Real estate: Your house as a hedge

Property is an inflation fighter, but not a money-maker.

The key things to know about property are, one, that it is a good hedge against inflation and, two, that prices go in cycles. Over the long term, house prices move up broadly in line with consumer price inflation. That is a tremendous reassurance when other investments and pension payments might not keep pace. And even though inflation may not be a major problem right now, new retirees have to think forward at least 20 to 30 years. On that time-scale, inflation could very easily return.

For many Canadians approaching retirement, paying off the mortgage is their key goal. Once the mortgage is history, they have somewhere to live for life. They can also sell and move to a cheaper property, smaller or further out of town, raising cash to spend on living. Or, if they prefer to stay where they are, reverse mortgages can be attractive as they get older.

But won’t property do better than just compensate for inflation? Don’t bank on it. Statistics Canada’s index of new home prices for the whole of Canada starts in 1981 and, since then, the average price of a new house is up 124% while the general price level is up 145% — not much more. Of course, new homes tend to be built on the edge of town, so houses in good locations downtown may do better. But it is hard to be sure in advance.

Moreover, house prices move in cycles, and we are at a relatively high point now. Many people in Toronto still remember the collapse in prices in the early 1990s: after doubling between 1986 and 1989, the price of new houses plummeted in 1990–91 and took until 2005 to recover the 1989 peak — a full 16 years. That was a bubble, of course, and we have not seen such an extreme rise in recent years, in Toronto at least. But Vancouver, Calgary and some other western cities have. Even in Toronto, prices have moved up substantially since 2000 and look relatively expensive compared with incomes and rents. So, even if prices do not collapse from here, the upside potential could be limited for a long time.

For those who own investment property, the key is the so-called cap rate. This is the yield earned on renting out the property after allowing for all the costs (but before any mortgage payments). If the cap rate is less than 4%, it may not be worth the trouble. The dividend yield on stocks is only just shy of that, and stocks normally outperform house values over the long term. Government inflation-linked bonds offer nearly 2% with no risk at all.

But it is possible to have a large investment position in property even with only one home. Try the following thought experiment. Suppose, hypothetically, you decided to sell now and rent instead: how big a home would you choose? If youwould scale down significantly, then you need to recognize that your current home is partly an investment, not just a place to live. That investment component carries both risks and opportunities, like any other.

The same test can be applied to vacation homes. Would you rent the same property if you did not own it, just for the enjoyment of it? If you would choose something smaller, you are again treating your second home as an investment. But after all the taxes, maintenance charges, insurance etc., you may find it is costing far more than makes sense — unless you are truly convinced that the price will go up strongly in coming years. Take a look at how much it would cost you to rent instead.

Finally, avoid the trap of thinking that just because you can buy a vacation home in Phoenix or Miami today for half the price of three years ago, it is a fantastic opportunity. Those areas saw a huge bubble; prices probably reached double the level they should have. A 50% decline just makes them reasonably priced, not the bargain of the century.

So go ahead: treat housing as a source of long-term security. Just don’t expect too much from it unless you are ready to play the cycle.