Via Wolf Street

What happens when the marginal buyer is the money launderer whose goal isn’t to buy a house, but to clean the money — and the more money the better?

By Stephen Punwasi, Better Dwelling:

Money laundering in Canadian real estate is a widely accepted fact of life these days, but the impact isn’t. Government and academics are still debating how much money is needed to distort a market. The truth is, not a whole lot is required to distort any asset market. This is a problem the stock market has been dealing with since the 1920s, and the reason it’s so highly regulated.

The key to understanding how laundering impacts prices, is understanding the marginal buyer. If you understand how prices are set, it doesn’t take long to see it’s not the amount of money that’s the issue. Price distortions can be the result of capital velocity, and the intention of the marginal buyer.

Squad Goal: Money Laundering

First, let’s clarify laundering. Money laundering is the process of making illegally-gained proceeds appear legit. Those proceeds can be from monstrous activity, like fentanyl trafficking. Sometimes it’s less nefarious, like earned income evading a country’s arbitrary capital controls. All of it is illegal however, and is people are trying to hide it. There’s a few ways to do it – but the all follow the same basic process.

Money laundering is usually done in three phases – placement, layering, and integration. Placement is the introduction of cash into a legitimate system. Layering is conducting multiple transactions through multiple accounts, to obfuscate a trail. Integration is working the money back into the legit system. Properly laundered money should be extremely difficult to tell from legitimate business.

One last time, the goal is clean money. Parking cash long term in assets is not typical – these aren’t investors. That said, the layering process usually involves moving cash around very quickly. Fast moving cash often leaves a wake, especially if it’s moving through real estate. To understand why, you need to understand a few concepts – marginal buyers, money laundering, and sales comps.

Marginal Buyers Be Cray, Cray

The marginal buyer is an important part of any asset market, especially fast moving ones. This is the person(s) or company that’s willing to pay the most for an asset. They are a small percent of the potential buyer pool, but the ones that actually buy the assets. The competition between marginal buyers is key to asset price escalation. Every market has one on the way up, but skill and motive determine how healthy the outcome is.

If the marginal buyer is a rational investor, they’re thinking about liquidity. They’re restrained in their bidding price, because they need to be able to make a profit. Rational consideration helps to keep a market sane. If the buyer isn’t bound by rationale or logic, things start to get sloppy.

A cannabis company making $20 million a year in revenue fetching close to the valuation of GM? An investment condo that produces negative cash flow? The buyers of these things aren’t making rational decisions. It doesn’t mean they can’t make money, but they are playing a game of greater fool. You’re hoping that the next buyer is more irrational than you – whether you know that’s the plan or not. When you have an influx of irrational money, it’s hard to figure out what’s real.

The Objective of Money Laundering

When you buy an asset, whether a home or an oz of pink kush, you try to get the best value for your time and money. You want a deal. The seller is trying to extract the maximum price they can get from you, without driving you away. They don’t want you to get a great deal. The balance of interests go back and forth, and is a fundamental part of a functioning market. Opposing interests help balance things, plus or minus a dash of exuberance.

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If you are money laundering, that’s not the case. The objective is to move as much cash, as fast as possible. This often involves large assets, and the bigger the price – the better. Especially if there’s a recurring payment component. Both the seller and the money laundering buyer want the highest acceptable price.

Sellers often feel somewhere between a genius and a lottery winner when they find this buyer. Competition between interests align, and there’s minimal friction preventing prices from going higher. The seller assumes their master negotiation skills prevailed. The money laundering buyer gets to move more money than they were asking for. The buyer seems “irrational,” but that’s just the market. Real estate agents without a clue, begin to rationalize and normalize this behavior. There’s no more land is a popular explanation.

Understanding How Real Estate Prices Are Born

We all know how prices are born. When a homeowner finds a selling agent they love, they go into a quiet backroom, make a few strokes, and boom! The multiple listing service spits out the comparables, a.k.a. your comps. Comps are a fancy way of saying what has sold around you, like the neighbor’s house. These numbers are then used to establish a baseline price, which a selling agent tries to push higher.

No comps in your neighborhood? No problem, we’ll use the neighborhood next door. Eventually, the arbitrary line disappears that separates the pricing in neighborhoods. This is when you hear dumb things, like “Shaughnessy Heights adjacent.” This spreads like a virus, from one neighborhood to the next.

Vancouver Real Estate Prices Overheating

A time-lapse of real estate sales in the City of Vancouver. Herd behavior can be observed in clusters, as people pay over or under the list price – based on whether other people are doing it.

Poisoning The Comp System

Smarter real estate agents can already spot the problem here. Let’s look at an example, say you’re shopping for a home in Anyplace, BC. You’re watching the homes in the neighborhood climb at an average of 5% from last year. You find a place you’re ready to put on offer on, do some research, and come up with an offer. All of a sudden, a money launderer shows up, and offers the owner 10% over ask for a “quick close.” You’re not too worried, your agent told you the place a few doors down is going to be on the market next week.

Unfortunately, the new place now uses the home owned by the money launder as a comp. Now the ask is 10% more than you were expecting, because the marginal buyer set the price down the street. Someone else bites, and buys it before it “goes too high.” Now the money launderer’s buy was just validated in the system. But wait – there’s more.

Remember, the goal of laundering isn’t to buy a house, it’s to clean the money. They list the home again, let’s say another 10 points higher than bought. Bonus points if they can turn it into a wash trade, and sell it to another associated launderer. A regular family shopping down the street uses your washing machine as a comp for their buy. Behavior typically only seen in the frothiest of asset bubbles, can surface quickly. Exuberant buyers, both illicit and legit, compete and drive prices higher.

