Housing: Real insanity
Our obsession with homes rests on a shaky foundation. How much longer can we afford it?
By Joe Castaldo
Canadians have come to view home ownership as a right, a belief that has intensified over the past decade as we’ve piled into the market. Real estate today is a central force in our culture and economy. Nearly 70% of us are owners, the highest level on record. Those who do not own long to in the future. A survey by private mortgage insurer Genworth Financial Canada released in 2009 found 68% of renters would delay major purchases and more than half would give up vacations if it enabled them to own a home.
For a renter past the age of 30, the pressure to buy is relentless. Friends take the plunge, and conversation shifts to mortgage rates, square footage and renovation plans. You feel compelled to defend your decision to abstain in the face of confusion, perhaps even pity, among homeowners you know. But doubt picks away at your conviction, and the fear grows that not yet owning a home shows a failure to enter adulthood, putting you at risk socially and financially. As headlines trumpet house price gains each month, the anxiety surges.
If that sounds like you, chances are you’ll eventually cave, joining the masses who drool over shelter magazines, troll MLS for fun, pop into open houses just to gawk, and tune into the endless stream of TV shows about buying, flipping, renovating, decorating and selling homes. “It becomes self-perpetuating,” says Alexandre Pestov of Toronto economics firm Three Bears Research. “You get all of these TV programs promoting this type of behaviour, and more and more people get sucked into it.”
Financially speaking, at least, the past decade has been a great one for owning a home. Resale prices increased by an average of 7% each year, and more than 10% between 2002 and 2007. And the market is still going strong. The average resale price rose 6% between January and February.
But amid this frenzied property chase, we’ve forgotten a crucial fact: the past decade has been far from typical for real estate. Between the late 1990s and 2006, the share of homeowners jumped four%age points, to 68.4%. Now consider that it took from 1971 to 1996 for the ownership rate to increase that much. (Though Statistics Canada data are only available up to 2006, it’s likely the next census will show the rate has risen further.) Prices nationwide have never appreciated like this before, and credit has never been so easy to come by, nor as cheap. For an entire generation of first-time homebuyers, these conditions are the norm. Their perceptions have been warped as a result.
This environment cannot last, and our decade-long real estate boom has left us in a dangerous situation. As prices have kept rising, Canadians have eagerly taken on mortgages, and household debt levels have soared to record levels. Some economists contend that we’re perched on top of a bubble that’s poised to burst or slowly deflate. Even the optimists say the best years for growth are behind us.
Yet the country has a lot riding on keeping housing aloft. Home equity accounts for roughly a third of the average Canadian’s net worth, and one-fifth of our gross domestic product is driven by housing-related spending, from renovations to new appliances. Hundreds of thousands of jobs are tied to the sector. The Canada Mortgage and Housing Corp., meanwhile, backs $473-billion worth of mortgages; if the Crown corporation were to run into trouble due to defaults, we’re all ultimately on the hook.
Everyone needs a place to live, of course. But we have inflated the significance of home ownership, and our governments have supported our ambitions, to a greater degree than in many other countries, partly in the belief that ownership benefits society at large. A closer look shows many of our assumptions about ownership are wrong. The economic consequences may now be painful. Past real estate bubbles were isolated to individual cities. This time, all six of Canada’s major real estate markets — Vancouver, Calgary, Edmonton, Toronto, Ottawa and Montreal — have seen strong growth, suggesting that if there is a correction, the fallout will be widespread. It’s time to ask what our real estate obsession in the past decade could cost us in the next one.
Nino Ricci, an award-winning novelist, purchased a detached home in Toronto’s Riverdale neighbourhood in 1997 with his wife, also a writer. The price was at the very limit of what they could afford, even with help from both sets of parents. They managed, however, and watched as the neighbourhood gentrified and the value of their home ballooned. “I’ve earned more from the increase in the value of my home than I have in my entire professional career as a writer,” Ricci says. “But the only way I can use that money is to run a credit line, and that’s a dangerous habit to get into.”
