But why?
It is a long answer but I will try.
How does a bank make money?
Well there are really only two ways a bank can make money - fees and lending.
Fees.
Checking, wire, transfers, business account fees, statement fees, taking the dog for a walk fee, depositing funds fee, fees for checking how much the fees are... ad infinitum.
One fee that I particularly enjoy with one of my HSBC business accounts is my account fee. I have a National Home Warranty bond - funds held in trust in a GIC account. This account earns minimal interest, 0.9% per annum maybe, okay not great but something. The cost to hold this account was 2% per annum. Or it was until I threw my teddy in the corner, then it was reduced to 1.25%. So I am lending the bank money and for that privilege, I get to pay them - very exciting! Not.
Lending.
When I was young and good looking, thinner, had hair etc a finance professor said if you can borrow at 1% and lend at 2%... borrow and lend everything you can get hold of. This is why bank are always asking you to change your bank 'come to us, we have bells and whistles, and pretty colours, we will even give you money. Come on, you can do it, yes you can, yes you can...'
They borrow hundreds of billions at 0.25% and lend the same at 2% - 36% (Credit cards).
What...? You thought the banks just put the money in a vault...? No, no, no, Mr Pickles, it gets lent to the man/woman/business on the street.
Capital Ratio.
But it cannot employ all the depositors funds, no, it needs to retain some. This is called the Capital Ratio. But how does it work? Glad you asked. Lets say there is a bank of Christoph Lummy Pie (CLP). Lets say CLP has customers with total deposits of $11m. With a Capital Ratio of 10% (Basel II regulations roughly for total capital) CLP can lend $10m. Brilliant, easy... yes I thought so too.
Risk.
What is risk? There are lots of definitions but I like 'Risk is exposure to an event and the likelihood of that event occurring... good or bad.'
A roulette table is a good analogy here; betting red or black will return you either double or nothing. But a casino will not profit if the odds are 50:50. Odds are not even, there is a green zero, (and on some tables a double zero). The zero will give the casino a 2.6% advantage, (double zero 5.6%). So a million $1 bets on the single zero roulette table will profit the casino $26,000... guaranteed. Casinos do not lose money.
So the risk (exposure) betting red or black is not 50:50 it is 50:47.4 with 2.6% going to the house.
For a bank the risk is the borrower will not pay back the debt. Different borrowing entities have different risk profiles - home owners - lower, credit card users - higher; the rates charged reflect the risk.
Bank Lending Risk at Big White?
It is a bit higher, the second property is lower on a homeowners priority than the first. The risk is a bit higher.
Okay, lets go back to that Capital Ratio thingy again.
What affects it? So Bank of Christoph Lummy Pie has deposits of $11m and has lent $10m, he is complying with Basel II regulations. What happens if the ratio changes (Basel III) and increases to 10.5%? Either the deposits have to increase or lending decrease. Or if there is a big withdrawal? Lending has to decrease.
Lending decreases by withdrawing from markets, mortgages not being renewed, your credit card limit decreasing, the Central bank seizing 10% of your deposits (Cyprus 2012). Or locally, no lending at Big White.
And it is not just the Capital Ratio thingy... there is also lending ratios. When a bank lends money to buy a property, the bank takes security on the property title - a mortgage. Lets say the bank will only advance 90% of property value. If that property value falls by 50% (Big White 2000 - 2014...?) the bank has an exposure, or an increased risk. If the owner walks, the bank has to foreclose, books a loss and reduces its' Capital and therefore affecting the funds to lend.
It is more than this actually the security and the difference between the property value and the mortgage is considered part of the 'undisclosed' capital (along with booked but unannounced profits). Accounting for the property's loss in value can affect the banks capital level.
Big White.
In the bull market 2000-2007 we saw banks with excess capital. Banks were searching for markets to employ the funds, unemployed funds do not make money. To employ the funds Banks expanded into marginal markets, higher risk markets - larger resources were going to development projects, funding home-owner purchases on recreational property.
When the crash came most lenders were in the same boat, losses were booked, and the ability to lend decreased. Compounding the problem new banking regulations (targeted at reducing the risks banks take - Basel III arrives soon) started to come into effect. So not only must the bank lend at a lower ratio, it also has a lower capital base.
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| Why is my stock price down?! It is the CEO dear, he is risk averse... |
E.g. take the bank of Christoph Lummy Pie, imagine the $11m of capital has diminished to $8.8m and the lending capital ratio has increased to 13%. CLP can only lend $7.67m. A reduction of 23%. Imagine if all banks had to reduce their lending by 23%...?
