Canadian Real Estate is one of a few things that really unite all those very different people living here. (Apart from beer, TV, hockey and few other highly intellectual activities). It really does unite people, not only for a reason that we all need some place to live in, but for the most part because of a truly firm consensus that you are unlikely to loose by buying a house or a condo here. This common belief is very well supported by many reasons of different levels of insanity. In this paper I propose to have a closer look at few major myths associated with Canadian Real Estate. Starting with the first one:
Buying a house is an investment. Indeed, the main catch-phrase which comes to everyone’s mind when thinking of a Real Estate buying is: building one’s equity. The typical line of thinking behind this may very well be expressed as the following insight: “I do not wish to rent and give away my money. Instead I want my money to work for me, so by gradually paying out my mortgage I build my equity, thus investing in my future.” Sounds familiar, right? It all means that the majority of home buyers in Canada perceive this as some sort of investment plan. The general idea behind such ‘plans’ is that you regularly invest in some ‘should appreciate forever’ asset thus growing your equity towards your ‘should come at some point’ retirement. Now, let’s look deeper into this long term ‘equity building’ strategy. In order to do this I propose to use much less complicated example of RRSP or any other long term investment plan. Why is it less complex than Real Estate investment? First of all, it doesn’t involve borrowing thus nothing depends upon interest rates, credit ratings etc. Secondly, owning mutual funds, stocks or bonds doesn’t involve any ‘maintenance fees’ or property taxes. It is pure investment of your hard earned cash into certain asset. Your investment outcome depends upon only one thing - the behavior of that asset’s price. Period. Let‘s assume that today (yes, today) someone called Mr. D’Lusional Jr. has just got his first job and has decided to start contributing some cash towards his retirement. Being a cautious person, Mr. D‘Lusional has approached a financial advisor at his local bank. After being told that his decision is very wise and that he looks and talks much smarter than a typical mammal of his age, our hero was given a brief lecture on investment. Financial advisor told Mr. D’Lusional that different asset classes expose his money to different types of risk. She talked about risk balancing, investment horizon and so on. She kindly informed him that government bonds are considered to be the least risky asset so a ‘well balanced portfolio’ should include a good chunk of those and so forth. At the end of that meeting Mr. D’Lusional knew he was doing the right thing. And it wasn’t just because of the advisor’s speech but mainly because there was a big poster on the advisor’s office wall. Like this:*
*In fact, I encourage everyone to look up in your local bank financial advisor’s office. There is a 90% chance that chart is still there. Although not necessarily exactly this one, but almost identical for sure.
Looking at this nicely designed poster, which shows the long term history of different asset classes, it is quite clear that you can safely invest in almost anything. All asset classes are growing. There are some bumps along the way but in general each and every line points towards north-east. However, the most important part of this chart is that even when the price goes down somewhat (say 15-20%) it tends to recover within few years. This means that if your ‘investment horizon’ is no less than 20 years (quite comparable with the typical mortgage term) your money will grow regardless of any occasional ‘corrections’. In fact, there is only one scenario which might really ruin you - if prices fall for twenty or more years and never recover to the point when you initiated you ‘investment plan’.
Like this:
What the f*@k is that? Well, this is the chart which no financial advisor would ever show you - the chart of Japanese stock market index NIKKEI. The left half represents the gradual rise towards 1989 peak at nearly 40.000 points while the right part illustrates how your ‘investment plan’ might go really wrong with prices falling nearly 4 times with no sign of any recovery for more than twenty years. This chart does not represent the stockmarket of some insignificant banana republic devastated by civil war - in fact, you are looking at the stockmarket of one of the top industrial countries of the world. Did they try to fix it? Yes, they are still trying to no avail. Japanese Central Bank has lowered interest rates to zero. They are buying their own government bonds, printing money like hell and doing every single trick US Federal Reserve is doing today. Results? Nothing! Nil! Zero! For more than twenty years. And by the way, here is the chart of Japanese Real Estate prices for you to enjoy:
Residential prices has collapsed more than 2 times (from 250 to 100 points) while commercial real estate has become 5 times cheaper.
