It’s time to think out of the box and I would like to offer an alternative explanation for the elevated levels of Vancouver property prices.
An overheated market
Vancouver house prices have indeed been on a wild ride.
Affordability is way out of sight for the average resident, according to RBC, as the % of the typical household income taken by ownership costs are at levels only fantasized about by real estate bulls:
In fact, Vancouver is the least affordable city in the world, according to a report by Demographia International. Anecdotally, I would tend to agree with the conclusions of sky high affordability. A “good” detached house on Vancouver’s west side is around $2 million, give or take, but a “good” job in the local newspaper pays $50-70K a year – you can do the math. There are cheaper houses in the suburbs and better paying jobs, but these examples vividly illustrate the affordability problem.
The standard explanations: Retirement capital, Asian money
Vancouver home prices have tended to command a premium over Canadian cities. It offers a milder climate and a better quality of life, but these kinds of valuations can’t account for these prices as there are other parts of the Canadian west coast that don’t cost as much.
Another standard explanation has been the influx of Asian money into the city. Ahead of the Chinese takeover of Hong Kong in 1997, there was a significant influx of Hong Kong residents into Vancouver. These new immigrants did not fit the profile of the poor fresh-off-the-boat immigrants of the past, but brash and wealthy. As a result, Vancouver earned the nickname “Hongcouver” for a brief time. There continues to be Asian money coming into Vancouver. Today, instead of Hong Kong residents, there are more wealthy residents from Mainland China, who have buoyed not only the Vancouver property market, but Sydney and now Hawaii's as well.
To me, the explanation of Asian funds as the sole explanation for buoying Vancouver prices is unsatisfactory. The 1997 effect would have been a one-time shock and would have worn off – and did.
The Overseas Chinese are culturally predisposed to showing of their wealth and the signs aren’t here. When I compare the local streets to Hedge Fund Heaven in Connecticut, where I had lived before, I don’t find the same level of luxury vehicles on the streets in Vancouver. The streets here are clogged with Toyotas, Hondas and Fords, whereas in Greenwich, CT, there are more Mercedes than Toyotas.
The Elephant in the room
One explanation that few people talk about, but is common knowledge about local residents and pops up in unusual places, is the underground economy in British Columbia. Hard figures are difficult to come by, but it is said that the size of marijuana crop, nicknamed "BC Bud", is about the same as the forest products industry in this province.
In addition, the local gangs have diversified into other drugs which are exported to the United States, namely different variants of ecstasy as meth labs have become more common in Vancouver.
Multiplier effect on steroids
Washington based Stratfor did an intriguing analysis on the effects of the drug trade in Mexico [emphasis mine]:
The amount of money pouring into Mexico annually is stunning. It is estimated to be about $35 billion to $40 billion each year. The massive profit margins involved make these sums even more significant. Assume that the manufacturing sector produces revenues of $40 billion a year through exports. Assuming a generous 10 percent profit margin, actual profits would be $4 billion a year. In the case of narcotics, however, profit margins are conservatively estimated to stand at around 80 percent. The net from $40 billion would be $32 billion; to produce equivalent income in manufacturing, exports would have to total $320 billion.If drug trade profit margins are in the order of 80% then its effects on the local economy must be much larger than its stated GDP contribution. While BC’s drug trade might be roughly equivalent to the forest products industry, its economic footprint is likely to be many times higher because of the higher multiplier effect as these enormous profits ripple through the local economy, which is inflationary.
In estimating the impact of drug money on Mexico, it must therefore be borne in mind that drugs cannot be compared to any conventional export. The drug trade’s tremendously high profit margins mean its total impact on Mexico vastly outstrips even the estimated total sales, even if the margins shifted substantially.
Imagine all this excess liquidity sloshing around in a localized economy. On top of that, all this illegal money has to get laundered. Some of the liquidity is likely to leak into the real estate market, one way or another.
I had pointed out before that property can be used as a store of wealth and real estate is just another form of money. So why not in Vancouver?
Threats to the drug trade
If the underground economy were to form a substantial part of the explanation for the stratospheric level of Vancouver property prices, then there are a number of distinct threats to the well-being of the local drug trade. After all, most of the product is likely going south to the US and not much comes back in the way of trade (except for guns, as Canada has much tougher gun control laws, but I can’t believe that the value of weapons imports could offset the value of drug exports).
The Canadian Dollar: The Canadian Dollar has risen from around 0.85 to roughly par in the last 3-4 years. The unfavorable exchange rate difference must squeeze profit margins. (It is difficult to conceive that drug gangs have major foreign exchange trading desks hedging their forex exposure.)
Changes in regulatory regime: There are other signs that the marijuana business is becoming more legitimate. California has an initiative to legalize pot. Legalization or decriminalization would take much of the price premium out of this illicit trade as you can see from this story about the legal marijuana market.
Harmonized sales tax: On July 1, 2010 the province will combine the federal Goods and Services Tax (GST) with the Provincial Sales Tax (PST) to form the Harmonized Sales Tax (HST). Some goods and services that were PST exempt will now be subject to HST. While decried as a tax grab by local taxpayers, it will create an environment that may make money laundering more difficult. The HST is a value-added-tax. Businesses are required to charge HST on all their transactions, but may deduct the HST that they pay as a credit to the taxes that they remit. These changes creates a paper trail of cash flows and make cash transactions more difficult - which will have the unintended effect of hindering money laundering operations.
Drought conditions: There are forecasts for drought conditions for much of British Columbia this year. Such conditions would serve to disrupt any agricultural product.
Looking for alternative theories
Economists have been struggling in the wake of Great Recession as many of the standard equilibrium models had failed. As a result, many have searched for alternative explanations of the current state of the world.
In the same vein, standard explanations of Vancouver real estate prices appear unsatisfactory. It’s time to think out of the box and look for other causes. I therefore believe that the underground economy forms a significant part of the explanation for the stratospheric level of Vancouver real estate.
Disclaimer: This post is not intended to condone or be an advocate for or against the drug trade, but an economic analysis of the possible effects of the underground economy on monetary liquidity and real estate prices.