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More than two centuries ago, the economist Adam Smith produced his landmark tome, An Inquiry into the Nature and Causes of the Wealth of Nations, in which he wrote, “a dwelling-house, as such, contributes nothing to the revenue of its inhabitant.” The father of modern economics placed housing in the same category as clothing and furniture – useful consumer goods that do not generate wealth. For the homeowner, a house is a “part of his expense, and not of his revenue.” Were Smith alive to make such a statement today, he would no doubt be regarded as a heretic.
These days, home ownership is widely heralded as the ultimate financial achievement and one of the surest forms of wealth creation available. Homeowners aren’t throwing away money on rent, the common thinking goes, but instead putting it toward an asset that can only appreciate in value. Indeed, home prices have more or less climbed steadily for decades. For these reasons, at least two generations have grown up with the same abiding principles when it comes to real estate: save for a down payment, buy a house, and work hard to pay off the mortgage. And you better get in soon, because God’s not making any more land.
Nowhere is that mentality more prevalent than in the current market, where housing has soared to record highs after a brief – but gut-wrenching – drop just over a year ago. Existing home sales fell 40%, and prices 12% from their peaks in late 2007 during the turmoil of the recession. But the average home price in January roared back to $328,537, according to the Canadian Real Estate Association, a jump of nearly 20% from the year before. Ultra-low interest rates are providing an unprecedented opportunity for young Canadians to buy their first homes. At the same time, there is a shortage of houses on the market, fuelling intense competition and bidding wars. “Some people don’t even balk at paying thirty, forty, fifty thousand dollars over asking now,” says Evan Sage, a real estate agent in Toronto. Many factors motivate people to buy property, but one nearly universal reason is for the economic benefits. “Every single decade, prices have gone up,” says Sage. “The one consistent thing is real estate.”
But a hard look at real estate returns shows that Adam Smith probably had the right idea after all. Viewed purely as an investment, an owner-occupied home has more than a few undesirable traits. In January, during a panel discussion at the annual meeting of the American Economist Association, Karen Pence, head of the Federal Reserve’s household and real estate finance division, pointed out a few of the drawbacks buyers tend to overlook. For instance, a house can’t be divided up and sold, like a stock portfolio, and it is highly correlated to the job market. Also, a house is undiversified; instead, its future is tied to a single neighbourhood.
Moshe Milevsky, an associate professor of finance at the Schulich School of Business in Toronto, has a similar take. “This blind devotion to investing in a house as being a very, very good idea might not make sense when all is said and done,” says Milevsky, who held off purchasing a home for his own family for some time. He believed it was not a smart way to allocate money. In fact, it flies in the face of what decades of portfolio allocation theory have shown. “It’s like a stock portfolio that consists of one stock,” he says. “If I could buy a house where the bedroom is in Toronto, the kitchen is in Vancouver, and another bedroom is in South America, then that’s a diversified house.”
But the dream of home ownership is so deeply ingrained, and the belief that real estate is the ticket to wealth so strong, that Canadians are increasingly willing to put their economic well-being on the line for the sake of four walls and a roof. This fact is reflected in the growing levels of debt. The average household in Canada now owes $96,100, according to a study released in February by the Vanier Institute of the Family, an increase of 5.7% over the past year. The same report found that mortgage debt is at a record high.
The euphoria around home ownership crowds out some of the unpleasant truths about real estate: mainly, that long-term returns are often modest at best. Some studies have found that stock indexes actually outperform housing. More worrying is that real estate prices can and do fall – and they can take a long time to recover. Canada has not been immune to severe price corrections in the past, and we could be on the verge of another one now. With interest rates set to rise and curb affordability, and with economists speculating about a bubble, staking one’s entire financial future on a home is not necessarily a wise bet. In fact, a house just might be one of the most overrated investments around.
The final months of 2008 were a difficult time for Vancouver real estate agent Peter Raab. His clients simply weren’t interested in buying houses, and the market was tumbling. Raab prepared for the worst, cancelling his vacation and cutting expenses. His practice slowed down so much that he didn’t get a paycheque for five months. “Everyone was trying to put on a brave face. It weeded a few people out of the industry,” he says. But Raab didn’t have to wait long for a recovery. His business started to pick up again in March of last year, as it did for agents across the country.
A number of circumstances brought buyers back. Canadians recognized the economy was not headed for disaster, and rock-bottom interest rates were too enticing to ignore. Buyers who had been waiting for the economy to smooth out before buying have started looking again, and others who may have waited until later in the year to purchase are acting now to avoid rate increases. The effect has been compounded in Ontario and B.C., where the introduction of a harmonized sales tax in July will increase the costs around buying and selling homes. Factor in a lack of housing supply and too many buyers, and it would appear prices have shot up alarmingly in a short amount of time, sparking plenty of debate over whether homes are overvalued now, and how they’ll adjust in the future.
