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Baby, we got a bubble!?

Think your home is a safe investment? Think again

Think your home is a safe investment? Think again

By Roger Martin and John Kelleher | Thu Apr 07 2011

http://www.moneyville.ca/article/970767--think-your-home-is-a-safe-investment-think-again

Think housing investments are safe? Check your assumptions. It's difficult to read a magazine or go to a cocktail party without hearing that housing investments are safe choices, certainly much safer than investing in the stock market. This belief is so prevalent that the average Canadian family maintains the majority, if not all, of its net worth in housing.

Unbeknownst to most of these families, their theory of home ownership as a safe, low volatility investment is based on the often-mistaken premise of no or little debt. This is a crucial blind spot because the moment that a large amount of debt is used to buy a home, that safe investment theory goes completely out the window.

Put simply, housing is only a safe asset under conditions of no or very low financial leverage or debt. A lack of appreciation for this critical assumption led to major tracts of the U.S. housing sector being wiped out and with it, the net worth of millions of U.S. families.

But Canadian homeowners have no reason to be smug — while our housing sector hasn't been wiped out like the U.S., the assumption of low debt is also false in Canada. This means Canadian homeowners' equity is much more risky today than is recognized.

Since most Canadian families buy a home with the aid of a large mortgage, it is critical to understand the risk/return dynamics of a family's home equity under conditions of high financial leverage.

When a family buys a home with, say, a mortgage of 90 per cent of the purchase price and equity of 10 per cent, the first income the family earns needs to pay the mortgage holder. The mortgage holder gets the safest cash flows from the family. In essence, the equity value of the house only maintains its value or increases if the mortgage holder is paid. That means that the equity holder, i.e. the family, is holding a much riskier financial asset than the mortgage holder. This is one of the most important principles in finance, yet this is not broadly well understood.

How risky does the family's home equity investment become? Financiers measure equity risk in relation to the stock as a whole. Studies show that home equity investments have a strikingly low risk relative to the market, 30 per cent of the risk, in fact, lower than investments in things such as regulated utilities. This is the source of the confidence in the safe investment thesis.

But that is the risk level for a debt-free home investment. What happens when that family buys that house with just 10 per cent cash down and a 90 per cent mortgage that promises an interest rate of 3 per cent to the bank over the long term?

Amazingly, the equity in the house has now become dramatically more risky than before. The equity is now three times as risky as the overall market rather than 30 per cent as risky. This is more risky than an investment in nickel mining stocks or Internet start-ups. Does this family understand that its net worth has been “banked†on something this risky? Does its financial adviser understand this? While it is true that the family will pay off the mortgage over 25 or 30 years, for very long periods of time debt levels are high and therefore the effective riskiness of the equity is very high, as millions of families across Florida, California and Arizona found out, sadly.

Part of what makes this difficult to see is the fact a house isn't a traded asset. You can't log on to Google Finance and see the value of your home's equity going up and down when the market moves. But that doesn't mean it isn't volatile.

A rule of thumb is that risk rises exponentially as debt levels approach 100 per cent. To make this clear, imagine a simple case. If one purchases a home with just $1,000 of cash and all of the rest in debt, even a minuscule percentage drop in the home's price would destroy one's entire equity.

Interestingly, the effect we are describing is exacerbated during times when the cost of debt (interest rates) is high. Given that we are likely in a period of rising interest rates, Canadians would be well advised to consider this effect and either avoid large amount of leverage when they purchase a home or pay down debt as quickly as possible if they already have a large mortgage.

Home ownership as a safe investment is a theory that holds under conditions of low leverage only. At the root of the U.S. financial crisis is the failure to appreciate that the large amounts of debt used to finance home ownership wrecks the “safe-as-houses†theory.

With all the safe cash flows promised to debt holders, housing equity was jammed chockablock with risk in a way that is difficult to see until equity values are massively impaired or wiped out altogether.

Canadians should check their own assumptions behind their belief in the safety of housing investments to avoid a similar fate as to what happened in the U.S.