Still, a line of credit against the value of their home is how Ricci, his wife and two kids fund a portion of their admittedly frugal lifestyle, particularly when paycheques become sporadic. During especially tight periods, Ricci makes interest payments on the credit line with money from the line itself. (“There’s nothing in the rules that prohibits that,” he says with a hint of mischief.) Ricci knows this pattern may not be sustainable. The implications of an interest rate increase worry him, but an even bigger concern is what will happen if his home drops in value. “I keep wondering, should I sell my home today? Is this my last chance to actually have retirement savings?” he says. “We’re both writers. We don’t have RRSPs or any assurance for the future.”
Having your entire financial worth wrapped up in a house and living on its nominal value is a risky situation. But in a way, Ricci is only following cultural norms. Homes today fulfill much more than a need for shelter. They are physical representations of our tastes and the lives we lead — or wish we led. Last year, Los Angeles Times columnist Meghan Daum chronicled a lifetime of housing lust in a memoir whose title sums up a common attitude: Life Would Be Perfect if I Lived in That House. “Few things in this world are capable of eliciting such urgent, even painful yearning,” she writes.
Canada has a long history of embracing property ownership (it was once a requirement to vote), and government policy continues to support it. “It’s a virtuous circle,” says Phil Soper, CEO of Royal LePage. “Governments have been elected over the years for putting forward policies that encourage home ownership, and people have in turn viewed it as good policy.” Ottawa created what would become the CMHC in 1946 to house veterans after the war. By insuring any qualified mortgage worth more than 80% of a property’s value, it is still the primary mechanism enabling Canadians to afford homes. Other measures, such as the capital-gains tax exemption on sales of principle residences and the tax-free withdrawal of cash from RRSPs for a down payment on a first home, further support our desire to own.
Politically, it makes sense for governments to cater to homeowners, a powerful voting lobby. But part of the logic behind supporting ownership is that it’s for society. The prevailing wisdom is that homeowners vote and volunteer more than renters. They’re more engaged with their communities. They’re even healthier. In short, property ownership makes better citizens.
The evidence for this is dubious. William Rohe, director of the Center for Urban and Regional Studies at the University of North Carolina at Chapel Hill, summarized the existing research a few years ago for a Harvard University housing journal. He found that homeowners have higher self-esteem than renters, but pointed out that the original studies may not have adequately controlled for other contributing factors. Numerous studies also show that homeowners participate more in volunteer organizations and political activities. It’s still unclear, wrote Rohe, whether ownership actually leads to this behaviour. Yet another purported benefit of ownership is that it fosters better education for children. Again, the evidence is weak. A paper in the journal Real Estate Economics published in 2008 examined much of the literature using more sophisticated analytical techniques. It found that children of American homeowners scored no better on math and reading tests than renters’ kids, nor did they have lower high-school dropout rates.
Neighbourhoods dominated by homeowners do have lower resident turnover, but there is a downside to that stability. During tough economic times, falling home values can trap lower-income families in distressed neighbourhoods. Studies, in fact, have linked high rates of home ownership to high levels of unemployment, suggesting that homeowners are less willing or able to relocate to find work. That’s why academics such as Richard Florida have argued that a shift to renting in the U.S. could help address the country’s dreadful unemployment rate, since it would make Americans more mobile.
Grace Bucchianeri, a professor of real estate at the Wharton School of Business, found the societal benefits of home ownership to be similarly overblown when she examined data collected from 600 women in Ohio. She found little evidence to support the idea that owners participate in civic and community activities any more than renters, and after controlling for factors such as income, housing quality and health, she concluded that owners were no happier. In fact, they spent less time on leisure activities and socializing with friends than their renting counterparts. When you look beneath our assumptions, Bucchianeri writes in her 2009 study, “the intuitive link between home ownership and well-being breaks down.”
As for the renter’s fear of losing out financially, that too is exaggerated. Today, the average home-price-to-rent ratio is at its highest level on record, which means renting may actually be more affordable than paying a mortgage. Furthermore, a 2007 study from the UBC Centre for Urban Economics and Real Estate found that over the past three decades, renters could have beat homeowners’ financial results. The study examined the theoretical returns of buying versus renting in nine Canadian cities. In four of them, renters who invested wisely could accumulate 24% more wealth than homeowners, and match it in three others. Renters come out behind only in Toronto and Calgary. The problem is, most of us lack the financial discipline to save and invest.
