One of the hottest topics this year has been the Canadian housing market, particularly in Toronto and Vancouver, which have seen home prices rise to astonishing levels. Throughout this extravagant bonanza, we have heard countless horror stories of individuals far exceeding their financial capacity in order to buy a house or condo. After listening to these stories it has become apparent that many individuals do not realize the financial commitments that they have locked themselves into. These financial commitments will undoubtedly burden them for the better part of their remaining years. Hence the title of this article: Home Ownership: The New Life Sentence?
In this article we will address the following topics:
Where we are today
“The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.” – Silas Marner by George Eliot
One of the most common biases is the extrapolation of historical trends into the future. As housing prices in Canada have only gone in one direction for the better part of three decades, it is no surprise that its citizens have succumbed to this bias and forgotten the laws of gravity. For much of this period, home prices were supported by encouraging fundamental trends such as nationwide employment, rising incomes, increased immigration and, in particular, lower interest rates.
Unfortunately, lower interest rates, which reduce the cost of borrowing for consumers, typically provoke reckless financial behavior, by enticing consumers to load up on cheap debt and spend beyond their means. Canadians have drunk the Kool-Aid and now owe $1.67 for every $1.00 of income (up from $1.39 a decade ago). This behavior is easily observed in the housing market where wannabe home owners, thanks to very low mortgage rates, are fooled by the false perception that they can take on a bigger mortgage. When consumers abuse the power of lower interest rates, eventually prices tend to diverge from their fundamentals. Generally proof of this divergence comes from affordability. In other words, if the top earners are finding it difficult to purchase a home, it is not a good sign for the housing market. (More on this below)
Too much debt inevitably leads to a period of mandatory deleveraging accompanied by a financial crisis. This phenomenon, academically termed a “Minsky Moment,” arises naturally when a long period of stability and complacency eventually leads to the build-up of excess debt and over-leveraging. At some point gravity takes over and the overvalued market resets as the following graph clearly shows for the U.S. housing market. Canada will be no exception to this.
As with any investment, when markets appear overvalued you are better off moving to the sidelines and waiting for a better entry point. Given that according to Global News, more than half of Canadians are $200 away each month from not being able to pay their bills, we are probably a lot closer than we know.
Understand the Carrying Costs: understand all the costs and your limits
The cost of owning a home is not limited to only principal and interest mortgage payments. There are other additional reoccurring costs that must be considered such as ongoing maintenance, utility payments and property taxes. Adding all these recurring costs together gives you your “carrying costs.” As a typical rule, carrying costs should not exceed 30% of your monthly pre-tax income. Abiding by this discipline allows your excess income to cover your living expenses, save an appropriate amount for retirement and most importantly provides a margin of safety should your carry costs increase unexpectedly (i.e. mortgage rate increases upon renewal).
In order to get a better idea on all the costs associated with owning a home, we have included the example below:
It should now be clear that the down payment is not the only payment required upfront. As this example illustrates, the actual upfront payment is $126,033, or an amount 38% higher than the down payment of $91,657. Additionally, the actual reoccurring monthly payment of $5,439 is 31% higher than just the mortgage payments of $4,157. All these expenditures are very real costs that must be paid.
The Royal Bank of Canada (RBC) closely tracks carrying cost as a percentage of the median pre-tax household income, known as the “Housing Affordability Measure.” [RBC’s assumptions assume a 25% down payment, 25 year mortgage at a 5 year fixed rate]. The higher this measure the more financially straining it is to own a home. As RBC’s September Housing Trends and Affordability report illustrates, the affordability index continues to worsen and is now at its worst level since 1990. The affordability measure in Canada for a single family detached home is 52.4%. In Toronto, this measure is 92.4% and in Vancouver it is a whopping 114.6%! These measures have never looked worse. The mortgage carrying costs alone, (just mortgage payments) in Toronto are 65% and 75% in Vancouver. This compares to cities like Ottawa, Calgary and Halifax with more reasonable mortgage carrying costs of 28%, 20% and 25%, respectively of pre-tax household income.