Roger Martin is dean of the Rotman School of Management at the University of Toronto as well as chairman of the Institute for Competitiveness & Prosperity. John Kelleher is president & CEO of RHB Group LP, a former consultant at McKinsey & Co., and an expert in corporate finance.
 
To those who scoff at the concept of $400 per sq ft in downtown Toronto, These are actual selling prices close to the St. Lawrence Market:


http://www.theglobeandmail.com/life...s-with-rare-200-sq-ft-terrace/article1976644/

Boiler Factory Lofts at 189 Queen E, 1160 sq ft, with 200 sq ft terrace, 12 foot ceilings, exposed brick walls, hardwood floors for $480100 = $413.88 / sq ft.




http://www.theglobeandmail.com/life...fers-for-toronto-one-plus-den/article1976625/

Lofts on Frederick at 180 Frederick, 850 sq ft. with skylit hallways, 11 foot ceilings, hardwood floors, for $350000 = $411.76 / sq ft.

Eug,
I believe that the building in question on Queen St. East is quite a bit older and as such, it has not appreciated very much. I note that it sold in 2007 for $400K. So $80K is a 20% increase in 4 years to present. That is probably reasonable appreciation or at least not massively excessive. However, it shows that older units do tend to slow down vs. new because people factor in repair, less desirability because it is "not new" and people just discount it.

As for the 2nd building, I believe again Frederick is 12 years old and then was a reno of an older place if I am reading it correctly. There is no old price there.

I agree that one can get $400/sq.ft. but whether we agree or not, a fairer comparison would be larger buildings with amenities if one is going to compare most of what we are looking at in the core. I agree the older buildings have room and may be more desirable but they may also appeal to a different group than the newer with all the "bells and whisles".

That said, I concur with you that it becomes difficult to justify prices which are 50-75% higher for new( but probably more like 25% higher to perhaps 50%) for high rise comparables.
 
CDR;

This is a great article and points out correctly the risk being taken. Unfortunately, both you and I know that it will only become apparent if there is a meltdown in prices. And at that point, it will unfortunately be too late for all those with 10% down. As well, from the US experience, we know that when 10% reduction occurs, it entraps those who had 15 to 20% because when they go to refinance, they suddenly have less equity. As well, people feel less well off and then sit on the sidelines thereby driving prices even lower.

Hence we better hope for a "stagnation or minimal decline" so that the psyche of deflation does not set in. If it does, the result of the house being safe will in fact go totally out the window as people watch their major asset and source of equity disappear. Really, all we are talking about is leverage working against you, which you and I clearly appreciate along with most on this forum. Unfortunately, when I was younger, I would not have appreciated this as much as I do now and I am fearful that a lot of young people who are buying fail to understand this, not because they are ignorant, but have not witnessed anything but price appreciation in real estate.
 
I believe that the building in question on Queen St. East is quite a bit older and as such, it has not appreciated very much. I note that it sold in 2007 for $400K. So $80K is a 20% increase in 4 years to present. That is probably reasonable appreciation or at least not massively excessive. However, it shows that older units do tend to slow down vs. new because people factor in repair, less desirability because it is "not new" and people just discount it.

As for the 2nd building, I believe again Frederick is 12 years old and then was a reno of an older place if I am reading it correctly. There is no old price there.

I agree that one can get $400/sq.ft. but whether we agree or not, a fairer comparison would be larger buildings with amenities if one is going to compare most of what we are looking at in the core. I agree the older buildings have room and may be more desirable but they may also appeal to a different group than the newer with all the "bells and whisles".

That said, I concur with you that it becomes difficult to justify prices which are 50-75% higher for new( but probably more like 25% higher to perhaps 50%) for high rise comparables.
I'm not sure I agree that "old buildings slow down" in terms of price increases unless there is something wrong with them. It's probably more likely that some overpriced new buildings slow down in price increases as they age, while older buildings go up relatively in parallel with the wider market. Actually, 20% over four years is pretty significant, and if anything that's faster than the wider market (according to Teranet's numbers), and this may be because there is upward pressure on lower priced units. Higher priced units get priced out of the market as prices rise.