Considering the inconclusive research, it might be time to rethink the degree to which governments support homeownership. David Hulchanski, an associate director of research at Cities Centre at the University of Toronto, for one, argues that our current system punishes renters. The feds used to provide subsidies to encourage companies to build rental accommodations, but by the 1980s, these had all been eliminated. “When the last one was killed, it was totally not feasible to build [apartment buildings],” he says. Developers found it more lucrative to focus on condominiums, which many renters can’t afford. Low-income Canadians, for whom ownership may never be attainable, are stuck with old, poor-quality rental stock.
Housing policy should stop blindly favouring ownership, Hulchanski argues. Eliminating the capital-gains tax exemption on home sales would be one way to free up some cash. “That’s billions that could be used on rental or social housing, and we rebalance the system,” he says. He knows the prospects of that are next to zero, however. “Even the NDP is silent on it.”
Where home ownership has benefited Canadians most over the past 10 years is where we now have the most to lose: our net worth. Houses have a forced saving effect. Wealth accumulates in the home as the owner pays down the mortgage. All the better if the value of the home increases.
Having so much locked in a single asset is also inherently risky. Moshe Milevsky, a finance professor at the Schulich School of Business, argues in his recent book, Your Money Matters, that many people should purchase later in life. When you’re young, he explains, the majority of your wealth is tied up in human capital, meaning your skills and the knowledge you employ to earn income. It’s illogical to then put most of your monetary wealth in yet another illiquid, undiversified asset. Only later in life, after you’ve exhausted your earning potential and saved money, does it make sense to buy a home, Milevsky contends.
But low interest rates have proven irresistible for middle-class Canada. For decades, we were at the mercy of double-digit and wildly fluctuating rates. Mortgage costs were substantial, and the chances of paying a significantly higher rate when it came time to renew dissuaded us from taking on too much debt. Then, in the early 1990s, the Bank of Canada began inflation targeting, which brought down interest rates and made the carrying costs of debt far more manageable. Home ownership became possible for millions of Canadians. The federal government further opened the doors in 2006 by allowing the CMHC to insure 40-year-long, zero-down mortgages, though it reversed the decision two years later.
The push toward home buying has had two effects. One was to send household debt levels up to nearly 150% of income, a record. And two, home values have skyrocketed. From 1999 to the end of 2010, the average resale home value rose 110%. In contrast, prices were largely flat during the 1990s. Both changes are worrying. Having acquired so much debt, Canadians are vulnerable to rate increases, and housing price gains have vastly outpaced wage growth. For some economists, the surge in home ownership, house prices and credit without strong income growth equals only one thing: a bubble.
David Rosenberg, chief economist at investment firm Gluskin Sheff, has been among the most bearish on Canadian housing, saying last year that prices could drop 20%. David Madani at Toronto research firm Capital Economics was even more pessimistic when he published a report in February predicting prices could fall 25% over the next few years. “It’s psychology driving the market,” he says. “We looked at income, supply, demographics, interest rates and took all of these things into account, and we still come up short in trying to explain why people have been so willing to pay higher and higher home prices relative to their income.”
Eventually, prices and incomes have to converge. Right now, home prices stand at more than five times incomes, well above the historical norm of 3.5. In Madani’s view, the only way to close the gap is for prices to fall. “These situations never have a happy ending,” he says.
COMMENT: But that is a stupid measurement. Prices are moot, we do not pay the full value of the house when we buy it. We pay mortgages. Thus, income to mortgage payment is the accurate measurement. But the doomsayers do not like that one, as it has not changed much in the past 30 years. When my father bought his house for $200,000 in 1983 with an 18% mortgage, his payments would have been around $2,400 a month with 20% down. A $600,000 house now, with a 3.79% mortgage and 20% down is barely $100 a month more. Couples with children saw median income rise 20% from 1980 to 2005, while childless couples saw an increase just under 15%. And mortgage payments only increased 4%. Thus, mortgages are actually CHEAPER today than they were three decades ago. That is why the real estate market is roaring along so well, affordability is better than it has been in a generation.
