costs over time. This helpful calculator allows us to compare relative numbers.

In February 2022, with the average Canadian national sale price of $816,000, a 20 percent downpayment, and a fixed mortgage rate of 3%, a typical rental condo in Toronto had a negative cash flow of about $1789 per month. But with a 3% annual appreciation rate over a five-year term, the total return could still be positive.

If property prices stagnate with zero capital appreciation, the negative monthly cash flow for the same investment amounts to a 37% loss over the five-year mortgage term (as shown below).

With a mortgage rate of 5%, the total loss on this negative-carry property balloons to 70% over a five-year holding period.

If the market price falls 20% (happening now?), the total loss on this average condo could be greater than 70% over a five-year holding period. Note: most property calculators do not allow one to input/model negative appreciation rates, even though negative returns have typically followed previous cycle tops.

The upside for those waiting to buy is that affordability can improve with falling prices, notwithstanding higher mortgage rates. For example, the average Canadian home price at $816,000 in February with a 3% mortgage rate required a higher 20% downpayment ($163k) and higher monthly mortgage payment ($3,089) than a $629,000 average home price in July (20% downpayment $125,000) and a mortgage rate of 5% ($2,927 per month). Further price declines could greatly improve affordability over the year to come.

Returns are also looking up for investors who wait to buy. However, doing so takes some cyclical insight, patience and cash at the ready.

This segment was recorded in February 2022 and remains highly relevant.

GMO co-founder and Chief Investment Strategist Jeremy Grantham says there’s a huge commercial imperative for big firms to play right up to the end of this market ‘superbubble.’ Here is a direct video link.

Today, amid all the media hyperbole, stocks remain historically expensive, and portfolio positioning remains skewed to risk assets. Household equity flows are shown below in blue with the S&P 2-year total return in yellow (since 1990, courtesy of Lance Roberts). The bear market bottom lies somewhere ahead when retail will be liquidating. No capitulation selling yet!