Prices of pre-builds do tend to go up from purchase date to date of closing, but that's not a direct comparison either. Remember with pre-builds the money is locked there, but you can't actually live in the place, and once it's built you don't even own it right away. You usually have to pay "rent" for a time until the place actually closes, which can be months down the line. That often gets overlooked in the appreciation calculations.

The reason I point these out is because I'm a buyer who does NOT want all the extra amenities, because I never use them, save for maybe a limited gym. And I'm like a lot of people who live in condos. I'd guess maybe less than a quarter of people in condos with pools actually use the pool regularly.

Too many people get caught up with all the extra amenties that many brand new condo buildings have, and then regret it later because they're paying through the nose both up front, and then every month through condo fees. Instead of complaining about the high cost of condos, perhaps they should have done a bit more research and considered resales much more seriously.
 
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Too many people get caught up with all the extra amenties that many brand new condo buildings have, and then regret it later because they're paying through the nose both up front, and then every month through condo fees. Instead of complaining about the high cost of condos, perhaps they should have done a bit more research and considered resales much more seriously.

but the resales don't have the developers' glossy brochures and slick presentation centres, with the multi-million $$$ marketing of the big R/E brokerages + advertising agencies like Baker, BJL, montana steele, etc.
 
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Having owned a condo for many years now, I can tell you from experience Eug you point out the lesson that everyone who owns learns:

It is not the cost to buy that kills you (though that too can be significant), it is the ongoing expenses and taxes and the forever escalation in costs that make condos difficult to maintain. I appreciate the same can be said for houses but one can defer certain expenses to more opportune times if necessary.

Add on the HST being added to the Reserve fund and the operating expenses and condo fees took a steep climb up in the past year.

All those amenities sound great but you are absolutely right that few use alot of them. And as for swimming pools, in fact the number I have heard quoted is somewhere between 1 and 2% use them in those buildings fortunate to have them and as you know, swimming pools and other wet spaces are expensive to maintain
 
but the resales don't have the glossy brochures and slick presentation centres, with the multi-million $$$ marketing of the big R/E brokerages + advertising agencies like Baker, BJL, montana steele, etc.

I have to tell you cdr I received a book from Shangrila. It must have cost a $100 to produce. Shows floorplans, amenities etc. and some sites around. Beautifully bound.

I guess when selling especially to foreign investors who can't see the actual sales site, you suggest with the slick brochure that somehow this reflects the quality of what the purchaser will get. I hope that will be the case. I guess, if they gave a cheap brochure one would wonder about where else they cut corners. Still, I have to tell you I was suprised at the "elaborateness" (if that is a true word) of the book.

Let's face it, the sales centers and brokerages try and sell you a "lifestyle" which may or may not have anything to do with the project at hand but is solely designed as you suggest to hook and reel in the potential customer. (And perhaps justify overinflated costs to purchase)
 
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Interesting discussion. Is there any good info out there about how much developers make off of high rises? Are there any public ally traded developers active in Toronto? If not, why not?
 
what is interesting is to see the number of comments and the gyst of the comments to the Globe and Mail article referred to in post 3084.

Alot of people not on this forum supporting it. Whether it is just those who want prices to come down or not, it certainly is heavily weighted by people who believe that the correction will come and likely be severe. That said, there is not a lot new in the article or different from what a number of us have maintained.

Ponyboy, I am not aware of any other developer's costs. I can only suggest that I saw a proforma on a development being built in the City. I won't say which. When it was proposed, there was a 7 year time horizon and based on the costs vs. the selling price; there was about a 25% profit built in on the actual cost of construction assuming sales at the prices on the proformas. Given the risks to the market (costs can go up, prices can come down) this does not seem unreasonable. However since only a portion of the development is financed by the developer/investors, if that amount is 20% (with the rest being loans included in the costs of the proforma) then the profit on the invested amount is 125%. Again the effect of leverage. Over the past few years, prices have gone up and in the particular development because of the 2008-2009 slowdown and cancellation of a number of projects, construction costs have actually gone down so the investors here will do better. However, the reverse could easily have happened. As well, the project is not yet completed and the residual sales could come in at lower than current prices or higher, costs could hit a bump, and the final return vary accordingly. Hope this info gives you some insight.