So, the main lesson here is this: asset prices can depreciate significantly and you might never see your initial investment money coming back in your lifetime. This rule applies to everything including real estate. Once bubble pops game over and so far the best minds in the world have not figured out how to fix this.
‘What does Japanese bubble have to do with Canada and how do we know if we have a real estate bubble here? First, let’s talk about bubbles. For instance, in the ideal world the fact that oil cost has jumped from 50 to 150 dollars/barrel in one year means that people have tripled their fuel consumption during the same period. However, in the real world this is not the case. There are always two types of demand for any asset out there. Real demand (people need oil to produce petrol for their cars) and speculative demand (brokers are stockpiling oil in off-shore tankers to sell it later at a higher price). While people might have indeed increased fuel consumption during that year by 10% (say, the Chinese bought more cars), speculators has bought much more in anticipation of juicy profits in the future. Meaning that 150 dollar price tag is supported mostly by speculators and not that much by real consumers. In our example increase of 10% in consumption supports $50 + 10% = 55 dollars/barrel and extra 95 dollars on top of that is a pure speculative bubble which is unlikely to last. (In 2008-2009 oil prices collapsed from 150 to 40 dollars in no time for that very reason). Now, let’s go back to real estate. Is there any way to figure out a ‘real’ non-speculative price of properties? Yes there is. In fact there are at least two widely recognized indicators: 1) How much people are paying for their rent. Why this is so important? When people are renting their place they are definitely NOT speculating. They are NOT investing. They are simply paying for a roof. So any increase in real demand for dwelling would almost immediately affect rents - more people are willing to live in the certain area and supply of new homes can not be increased very fast - so the rents would go up.
Mind the gap!
I believe this chart needs very little explanation, if any. For 30 years the rent index in Toronto has been gradually increasing and there is no doubt that this reflects population growth, inflation and some other natural factors quite fairly. In fact all that buzz that ‘more immigrants coming to Canada - so they would need more place to live - so real estate will never depreciate and so forth’ is nonsence. Rents (red line) has already absorbed all that ‘growth’ by rising over 2,5 fold in 30 years. However, house prices (blue line) just rocketed up as if there is no tomorrow. That gap between blue and red lines is what speculators have done to the market and that is a very vivid picture of the coming collapse. In order to somehow match the ‘real’ demand house prices should be cut in half.
The following chart doesn’t help out real estate prices either:
According to this picture, as of second quarter 2011 Canadian Price-to-Rent ratio (the size of that gap from the previous chart) is THE highest among top industrial nations in the world. You might notice, that even the fact that Japanese real estate is ‘dirt cheap’ compared to the historical average doesn’t help them much. Once deflationary spiral takes hold prices can collapse far beyond rational and most importantly stay there for decades. That means that prices do not have to stop at median line and can easily proceed to collapse further. In our case that would mean houses loosing more than half of their current value and staying at those levels for a long time to come. The idea of rent representing real demand brings us to the issue #2: Affordability. Another historical proportion which really helps in identifying real estate speculation. Median house prices versus median incomes.
It is clear that family income affects home buyers. The amount you can pay every month for your mortgage is limited by your income so any increase in mortgage rates would mean houses become less affordable. In fact, an increase of only 1% in mortgage rates would increase your monthly payment by at least 8%. Do you realize what it means? Just 1% increase in rates would mean that the whole freaking Canada would have to come up with around 8% growth in their incomes just to keep all properties. If they can’t come up with that extra cash - then they would be forced to sell. With higher rates there would be fewer buyers so Japanese real estate scenario doesn’t look that unprobable at all... On the other hand, those who rent can’t face such a dramatic increase in their cost of living, because according to the law the rent can not be increased by more than 0.7% a year. So those of you, homeowners, who believe that renters would help you out are mistaken. Renters would simply go for less fancy style of living as opposed to suddenly starting paying you 8% more just that you can pass those money to the bank. No, Sir.