“There’s a unique confluence of factors that has driven house valuations up this sharply,” says Derek Holt, vice-president of economics at Scotia Capital. “They’re all temporary, and that’s a house price bubble that could be pricked as we go off into the next year.” The rate of growth in home prices for the past 10 years has in fact been out of line with prior decades, pointing to lofty valuations today, according to Holt. Prominent Canadians such as money manager Stephen Jarislowsky and former Bank of Canada governor David Dodge have also sounded the alarm recently on today’s unusually rich home prices.
Although both federal Finance Minister Jim Flaherty and Bank of Canada governor Mark Carney have said they do not believe Canada is in the midst of a housing bubble, they are clearly watching closely. Carney warned about rising levels of debt late last year, as the household debt-to-income ratio reached a record high of 145%. Flaherty took steps to cool the market in mid-February by changing some of the rules around government-backed insured mortgages, most notably with the provision that all borrowers now must meet standards for a five-year fixed rate mortgage, even when opting for a lower rate and a shorter term.
The change was to ensure Canadians don’t take on more mortgage debt than they can handle, but impending increases to interest rates still pose a danger to recent homebuyers who took advantage of the cheap credit available over the past year. Even a one percentage point change in a mortgage rate can increase the monthly payment by hundreds of dollars, and it’s unclear how homebuyers will cope down the road. A study by CIBC in December said less than 4% of Canadian households would be vulnerable to rate increases, whereas the Bank of Canada estimated the number was considerably higher, at 5.9%. But so strained do Canadians feel that a survey from the Canadian Payroll Association in September found nearly 60% of the respondents said they would have trouble making ends meet if their paycheque was delayed by even one week. This group included many first-time buyers.
Canadians are clearly more than willing to take major financial risks to buy a home. What’s ironic is that real estate price gains can be somewhat of an illusion when inflation is taken into account. “People get fooled by nominal numbers,” Milevsky says. Long-term returns in real terms are less than spectacular. Harvard economics professor Edward Glaeser looked at the returns in more than 300 metropolitan areas in the U.S. between 1970 and 2000 (before the unsustainable credit-fuelled boom) and found prices increased on average only 1.7% annually. Yale School of Management professor Roger Ibbotson and a colleague examined returns between 1978 and 2004, a period including part of the U.S. housing bubble, and found residential real estate provided an annualized return of 8.6%. The S&P 500 significantly topped that with a 13.4% return.
Housing in Canada hasn’t behaved much differently. In 2004, Milevsky examined the compounded annual returns on residential real estate in a dozen Canadian cities over the past 25 years. Toronto provided the best return at 5.75%. But the TSX provided an 8.64% return over the same period. The S&P 500 index did even better during that period, at 13.85%. The drawback, of course, was that stock indexes were far more volatile than real estate, although in some markets, the difference was not so pronounced. Real estate in Vancouver, for example, provided only a 3.68% compounded annual return with nearly the same level of volatility as the S&P 500.
Homeowners can easily argue that while the returns are modest, at least they are building wealth rather than paying rent to a landlord. Leverage can also make a huge difference on returns for homeowners if they choose to sell. In crude terms, assume a 20% down payment on a $500,000 house that is sold a few years later for $550,000. After paying back the mortgage, the seller is left with a $50,000 profit, or a return of 50% on the initial down payment. As far as investments go, that is an eye-popping return. But leverage is damaging when prices fall. A homeowner can end up with outstanding mortgage payments worth more than the house.
There are also a slew of egregious fees associated with real estate that affect returns. There are home inspection and appraisal fees, which can total hundreds of dollars each, not to mention land registration fees, legal fees and perhaps title insurance to purchase. Real estate agents take a commission, too – expect to pay at least 2.5% of the purchase price of the home. Regular maintenance has to be done for the home to maintain its value, and that can quickly add up. Canadian personal finance authors Eric Tyson and Tony Martin say a home usually needs to appreciate about 15% in order for the buyer to recoup all of the transaction and maintenance costs.
A society of renters is also more mobile. Andrew Oswald, an economics professor at the University of Warwick in England, found that high unemployment goes hand-in-hand with high rates of home ownership. In Britain, unemployment doubled since 1950 as the share of the population that rented dropped from 60% to less than 10%. Oswald found similar relationships in other countries, such as Finland and Spain. The Netherlands and Switzerland, by contrast, had lower unemployment and a lower rate of home ownership. Oswald theorized that, while homeowners are often stuck with their property through tough labour markets, renters can more easily relocate to find work, which lessens structural unemployment. His theory has been criticized for placing too much emphasis on a causal link between home ownership and unemployment, but it does echo Fed economist Pence’s concern about the correlation between home prices and the job market. Prices fall when the labour market tanks. Everyone needs financial security during those uncertain times, but for homeowners, their greatest asset won’t necessarily deliver.