There used to be Bramalea which I believe was publically traded but went bankrupt about 20 years ago. I am sure there are public traded developers. There is Toll brothers in the US but they mainly build luxury homes. Not really pertinent to your question.
 
The high cost of rising home values

Dragica Donia bought her downtown Toronto row house more than two decades ago, figuring that it would suit her well during her retirement years.

But now, at 76, she’s worried everything will have to change. High property taxes mean she might not be able to continue living in her modest residence near the popular Little Italy neighbourhood.

“This is a very real concern to me,” said the 76-year-old senior, a retired administrative assistant. “I am going to have to sell my home and rent if taxes keep going up.
 
...from Jamie Johnson at Remax condos plus.

"Since the so called experts keep missing on the market, and the main stream media keeps publishing these errors, we decided that the only way to deal with these misconceptions is with humour. Hence we are repeating our favourite joke.

When Einstein ran into a third person, he again asked the same question about their IQ. The person replied this time “75â€. “Perfect†said Einstein: “So where do you think the real estate market is headed!!â€

I applaud Jamie Johnson for this rare display of humility and self awareness by a realtor. I agree with him that most of the expert projections (TREB, etc) sound like they were produced by a 75 IQ.:cool:
 
I applaud Jamie Johnson for this rare display of humility and self awareness by a realtor. I agree with him that most of the expert projections (TREB, etc) sound like they were produced by a 75 IQ.:cool:

I am not sure daveto he was bgeing particularly humble. Instead perhaps he was more dissing the so called "experts" who are predicting like many of us on this forum a correction (economists rather than TREB etc). He subscribes to the belief if I can paraphrase him that all real estate markets are local (I agree) but that there is no reason to expect any significant correction in the near future given immigration, downtown needs etc. and on this note I am not as convinced. However, it was indeed a display of self awareness and humility if indeed taken within the context of the "Einstein joke".
 
I am not sure daveto he was bgeing particularly humble. Instead perhaps he was more dissing the so called "experts" who are predicting like many of us on this forum a correction (economists rather than TREB etc). He subscribes to the belief if I can paraphrase him that all real estate markets are local (I agree) but that there is no reason to expect any significant correction in the near future given immigration, downtown needs etc. and on this note I am not as convinced. However, it was indeed a display of self awareness and humility if indeed taken within the context of the "Einstein joke".

Ha - yes, I agree. But it was an ironic diss, considering that the source of most projections we read in the MSM is the RE industry themselves.

While we're on the topic of "all real estate markets are local..."...

I view this as a self-evident truth which is completely irrelevant to the topic at hand. Yet it is trotted out by the RE bulls as some sort of omnipontent argument. (I'm not referring to you, Interested).

Sure. Real estate is local. It can't be picked up from Thunder Bay and moved to Toronto. But so what.
But the financing and the CMHC guidelines are not local. They are substantially the same throughout the country.

Speaking of local markets, here is are a couple of helpful chart that puts the Ontario RE market in perspective as compared to the national figures.

Flavours of '89, anyone?

http://financialinsights.files.wordpress.com/2011/04/ontario-house-price-to-gdp.jpg
ontario-house-price-to-gdp.jpg


http://financialinsights.files.word...io-house-prices-divided-by-gdp-per-capita.jpg
ontario-house-prices-divided-by-gdp-per-capita.jpg


http://financialinsights.files.wordpress.com/2011/04/change-in-per-capita-gdp-and-house-prices.jpg
change-in-per-capita-gdp-and-house-prices.jpg
 
Daveto,
Your graphs do look almost like a carbon copy of 1989.
I do wonder though this time around if there is in fact more foreign investment supporting the market than in 1989. I also wonder if the resource boom now may in fact allow Canada to shine and weather the correction if it occurs better than in 1989. I am not a believer that "it is different here", just wondering if perhaps some parameters have changed enough to at least cushion somewhat the inevitable correction back towards the mean.

Perhaps I naively cling to the hope that prices may just stay level as they did from 1992 to 1996 and allow some catchup of per capita GP. This would be a lot less disruptive to everyone than a boom/bust cycle which unfortunately appears to be the way things usually play out.
 

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