The Toronto Real Estate Board estimates that first-time buyers accounted for over half of Greater Toronto Area (GTA) home sales last year. This means that these young individuals have locked in a very large part of their household income for the next 25 years, just to cover the costs of owning the roof over their heads, leaving a tiny income buffer for food, entertainment etc. Forget about saving for retirement! With such little margin of safety, the slightest rise in mortgage payments will increase their carrying costs to a level that will consume as much as 100% of their income! This is not sustainable.
The Impact of Rising Rates
After seven years, the Bank of Canada raised interest rates in July and again in September; solidifying the initial steps in their path to normalization. Higher interest rates mean higher borrowing costs and thus higher mortgage payments. The table below illustrates this sensitivity to mortgage payments:
RBC estimates that just a 100bps (1%) increase in mortgage rates would lift the affordability measure in Canada by 3.5%, by 7% for Vancouver and 6% in Toronto. Carrying costs can only stay elevated for so long until a tipping point is reached. When this happens, either household incomes must rise enough to offset the increase in payments, which unfortunately almost never happens, or home prices must decline to a more affordable level, resetting the carrying costs to a much lower income ratio. The latter is the most likely scenario as history has proven again and again. This is why rising interest rates have always been strongly associated with house price declines. According to a Scotiabank report, home prices in Toronto and Vancouver would need to fall by 30% and 25%, respectively in order to bring the mortgage carrying costs just back to their respective (still elevated) averages of 38% and 54%. Alternatively, it would require 10 years of constant home prices and average income growth at current interest rates to arrive at the same result.
The lack of margin of safety and income buffer to weather a rise in interest rates was increasingly apparent in a Manulife survey published in May. The survey showed that three quarters of Canadian homeowners would have a difficult time paying their mortgage each month if payments increased by just 10%. A 10% increase in payment requires just a 1% increase in the typical mortgage rate. Furthermore, 14% of respondents admitted that they wouldn’t be able to sustain any increase at all. Many Canadians are not prepared for the inevitable increase in interest rates as they have overextended themselves in their efforts to purchase a house they can’t afford.
Renting: the alternative
As we’ve mentioned previously in this article, when markets look frothy, you are better off moving to the sidelines. This means to rent. Even though home prices could continue to rise, becoming even more overvalued, the risk to the owner of the market correcting back to its fundamental levels is now very high. Renting is the alternative that allows the tenant to avoid this risk. Most importantly, when markets are overvalued, renting doesn’t bind you to a life sentence of unaffordable ownership payments which can devastate you financially. In fact, the ratio of mortgage carrying costs to rent is at its highest level since 1990 as a result of the rapid rise in home prices far outpacing the growth in rental prices.
It is very important to understand the costs and trade-offs between owning and renting and for more information on this we recommend that you visit the link below:
There is the general perception that buying a home is a good investment. However, this depends on personal circumstances such as how much debt you need to borrow. In order to understand the actual return or profit accrued to you, you must also subtract out the total carrying costs paid over the time period of ownership. As we mentioned previously, these costs can be very high and thus meaningfully reduce the sale proceeds that contribute to the final overall return.
Purchasing a house with the help of a mortgage can assist in magnifying the return as the initial capital outlay is much smaller (i.e. just the down payment), but this benefit would be offset by higher carrying costs (via mortgage payments). For anyone interested in purchasing a home, we recommend visiting the link below to see just how much principal and interest you end up paying in aggregate over the term of your mortgage. The results might shock you!
It is interesting to note that the average home appreciated 480% over the period of 1984-2016 (an annualized rate of 5.6%). However, if the individual had opted to instead invest their money in the S&P 500, the total return in Canadian dollars would have been 3,161% (an annualized rate of 11.1%). The stock investor is materially advantaged in that by owning the company’s in the S&P 500, cash flow is received in the form of dividends, which compound over time; while the house owner has negative cash flow due to the carrying costs. So buying a home is a good investment, if purchased at the right price, but not necessarily always the best investment.
It sometimes makes sense to purchase where you live, and sometimes it does not. This is a decision that should only be pursued when the terms are favourable and affordable throughout the entire ownership period and not just the first few years. When it comes to investing, patience is a virtue!
The Summerhill Team