calculations – Investing Intelligently

Global TV Says Vancouver Housing Bubble Has Burst

Just over 4 months ago, I wrote that the Vancouver housing bubble had finally burst. The mainstream media has finally come on board and is supporting the idea that housing prices will fall over the next few years, based on a report from Central 1 Credit Union. Take a look at this report from Global TV:

Global TV is now saying that the “air is now officially out of the real estate balloon.” My only complaint with the piece is that there is no mention of the complete lack of affordability being any factor in the price drop. They are attributing the drop to “the global financial crisis and a big drop in consumer confidence” which have “combined to drive the housing market into recession.” Helmut Pastrick mentioned the “uncertain and volatile times we’re living in.” They say “how many times have we heard that somehow Greater Vancouver’s real market was insulated from what was happening in virtually everywhere else in the western world….that prices were falling?” They talk as if there are only two possible outcomes: either Vancouver is insulated from the rest of the world in which case our prices won’t fall along with the rest of the world, or Vancouver is not insulated in which case our housing prices will fall because prices are falling elsewhere. Even if Vancouver were completely insulated from the rest of the world (no trade, no communication, an island in the middle of the ocean) our housing prices would have to fall in order for affordability return to normal levels. Yet the piece leaves us with an overwhelming feeling that Vancouver’s real estate market woes are the fault of others, the fault of a US/world credit crisis and of a US/Canadian recession, the fault of some mysterious outside, external force. There is some mention that speculators and investors, who up until recently were lining up to pre-buy condos are likely to be the hardest hit, but no mention of their part in causing this mess. No mention of the fact that housing prices were just too damn high and affordability too damn low.

The real estate agent near the end says that we are now (or are soon to be) in a “classic move-up market.” What he is saying is that when housing prices are low, it is easier to move up from a small townhouse/condo to a house, for example. It’s funny because this is what a lot of people were doing when market prices were high; taking the equity out of their home and buying a second home or moving into a bigger house, while taking on more debt. Obviously when market prices are on the low-side it is a better time for a “move-up”, just like it is a better time to buy, or to enter the market for the first time. When market prices were high it is a better time to “down-grade”, or to leave the market entirely and become a renter.

The piece also got some of the math wrong. A drop of 12%, 13%, and 5% is an overall drop of 27.2%, not 30%:

The above is just a complicated way of saying that you had something that was reduced by 12%, then 13%, the 5%, the result would be a reduction of 27% from the original, not 30%.

Hmm, my guess is that no banks will be offering 0% down mortgages any time soon… at least not unless you have some other really expensive assets that they think they can repossess..

VEA vs XIN: Foreign Exchange Fees vs. Higher MER

A commenter named Blitzkrieg asked:

How do currency exchange fees factor into the decision between VEA and XIN? XIN’s MER is 0.35% higher than VEA’s, but it is purchased using Canadian dollars, so there is no exchange fee. VEA’s MER is nice and low, but don’t you immediately lose a few percentage points of your investment when you buy it due to currency exchange fees?

He’s exactly right. The answer to “which one is better, VEA or XIN, from a cost perspective” is “it depends.” In this case, it depends on how long you hold your investments.

I did some similar calculations to determine the “effective MER” of a foreign currency investment over time but this time I do it a bit more simply, to determine, simply, how long to I have to hold my VEA until it beats XIN.

When you buy VEA, you’ll pay a foreign exchange fee (spread). This varies depending on your broker but they range from 0.5% to 1.5% each way. Let’s assume it’s 1% each way. So when you use Canadian dollars to buy VEA they convert your dollars to USD but they take 1.5% for themselves. So our present value has gone down by 1.5%, or 98.5% of the original. When we sell your USD investment, VEA, in the future, the broker/banks will again take 1.5%. So your final value is also reduced by 1.5%. So originally, we had this:

FV=PV (1+i)^n

Our initial PV needs to get reduced to 0.985 of the original, and the result of the right-hand needs to be reduced by 0.985 (when we sell the investment). So what we end up with is this:

$FV_{VEA}=(0.985)(0.985)PV (1+i)^n$

If we invest in XIN, there are no foreign exchange, just an MER that is 0.35% higher. This 0.35% will reduce our annual return, so we get this:

$FV_{XIN}=PV (1+i-0.0035)^n$

We can get rid of PV (it won’t affect the result) and assume a return of 7% (i=0.07). It turns out that:

$FV_{VEA} > FV_{XIN} \quad \textbf{if} \quad n\geq10$

So if we hold onto our investment in VEA for 10 years or greater, we will end up better off, assuming a rate of return of 7% (note that the rate of return does not have much effect here, eg. 10% rate of return gives the same result) and a foreign exchange fee of 1% each way. The two variables that have the greatest effect here are the foreign exchange fee and the difference in MERs.

Paying Down Student Loans vs. Contributing to an RRSP

There are many people, me being one of them, who ask themselves “should I put money into my RRSP or pay down my debts?” For very high interest debt, such as credit cards and bank overdraft, this type of debt should always be paid down before anything else. For other debt such as student loans, bank loans, and mortgages, the answer is less obvious.

I have come up with a good, simple example, to answer the above question. Imagine you had at least $1000 room in your RRSP and you owed $10,000 at 7% as of January 2006. In January 2006, you have a choice of either putting your next paycheque (of $1000) towards an RRSP invested in a balanced portfolio of bonds and equities, or towards the $10000 loan. You can do nothing else with your loan or your RRSP until January of the following year.

Case 1: If, in January 2006, you put $1000 towards the $10,000 loan, you would be left with $9,000. Over the next year, you would be charged $630 in interest, a savings of $70 over what you would have paid had the loan principal still been $10,000. Your net worth based on the RRSP and the loan would be -$9,000 – $630 = -$9,630 at the end of the year.
Case 2: If, in January 2006, you put $1000 into the RRSP invested in a balanced portfolio of bonds and equities. To be conservative, we will assume that it will appreciate by 7%, however, it doesn’t really matter so much as we will not be realizing any value on this portfolio for years to come (until we retire, presumably). After one year, the RRSP portfolio will have appreciated by $70. In April 2005, you will receive a tax refund. Assuming a marginal tax rate of a modest 18%, you will receive $180 in refunded taxes in April. You can then apply this to your loan in April or put it in your RRSP. Let’s keep the calculation simple and just hold it as cash until the end of the year (not a smart thing to do in practice, as technically you owe that $180, more or less, to the government later on). During the year, our loan accumulates $700 in interest. At the end of the year our net worth will be -$10,000 – $700 + $1000 + $70 + $180 = -$9,450.

In Case 2, we are $180 richer than in Case 1. This came directly from the RRSP tax credit as the amount that the RRSP holdings grew by was exactly compensated by the extra amount we owed on the loan. This demonstrates the power of RRSPs. The $1000 + $180 is now pre-tax dollars. The government has refunded us the $180 in taxes on that $1000. The $180 is not free money, as we now owe the government some taxes when we take our money out of the RRSP when we retire. It is our hope, however, the when we retire we will be in a lower tax bracket and the $180 in taxes will actually be less (let’s say $150). So really we are $30 ahead, not $180, but still, thanks to tax deferral (deferring taxes on income until we retire), we are ahead.

One strategy is to contribute monthly to your maximum allowable limit, then to apply the tax credit in April to your loans. The tax deducted from your paychecks acts as a forced savings device for an annual loan principal payment.