Invisible Hand of Income (Inequality)

First off I’d like to say that this whole blogging thing is new to me and so I’m still working out the quirks.  So bear with me.

Now a lot of  commentators say that house prices are way off fundamentals, rental incomes don’t jive with the prices.  Most of the times they are using analysis based on the tradeoff between rent and mortgage payments.  The general idea is that over the long term, a “rational” individual would choose to pay less for living in an almost identical home if given the choice between rent and a mortgage payment on that place.  Ultimately, the ability to pay for rent or mortgage payments is capped by what the incomes levels are in that market.  Many claim Vancouver’s prices are not justified by the income levels.

But this is where I think the problem lies.  According to BlockTalk, in the Dunbar area, the average income level is $122,948.  Using the CHMC mortgage calculator for how much one can afford, the numbers are:

SCENARIO 1:
Monthly Income Required: $10,245
Monthly Property Taxes: $600
Monthly Heating: $100
Financing: 3.5% fixed, 5 years, 25 year term, mortgage of $516,434, monthly payments of $2,578
Downpayment: $500,000
Maximum House Price: $1,016,434*

* According to CHMC, the first rule is that your monthly housing costs should not exceed 32% of your gross monthly household income.  Housing costs include monthly mortgage payments, taxes and heating expenses.  The house in the picture above was on the market recently for $949,000

Now what if monthly income is $15,000?  Let’s see:

SCENARIO 2:
Monthly Income Required: $15,000
Monthly Property Taxes: $600
Monthly Heating: $100
Financing: 3.5% fixed, 5 years, 25 year term, mortgage of $821,198, monthly payments of $4,100
Downpayment: $195,000
Maximum House Price: $1,016,198*

In scenario 1, you could say it was a dual income couple making $61,470 each.  In scenario 2, it could be a couple making $90,000 each.  You’ll notice that there is a very significant downpayment required.  But houses like the one above are being sold.  And the bears say that this is because of the extremely low mortgage interest rates.  This is true.  Are the buyers overextending themselves?  Well these scenarios are based on the criteria set out by the CMHC on 32% debt-to-income ratios.  Is it so hard to imagine a couple (gay or straight) making $60,000 to $90,000 each?

It’s the downpayment that’s troubling.  For both scenarios, they require a downpayment from $195,000 to a whopping $500,000.  But is this necessarily unrealistic?  These houses are being sold and this is what the market can bear. Believe me, there are houses in this area that selling for much more than $949,000.

Where does the downpayment come from?  This is probably the most mysterious part.  But it doesn’t really matter because its unobservable.  It could be from inheritance, from an asset sale, from the sale of a business, or maybe it was just saved earnings!  Is it that hard to imagine our hypothetical couple saving $50,000 to $100,000 each – maybe because they’re too busy working to spend their earnings – and then topping it off with a gift from both sides of the family towards their first purchase?  Or what if these people are just stinking rich or come from very well-off families?  Why is this so hard to believe?  Maybe bears aren’t good at empathizing with bull.

This is what I perceive to be some of the problems with the bearish point of view.

1. Averages are mediocre – The average income figures are obscuring what’s actually happening out there.  An average houshold income level of say $75,000 doesn’t really tell you what is happening at the upper end of the distribution.  Who says that the income distribution needs to look like a bell curve?  Don’t income distributions follow power laws anyways?
2. Rich people buy in Vancouver – One of the complaints is that income levels can’t sustain the current market.  Bears believe in fundamentals, but why can’t they believe where the market clears prices correctly?  Because ultimately they can’t believe that there are so many rich people out there.  Or they might brand these people as “greater fools”.  I personally know a few Goldman Sachs employees based out of Manhattan that recently purchased very high end condos in Kits.  A common complaint is that institutional investors are not jumping into the Vancouver market.  So why are Wall Street investment bankers making such foolhardy purchases for themselves?
3. Self-Righteousness – Bears are complaining about high prices because they’re too high.  But too high for whom?  They don’t think the prices are worth it.  But does it compute that it might be the right price for other buyers?  How can one justify buying a $250,000 car?  Because it’s worth it to them.  Some like their caramel machiatto, others like their double-double.  Go figure.  But when bears say they can’t understand the stupidity of making a purchases that breaks the laws of the price-income ratio, they are basically saying why don’t others think like I do?  Why aren’t others as “rational” as me?
4. Affordability Self-Selection Bias – People that congegrate on the Internet to talk about the “bubbly” prices of Vancouver real estate tend to reinforce each other’s beliefs.  Finding other people who share your opinion only reinforces… well, your opinion.  Just because there are so many bears out there doesn’t mean that they’re right.  We can ponder the “wisdom of crowds” all we want, unless of course the crowds are dead wrong.
5. History is a Guide – Many bears believe that prices will achieve some long-run historical average.  They don’t believe in paradigm shifts away from what they perceive is a solid fact of history: the price-income ratio.  But paradigm shifts do occur.  For example, consider that property rights and capitalism are in fact complete paradigm shifts that only in the past 30 or so years the rest of the world have come to realize as the best form of organization for a country today.  It might not always bethis , but then that would be a paradigm shift for the future.  We can’t be so close-minded about possibilities when using historical data.

The bottom line is that the reason why prices are so “high” is because there is, amongst the buying public, a huge and large income inequality.  It’s that simple.  For what else could be driving the market to clear at these prices, given the hyper-connected infoglut of a world we live in?