Driving Exuberance In Canadian Real Estate

An index of exuberance Canadian real estate buyers are demonstrating, in relation to pricing fundamentals. Once above the critical threshold is breached, buyers are no longer using fundamentals. Instead they resort to market momentum, and the possibility of reward is justification enough.

Now in this example, just a few sales would have helped to push the comps up to 21% higher. There would also be hundreds of sales validating the price movements in between. Each time the launder injects capital, they inject a new marginal buyer. The whole time, Boomers are stoking the coals on this fire, explaining this is “earned equity.” If you want your own, you need to work as hard as they did. Standing by as each irrational player enters the market is exhausting work. Boomers also had to save uphill for a down payment… both ways, in the snow or something.

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“It Wasn’t That Much Money”

Still think a small amount of money can’t influence prices? Clearly you’re not familiar with another asset class – stocks. CNBC host Jim Cramer once ranted that his fund could manipulate stock prices with as little as $5 million. Nav Singh Sarao, spoofing just $170 million worth of orders, set off events that led to the DJIA losing $1 trillion in just a few minutes. Note: the orders were spoofed – meaning he only had a fraction of the money. More formally, academics determined traders can use less than $500,000 to raise a stock price 1%, by targeting the bottom half of the liquidity spectrum.

Smack That Ask: It’s Not What You Pay, It’s What You Think People Will Pay

An example of Dynamic Layering, the spoofing technique used by Nav Singh Sarao. The lower dots are bids placed, that only sometimes execute as a trade. Free markets can’t effectively determine if participants are executing trades in good faith – required for natural price balance.

Source: US Department of Justice. 

Each of the situations are different, but have two common things – influence and intent. While not that much money, each example precipitated events that had a big impact. The actual trades weren’t so important, so much as influencing volatility. Setting the marginal buyer definitely counts as an event that influences market direction.

Each one of these events are also easily mistaken for an accident, which conceals intent. Fat finger, trade algo gone wild, and/or eager market buyer. Each one of these situations could have been caused by regular, everyday occurrences. Now it’s unlikely that money laundering is focusing on systematic trading of homes to inflate prices. It could however, be one of the times an unintentional destabilization of a market is just a side effect.

Velocity may also be playing a large role here. When cash goes into one house, it’s eventually sold. That cash likely gets pumped through multiple transactions for the purposes of layering. That means more houses are being bought with the money, and profits. More sophisticated operations also have combined layering with an integration platform. Bonus points if the integration platform is registered with FINTRAC. That way the integration platform is also in charge of submitting suspicious transaction reports.

Combine this with an opaque comp system with closed data, and it’s really hard to catch. The chances of buyers being able to do their own due diligence on a property buy is virtually nil. Closed systems also mean no wide scale analysis of the transaction. There’s very little way for anyone outside of regulators to actually be able to determine it.

Where’s The Money At?

While Canadian cities are debating whether dirty money impacts prices, the rest of the world made up its mind. Transparency International UK found a significant correlation between shell companies, and elevated prices. London for instance, has 87,000 homes owned by anonymous companies. According to Christoph Trautvetter of Netzwerk Steuergerechtigkeit, the estimated impact from dirty money in London is 20% of the price increases.

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London, UK Average Home Sale Price

The average sale price of a London, UK home. The estimate removes the 20% of annual gains attributed to the influence of money laundering. The number also assumes no laundering was done prior to 2008. LOL.

Source: HM Land Registry (UK), Better Dwelling.

There’s a similar setup brewing in Canada, politicians are just a little less willing to look into it. Transparency International Canada found 50,000+ Greater Toronto homes bought by companies without known beneficial ownership. Even worse, $20 billion of the funds used were not subject to any anti-money laundering checks. In Vancouver, local politicians are still claiming money laundering is over exaggerated. Meanwhile, in European Parliament, Vancouver is literally being used as an example of opaque ownership distorting home prices.

Money Laundering Through Commodities Is Old News, The Velocity Is New

Laundering money through real estate is far from new, but the velocity and volume is. Traditionally, launderers would buy, hold, and sometimes even rent the places out. The lack of scrutiny in real estate transactions, has always made it a prime landing spot. Every city has a few well known families connected to local mobs, that just happen to be in real estate. The impact to home prices are minimal when the volume is low and slow.

Treating real estate like a global commodity market makes it fast and high volume. The real estate industry in Canada encourages foreign capital. In fact, Canadian banks openly helped clients with “placement,” obfuscating deposit trails. The faster you can place, the faster prices rise, and the more they welcome foreign capital – the easier the wash.

This has always been an issue stock markets have had to deal with. Equity is issued, artificial volume inflates prices, and launderers liquidate to unsuspecting victims. Equity markets have increased ownership transparency on larger exchanges, making it more difficult. However, it’s still common, especially on European and Asian stock exchanges. Treating real estate like a stock market encourages the same type of laundering, without the transparency.

Fun fact: The now defunct Vancouver Stock Exchange was popular with money launderers. It was so popular, Forbes called Vancouver the “Scam Capital of The World” in 1989. The Coordinated Law Enforcement Unit in British Columbia warned the government of organized crime on the exchange as early as 1974. Those warnings were largely ignored. Are you also sensing a pattern here?

Money laundering is not the sole reason for much higher prices, but it fans the flames. Low interest rates and easy lending allow regular families to provide liquidity. If a launderer can’t get clean cash, they don’t transact. There’s no appeal without house horny buyers overbidding comps, or rapidly flipping.

Money laundering investors however, can influence the direction of the market. A real estate market is only as good as its last comp, set by the marginal buyer. If that marginal buyer was laundering money, they have motivation to overpay. Regular households buying into this, provide comp validation, and liquidity. Most households never consider where their liquidity is going to come from. By Stephen Punwasi, Better Dwelling.

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