Don’t let irrational exuberance send you off the rails

AACI | Vice President, The Regional Group of Companies Inc.
  • Dec. 10, 2014

John ClarkRemember Alan Greenspan? He was chairman of the U.S. Federal Reserve back in the day of the telecom boom and bust.

He famously used the term “irrational exuberance” in a speech in 1996. It was interpreted to mean (since just about everything the man said required interpretation) the stock markets were overvalued. A few years later, that proved to be all too true.

I find myself thinking of that phrase as I keep an eye on what’s happening to property valuation in Ottawa along the route for our Light Rail Transit (LRT) project, which is in the midst of Phase 1 construction. As could be expected, real estate adjacent to planned LRT stations has become premium real estate.

A little irrational exuberance is the nature of the beast when it comes to land speculation. There is often an initial flurry of interest that drives up prices. But then common sense prevails. Market valuations ease to a more reasonable level. Those who were quick to buy at the inflated price can find themselves stuck.

Why does this happen, and what are the consequences? Let’s look at it from the perspective of two different groups – the developers, and the homeowner/investor purchasers of units.

The risk of an inventory glut

When it comes to development adjacent to Ottawa’s new LRT stations (or just about any similar transportation infrastructure project in any major city), the gleam in a developer’s eye these days most often involves condos. They may have in mind a mixed-use development that also includes office and/or retail space, but the residential component is still seen as the big money-maker.

But developers must bear in mind that the biggest driver of the residential real estate market is still homes with driveways and yards, as small as they may be in a suburban landscape. Condos appeal to a much smaller segment of the market. This means it can take time for even a healthy market to absorb new inventory.

Which brings us to the key consideration – how long will it take to sell the last 20 per cent of your inventory at the inflated prices you must charge to cover an inflated land acquisition cost?

Why the final 20 per cent rather than the rest of the units in the building? Because a developer is usually just recouping costs to break even on the first 80 per cent of the units sold. Profits only come with that remaining 20 per cent.

I spoke with a developer a little while ago who was still trying to move inventory in a condo project, eight years after the first occupants moved in.

Timing is critical, both in terms of when you buy the land and when you commit to a construction start. Once you break ground, you have committed yourself to a substantial financial obligation that is far greater than simply holding on to a piece of undeveloped property. You can’t afford to bank on demand materializing when the building is ready for occupancy. A minimum number of pre-sales are crucial before taking the leap.

Otherwise, a developer may find themselves in the situation of having to become a landlord for the short term, to rent unsold units to generate some revenue.

It’s all about lifestyle

Then there are the buyers. These can be divided into two categories: A minority are investors who are looking to rent out units. The majority, however, are looking for a place to live.

For most of these people, it’s a question of finding a desired lifestyle. In terms of a rationale to buy, lifestyle should be the overriding consideration.

Why? Because purchasing a unit in the hope of a profitable return on the investment isn’t likely to have a happy ending.

When you factor in the cost of purchasing what sometimes may be an overpriced product and the ongoing cost of ownership, such as condo fees, banking on possible appreciation in value may be irrational.

(And don’t forget my last post, in which I warned about the long-term quality and comfort issues with some of the condos built today. Either their resale values will suffer as a result, or there will be some big capital costs for owners to shoulder in 15 years or so.)

That’s why this purchase should be considered a lifestyle choice: you like living in a central urban location; you like the convenience of nearby rapid transit, which allows you to forgo the expense of owning a car (this can make a huge difference in how much of a mortgage you can carry).

So what’s the takeaway?

Wise developers, like wise stock market investors, don’t jump in when there is a wild uptick in land values. Rational developers look at what most of the tribe is doing, and do something else. They wait for prices to moderate before buying, if they didn’t have the insight to get in ahead of the rest of the market before the uptick began.

For individual buyers, the emphasis should be on what they can afford and what suits their desired lifestyle. Given the possible issues of building quality, and exuberant land speculation that may have made for over-priced units, a return on your investment may otherwise be a long time in coming.

To discuss this or any other valuation topic in the context of your property, please contact me at [email protected]. I am also interested in your feedback and suggestions for future articles.

John Clark is Vice President with The Regional Group of Companies Inc. He has more than 33 years of experience in the real estate appraisal field, is a fully accredited…

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John Clark is Vice President with The Regional Group of Companies Inc. He has more than 33 years of experience in the real estate appraisal field, is a fully accredited…

Read more

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