The effects of such a decline would be far-reaching. When we feel wealthy, we spend more, and a lot of it is tied to our homes. Housing-related spending accounts for 20% of the country’s GDP, and home-renovation expenditures have swelled from 1.6% of GDP in 2000 to 2.8%. But if our net worth takes a hit, we’ll stop spending to save and pay down debt, and economic growth will slow. A pullback in renovations alone could hamper GDP growth by 1%, according to Madani. The construction sector would also feel pain. It accounts for 7% of overall employment today, and could shrink to its long-term average of 5.5%, marking the loss of 250,000 jobs.
The extent of the potential damage to household balance sheets is unclear. The CMHC points out that the average equity in the properties it backs is 45%, meaning that if prices fall, it’s unlikely that many households would end up owing more on their mortgages than their houses are worth, as happened to so many in the U.S. But the CMHC does not disclose the full breakdown of its loan portfolio. We don’t really know how many people have minimal equity in their homes or what their mortgage terms are. “The CMHC seems to think the average equity in their portfolio matters,” Madani says. “But it doesn’t. It’s the tail end of the distribution that matters.”
Critics charge that independent risk assessment of the CMHC is virtually impossible, a pertinent point given the heightened fears of a bubble. The C.D. Howe Institute recently published a paper arguing that the risk to taxpayers is unacceptable, and urged the government to pull back from the mortgage-insurance business. The corporation does have an ample cash cushion in case of mortgage defaults, but that didn’t stop Rosenberg from writing last year that the possibility of a taxpayer bailout is “near the top of our concern list.”
Few other economists are worried about CMHC liability, however. Sheryl King with Bank of America Merrill Lynch in Toronto, for example, says the structure of Canada’s mortgage market and strict lending standards greatly reduce the possibility of a U.S.-style meltdown. The signs of a classic bubble, such as a run-up in real estate speculation and oversupply, are also absent, and even though home prices are high, there is no reason to think they’ll plummet. “You usually need an economic event to spark a big decline in home prices,” she says. “Canada is not faced with that type of situation.” While the global economy remains fragile, our situation domestically is comparatively rosy. “The Canadian economy is doing well, and it’s recovered from the recession,” says Craig Alexander, chief economist at TD Bank Financial. One factor that could seriously impact home prices is rapidly rising inflation, which would force the Bank of Canada to raise rates. But a spike in core inflation is a very low possibility, Alexander says.
What most agree on is that the coming years will be very different from the past decade for real estate. Homeowners have experienced only falling rates, which increase affordability. But rates are now so low that they can only move up from here. “When I give seminars, I really have to stress just how unusual this situation is,” Alexander says. When rates rise, affordability will erode, buying activity will slow and home prices will stagnate. The effect could be greater if the federal government continues tightening mortgage rules by reducing the maximum amortization period from the current 30 years back to 25. “It’s possible we’ve seen the best days of price appreciation,” King says.
Homeowners expecting the blockbuster growth rates of the 2000s will be disappointed, and those who bought at the peak of the market won’t see much increase in value. The next few years could more closely resemble the 1990s, a sleepy period for real estate, to allow incomes to catch up to prices. Even in a flat housing market, consumer spending could weaken since homeowners will not feel as rich as they do when prices rise. “We’re talking about lower rates of growth than we’ve had,” says Soper at Royal LePage, “and you’ll see it in all housing-related industries.” That means slowdowns for agents, contractors, decorators and countless others who earn a living from the real estate economy.
Let’s hope such an optimistic denouement to our housing frenzy plays out. Of one thing we can be certain: the great surge into home ownership is over for now. “When we look at the rate 10 years from now, it probably won’t have gone up at all,” Alexander says. The best-case scenario, in fact, may be for real estate to become boring again. The social pressure to buy could dissipate, and the urges propelling us into ever larger, pricier homes could lessen. Houses might even go back to being merely places to live.
Contact the Jeffrey Team for more information – 416-388-1960
Laurin & Natalie Jeffrey are Toronto Realtors with Century 21 Regal Realty.
They did not write these articles, they just reproduce them here for people
who are interested in Toronto real estate. They do not work for any builders.
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