In December of last year, CIBC economist Benjamin Tal estimated home prices in Canada to be about 7% overvalued, which he deemed to be a “modest overshooting” that did not necessarily portend a dramatic price correction. Economists at TD Bank Financial Group put the overvaluation at 12%, adding it could rise to 15% this year as buying activity rages on. David Rosenberg, the chief economist and strategist now at Gluskin Sheff + Associates who called a U.S. housing bubble back in 2004, has a more pessimistic take. He says home prices in Canada are between 15% and 35% overvalued, and could plummet as far as 20% from current levels. “That isn’t cataclysmic, but believe me, that would hurt a lot of people,” he says. A drop that steep would wipe out virtually all of the gains made in the past year and could leave some Canadians who bought at the top of the market with negative equity in their homes.
Housing has undergone painful corrections in the past. The current crop of homebuyers is likely too young to remember the housing bubble that burst in 1981, and the slow recovery that followed. According to data from the Centre for Urban Economics and Real Estate at the Sauder School of Business in B.C., the average real home price in Vancouver took more than 10 years to get back to its peak, before dipping again in the mid-1990s. Calgary fared even worse. Home prices didn’t return to 1981 levels until the first quarter of 2006. Toronto homebuyers experienced a similar pain when a speculator-driven bubble burst around 1989. In real terms, prices didn’t recover until 2007.
A wait that long can be brutal for those who bought at the top of the market. It can also thwart retirement plans for those expecting to sell their homes and use the profits to downsize and fund their golden years, particularly if they’ve neglected to save by other means, such as with an RRSP. Canadians have a significant portion of their wealth tied up in real estate – roughly 48%, according to the Vanier Institute of the Family, the highest level in two decades. The fact that real estate markets do fall highlights the need for Canadians to prepare for wild swings in the economy. That message is perhaps more important than ever as the buying rush continues, and the market looks increasingly pricey. “If you’re going out buying a home today, understand that you’re not following the doctrine of buy low and sell high,” Rosenberg says. “You’re doing the exact opposite.”
The problem for policy-makers – and buyers trying to figure out the best time to enter the market – is that the existence of a bubble is impossible to know for certain until it pops. Gregory Klump, chief economist for the Canadian Real Estate Association, argues we are not yet in bubble territory. “I would describe this as a micro-cycle where demand is outstripping supply,” he says. Housing starts are rising, which will help to satisfy demand. Higher prices are also bringing the sellers back to the market who disappeared in 2008 when sales activity dropped, all of which will lead to a more balanced market later in the year. There are signs of optimism elsewhere, such as in the Canadian house-price forwards market operated by Teranet and the National Bank Financial Group. The market allows investors to essentially place bets on where prices are headed, and the index reflects their collective sentiment. As of January, the index showed investors expect a bump of up to 9% in residential real estate by 2014. (Those investors have been wrong before, of course; last year, the index showed a potential nosedive of more than 20%, the exact opposite of what transpired.)
Not everyone is so sanguine about the market. “We’re not in a classic bubble yet, but some of the pre-conditions are certainly in place,” says Douglas Porter, deputy chief economist at BMO Capital Markets. One of his concerns is that the central bank is not going to raise interest rates any time soon. Carney pledged to keep rates steady until at least mid-year, and that could mean several more months of frenzied buying. The longer home prices continue to rise out of sync with the rest of the economy, the more worrying the situation becomes. Prices have already skyrocketed while incomes have barely moved, and the home-price-to-income ratio in Canada is at its highest level since the early 1990s.
Scotia Capital economist Holt sees a few possible outcomes as the temporary factors supporting the housing market start to wane. One is a “soft landing,” where activity cools gradually. The other is a rapid decline. Holt says the speed at which the market recovered since last year lessens the odds of a soft landing. “We’ve had four or five drivers of the housing market leading toward strong house price gains in a very short period of time, and I think they all come off simultaneously,” he says. “That points to just as quick a descent.” The new federal mortgage changes will cause the housing market to “turbo-charge” over the next while, according to TD Securities’ chief economics and currency strategist Eric Lascelles, as buyers rush to get in ahead of the implementation date in late April. Once that day passes, the new rules become just another factor that, in Holt’s view, will contribute to lower prices and sales activity in the months ahead.
Ultimately, all of the uncertainty and concern around residential real estate is likely not going to deter many people from purchasing a home. A house is much more than an investment, after all. It is firstly a place to live. Even Milevsky, the finance professor at Schulich, caved and bought a house after resisting for a while. “We have a large family, and they wanted somewhere to call their own,” he says. If prices fall, a home still provides a roof over one’s head, unlike a stock portfolio. The danger comes when people link the idea of a house as a home with the idea of a house as an investment, particularly if they stretch their finances with the expectation of getting rich in a few short years. “There can be long periods of time where the real appreciation of housing is negative,” Milevsky says. “All of that means is caution is warranted.”