The Sub-prime lending fiasco was probably worse than this, international bank balance sheets lost hundreds billions from their balance sheets - an assets thought to be worth $50b worth zero...? The bank's lending capacity drops by half a trillion dollars. This is the reason for the bail-out.
So lower risk markets are maintained the higher risk markets are cut - Development... Resort real estate lending - Big White.
Affect on Values.
Without bank lending potential purchasers cannot make buy - big problem one. Big problem two - purchasers are concerned about the exit strategy - if banks are not lending who will by my property when I want to sell? And the big problem three - falling property values create deflation. If the expectation is that property values will be lower, buyers will postpone their purchasing decision.
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| Fascinating... but I'm not asleep... |
Interesting the banks create their own problems here - foreclosing on properties creates downward pressure on property values. And the banks only marketing 'tool' is price reduction. It can be argued, dropping prices causes buyers to defer their buying decision.
Resort Municipal Status.
If Big White became its' own municipality the risk profile (in the eyes of the banks policy) would change. The perception is a lower risk, therefore the lending rules are less stringent - more buyers can buy... And again the banks perception will be self realized, more buyers will be attracted to the market.
Revenue Streams.
Capital markets are driven by revenue - actual and expected.
At Big White the average occupancy for properties in the resort is 22% per year. Lets say my $300k property generates $15k of net revenue - 5% return. If occupancy increased to 33% with a commensurate increase in revenue to $22.5k the return would be 7.5%. A buyer needing a 5% return would pay $450k for the property. Now if the revenue was $15k but was expected to increase to $22.5k how much would the buyer pay? More than $300k but less than $450k...? Probably.
What if the revenue was expected to grow at say 2% per annum? The formula the investment community use to value growing revenue streams is the current revenue ($15k) divided by current revenue rate less the growth rate. Or 15000/(0.05 - 0.02) = $500k... at $22.5k the value is $750k.You may want to ignore that gobbley gook above - it just means a growing revenue stream attracts a higher valuation.
Should you sell?
Actually it should be should you sell based on purely financial decisions. But I will give you financial questions to ask yourself.
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| Really...? |
- Can you sustain the cash-flow for the foreseeable future?
- What is the amount of capital paid down off your mortgage each year?
- Will the revenue stream grow - or is expected to grow?
- Your mortgage payments will likely remain the same, however, by how much will the purchasing power of those payments decrease? $10 today will buy you a Guinness at Blarney - what will it cost in ten years - $20. This indicates a inflation rate of 7% per annum. Or... a mortgage payment value deflation rate of 7%... make sense?
- What is the tax deduction value of the interest payments?
- Will the property appreciate in value?
All things being equal, your mortgage payment in 10 years will have depreciated in value, the revenue stream will have inflated, the outstanding debt will be 10 years lower.
Finally - market efficiency.
Markets are dynamic, they always move to an equilibrium balance based on current information. However market participants are human and emotional, leading to markets being over-bought (2000 - 2008) and oversold (2009 - 2014...). Over-buying drives up values, over-selling the opposite. The question to ask - is the market over-sold? For me it is. We are below construction costs, we are at a 14 year low (probably the only one in the world... maybe Iceland is lower) comparable markets have not dropped (Sun Peaks, Whistler, Silver Star) and the closest city (Kelowna) is probably still double its' 2003 levels. Are we oversold...?Despite being a small market, we are a global market, many of our owners are foreigners - this has a dramatic impact on values. Global sentiment and exchange rates have very high impact-
- A strong US and UK currency attracts buyers, a strong Canadian currency creates sellers because a capital loss is mitigated by a currency gain.
Conclusion.
A Resort Municipal Status will have a positive impact on bank lending, leading to upward pressure on property values. A weakening of the Canadian currency will have an upward pressure on values. An expectation of increased revenue streams will create upward pressure on values. A recovering global economy will create upward pressure on property values. Is it a good time to sell then? Not for me... but then again I have made many poor decisions...
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| Like Me! |
Sólido Properties owns, manages, rents properties at Big White; at the same time we try to balance our revenue streams and encourage value growth (for our own selfish reasons). If you would like to discuss improving your property's revenue stream (and thus my bottom line...) we can help.
Contact us at solidorentals@gmail.com or 'like' us on Facebook.
PS - I am not a financial advisor, this is not to be considered a professional opinion i.e. you can't Sue me. You are responsible for your own decisions... yes you are!