All this leads us to the second popular myth from Canadian Real Estate la-la-la land:
Buying is better then renting Indeed, why would someone give his money away as opposed to paying for his own place and ‘building his equity’? Let us look into that with real numbers. Since I really prefer living in condos I would give you calculations based on my own experience and things that I know for fact. At this very moment you might find quite comfortable 2 bedroom condominium with good amenities at a nice location for 1,800.00 dollars a month. You pay nothing above. Everything is included and you have no obligations beyond your lease agreement of say 1 year. Now, let’s assume you would buy this place. This condo has a price tag of 400,000.00 dollars at least. Suppose your downpayment is 80,000.00 or 20% of the list price, the rate is 3% 5-year fixed and amortization period is 20 years. Those are quite realistic (even optimistic) assumptions as you may check out for yourself. As the result you pay: 1) CAD 1,771.74/month to the bank 2) CAD 333.33/month property tax (CAD 4000/year) 3) CAD 400.00/month maintenance fees + utilities* So, during those 20 years you would be paying CAD 2,505.00/month out of which only CAD 1,333.33 would go directly towards you equity. The funny thing is that if you are living in a condo which could be rented for CAD 1,800.00 but paying CAD 2,500.00 this means that you can rent it and save CAD 700.00 /month. So, given that you have 80,000.00 for your downpayment let’s see what you can achieve with all that while living at the same place:
The simple online calculator informs us that by investing 80,000.00 dollars at once and contributing 700.00 each month for 20 years you would get CAD 297,741.17 in the end. Well, that is less than 400,000.00 but the risk in minimal. Next to nothing. Which brings us to the topic of RISKS! Namely: 1) Real Estate prices might go down (hard to assume they wouldn’t) 2) Interest rates might go up. Since we have covered the first issue before, let’s look into interest rates. First of all we would agree upon the single most important factor which determines rates. And that factor is the risk of default. The interest rate for good ‘class A’ borrower would be lower than that for a bad ‘class F’ borrower. It’s pure math and logic: if an average statistical chance of default by ‘class A’ borrower is 1% this means bank must charge those people at least 1% just to get it’s money back (say bank has lent money to 100 ‘class A’ people. 99 pay for the chance of 1 defaulting). The same bank would charge ‘class F’ borrowers 20 % because historically this group has defaulted 20 times more often and so on. In order to find out how low (or high) our current rates are we should compare ourselves to THE BEST borrower out there. By THE BEST I don’t mean someone who would never default on his promises, I simply mean someone who would be the last to default on this damned planet:
*in reality maintenance fees would grow from around 200/month when building is new up to 600/month during those 20 years, for simplicity I took the median price of CAD 400. Even if we talk about houses as opposed to condos consider that any real estate requires maintenance and utilities which typically would be no less than 1% a year - so our calculations are valid for any type of property out there.
Please, meet Uncle Sam!
Like it or not, The United States of freaking America is THE most powerful economy on Earth supported by global military domination and the United States government has the power to collect taxes form all that - pure and simple. So we are safe to assume (and global credit markets concur) that if any bank or person is willing to lend some money - the safest bet is Uncle Sam. You might be interested to know, how much does it cost for American government to borrow money for the same period of 20 years? I’m pleased to report that 20-year US treasury bonds yield exactly 2.65% as of January 2013. If you are about to tell me that the chance of US government defaulting on it’s obligations is more or less similar to that of an average Canadian I would propose you stop reading this paper and have your head examined now. These two entities are simply incomparable. ‘How come, - you may ask - Canadian banks are lending money to us at nearly the same rate as to the US government at the moment?’ Well, let us see. Decisions in any big corporation (banks included) are made by few people (managers) who don’t give a shit about anything except for their salaries and bonuses (humans, you know). Their personal wealth depends upon their ability to grow business, which means more loans and mortgages. Period. As the result they are quite happy to ruin the whole bank in the future by getting more people to become their clients today and collecting good bonuses this year. So they ‘adjust’ risk assessment models to the point when more people can afford to pay loans back (at least for now). ‘Now, that’s a relief - you may say - those greedy managers would definitely go on and charge us 3% for a long time to come - so I shouldn’t be worried?’ No Sir. Even their level of insanity has a limit - and that limit is (you guess it) those 20-year loans to US government rates. Banks can close their eyes and give money to anybody at nearly the same rate but they can not charge you LESS. Because at that point even the insanest bank manager of all would prefer to give a loan to US government - which is many times safer and easier thing to do. Bottom line: While chances are slim that banks would continue to give you loans at nearly the same rates as to the US government there is NO CHANCE at all that someday your mortgage rates would become less that those of the US government. Your personal well-being hugely depends upon world credit markets and these markets look like this:
As you may see, interest rates are at their historical lows. I would like to draw you attention to period at around 1980, when according to the chart rates have risen to more than 15%. You think that would never repeat? Think again. Even if we assume that 18% is a joke form 80-s we would be very foolish if we don’t ask ourselves much simpler question: what is the historical mean? (average rates of the last 50 years if you will). According to the above chart it is somewhere between 8% and 10%. We will get there for sure within 5-10 years. Even if bankers would be still considering average Canadian borrower as good as the US government (I don’t think so), the US government itself would experience rising rates of borrowing just because politicians love to promise things, which in reality societies can not afford (Obama-care for instance). Within 5-10 years USA would face the same problems as Greece, Spain, Italy, Ireland etc. has just experienced on the other side of the pond - namely sovereign debt problem and rising rates. Yes they would be the last to see that but it doesn’t help you much, because once those insanely low US interest rates would start rising - your rates would rise too. And at much faster pace. So let’s go back to your condo: You just bought it for CAD 400,000.00, paying down 80,000.00 at 3% 5-year fixed with 20 year amortization period. You pay CAD 1,771.74/month to the bank + CAD 333.33/month in property tax + CAD 400.00/month in maintenance fees + utilities = CAD 2,505.00 monthly. That is almost guaranteed for the next 5 years. Based on what we just have learned about interest rates and their history let’s assume a fairly sane increase of rates in next 5 years towards 6%. It is very realistic assumption (I would say even optimistic one) from historical perspective. Now, what would be your numbers then? You (as a condo owner) would be faced with at least CAD 500/month increase in your monthly payments once the 5 year fixed period expires. When rates increase (personally, I doubt that rates will stop rising until we reach middle teen figures) you would be facing 3 possibilities: 1) Continue paying. That is fine, but only if you can afford that. You can? Hold on a second, than means that you are able to rent the same apartment and contribute not 700 but 1,200 dollars each month towards your very safe saving plan with ING DIRECT (or any other bank for that matter). Hm... CAD 435,569.68 that is even more than 400K.
If you are a saver as opposed to property buyer/borrower an increase in interest rates would mean banks will pay you more that lousy 1.35% for you money. The increase in rates will work in your favour. While being a borrower at that point means paying more to the bank in a form of interest. That’s what I call giving away your money... 2) You might rent this place out to help you pay your mortgage and move to a less stylish place. The question here is: why didn’t you do it the first place so you could contribute more to your savings and not oblige yourself with monthly payments for 20 years? Besides we have already concluded that renters will NOT absorb that huge jump in cost so most likely you and others like you would go for option #3 3) Sell the property you can no longer afford. This happening across the country would make prices collapse, inducing more selling and further property depreciation. One of the side effects would be an unpleasant feeling that your downpayment is gone, once your property looses 20% or more of it’s value. After 5 years you still owe say 240,000.00 to the bank. At that point your property is worth 320,000.00 so out of 80,000.00 downpaynent + 80,000.00 equity you’ve already built during 5 years* there is only 80,000.00 left. See? 20% ‘correction’ in prices wipes out half of your equity.
*Reality is even worse since your payments of first 5 years are mostly going towards interest.
So, let’s recap what we have learned: 1) House prices in Toronto (as well as in the whole Canada) are at a historical highs by all standards. By ‘standards’ I mean not only nominal price but mostly price relative to rents and incomes. This would not last! 2) Interest rates throughout the world are at a historical lows Combine these two and you can see that your chance of winning with home buying today are pathetic to say the least. If you are still insisting on obliging yourself with mortgage payments for the next 20 years while you can save your extra cash and build your equity with almost zero risk at any bank and rent your place at the same time... I‘m speechless.. In fact, by buying anything here today you are betting that rates are unlikely to go up and house prices are unlikely to go down for at least 20 years to come. I wouldn’t do that.
If you have any further questions - feel free to contact me at yurisergeev@yahoo.com Cheers.