As Safe As Houses
Tactics Newsletter | November 2012
Nothing seems to make Canadians feel as secure – both emotionally and financially – as the value of their home.
The phrase “as safe as houses” is thought to have originated from the U.K. in the mid-1800’s, when the railway bubbles began to burst and speculation once again favoured “bricks and mortar” (houses). Since then, it is commonly used to mean a “guaranteed investment” or “sure thing.”
In fact, if you ask almost any young Canadian today (say under the age of 45) they would likely say real estate is the best investment one can make, and subconsciously they might believe real estate prices can only go up. It helps to have this position if you didn’t own real estate during the downturns of the early 80’s and 90’s.
But like all asset classes, real estate prices are subject to boom/bust cycles and so one must be willing to accept there are times to have more exposure to real estate, and times to have less (the same applies to other assets like stocks and bonds).
Now before we begin to review the Canadian and local residential real estate markets, the purpose of this article is not to demonize real estate as an investment, as some financial advisory firms might do who would rather have their clients buy “traditional” investments such as bonds and stocks from which they can earn their commissions.
As our clients are well aware, NWM has been a long-time investor in real estate and we continue to allocate a reasonable allocation to client portfolios, so we fully understand the value that real estate can add to one’s overall financial position. However, this newsletter will focus on residential real estate and less so on commercial real estate which we continue to own and prefer as an investment in this current environment.
The purpose of this newsletter is to step back and review the empirical evidence and hopefully answer three important questions:
- Is the Canadian (and Vancouver) real estate market truly overvalued, and if so by how much?
- What is our outlook for home prices? Big crash, muddle through or bull market ahead?
- What opportunities continue to exist in real estate investments today?
They say a picture says a thousand words – which means this newsletter may say too much given that there are about a thousand pictures (charts). For those less inclined to wade through all the details, here is our executive summary:
Over the long-term real estate prices fluctuate and go through boom and bust cycles. Thus buyers and sellers who are either moving up or down the “property ladder” need to pay close attention of where they are in the current cycle.
The evidence suggests that Canadian real estate is some of the most unaffordable in the world; thus, a decline in average home prices seems warranted and overdue, and in our opinion may average 5% – 15% (especially in certain markets within Vancouver and Toronto).
Real estate prices have had the benefit of significant “tailwinds” over the last 10 years (falling interest rates, easy access to credit, foreign investment, etc.), but these same factors should eventually reverse and become formidable “headwinds” going forward. That being said, we do not expect these headwinds to be material in the short-to-medium term.
We caution home buyers and speculators from overextending themselves to residential real estate at this time (especially first-timers). Renting in the short-to-medium term has never looked so attractive.
Commercial real estate (industrial, office, retail, self-storage) does not appear to be as over-priced as residential real estate and continues to present a more attractive investment opportunity. We (NWM) continue to hold and acquire high quality commercial property in Canada and the U.S. (especially since U.S. prices have already declined over the last few years).
Please speak to your financial advisor before making any major decision with respect to your real estate holdings to ensure it is appropriate for you based on your unique financial position and objectives.
LONG-TERM REAL ESTATE CYCLES
Over the long-term, real estate prices are cyclical and tend to experience booms for approximately a decade, followed by a few years of price declines (some sharp, some gradual) and then relatively “flat” prices for six to seven years. Thus, once markets hit their peak it can take more than a decade for real estate prices to hit new highs in nominal term, and much longer once one adjusts prices for inflation.
Figure 1 illustrates the cycle of average home prices in Vancouver from 1977 to 2012, and you can see housing prices remained relatively flat after the downturns in the early 80’s and 90’s, followed by the historic rise in prices starting in 2002. Prices appear to have hit a peak in 2011 with “average” home prices falling approximately 12% since then. Could this be the beginning of another decade of falling/stagnate home prices?
Residential Average Sale Prices – Jan 1977 to Sep 2012
What about home prices over a longer period of time?
Figure 2 illustrates the Case-Shiller U.S. real home price index from 1890 to 2011, or over 120 years. As you can see “real” home prices (i.e. prices adjusted for inflation) did not increase for over 100 years until the debt-fuelled boom starting in the mid-1990’s, followed by the collapse in prices starting in 2006.
Unfortunately we could not find any housing price index that went back further than 120 years, but anecdotally we would expect prices of real estate to more or less keep pace with inflation (and deflation) over the long-term.
The fact is, however, real estate prices (and price inflation) do not always move upwards at a steady pace as is commonly believed (at least by younger Canadians), and are prone to declines when prices become unsustainable relative to certain fundamentals.
IS CANADIAN REAL ESTATE OVER-VALUED?
Simply put, Canadian real estate is some of the most expensive / overvalued in the developed world.
The Economist house-price indicator (Figure 4) suggests that Canada boasts the most expensive real estate market in the world relative to rents (77% overvalued) and third most expensive relative to incomes (32% overvalued). Overall our real estate market appears to be overvalued by 54%!
Figures 3 and 4 measure basic “affordability” based on the price to own real estate relative to what one could rent a home for, and based on the average income of households in that country.
House Price to Rent and Price to Income Ratios (end 2011)
Why are rents and incomes meaningful as an affordability measure? If the cost of owning one’s own home becomes too expensive relative to renting that same home, then more people (or at least the logical ones) will choose to rent, causing real estate prices to fall and rents to increase (basic supply and demand fundamentals).
This process will occur until the market comes back into equilibrium and the cost of owning a home relative to renting becomes attractive once again.
The same principle applies to income; there is only so much disposable income a family has to allocate to housing relative to other basic needs such as food and clothing (and vacations to sunny destinations during the cold Canadian winters of course).
Therefore, to get back to longer-term averages, rents and incomes either need to increase significantly or prices must fall. Given the soft global economy and relatively high unemployment, we don’t expect incomes to rise much as employees have virtually no bargaining power with their employer, which leaves only rents and prices to adjust.
We believe that rents will increase marginally, although the glut of new condos in certain urban cities will likely keep rent increases subdued, and thus falling prices will have to do most of the heavy lifting to get prices back to equilibrium.
So back to the main question: is Canadian real estate in a “bubble” or are current valuations supported by strong economic fundamentals?
Figure 5 also confirms that Canadian home prices are well above long-term averages (approximately double) when compared to U.S. house prices. Of course this ratio has increased due to falling home prices in the U.S. and rising prices in Canada.
Nevertheless, the evidence is overwhelming that Canadian real estate prices appear to be overvalued relative to basic affordability measures such as rents and incomes. Furthermore, as we don’t believe rents or incomes will rise significantly in the next few years, prices need to fall to normalize affordability.
Of course, not all real estate markets in Canada are created equal. Arguably many parts of Canada are fairly valued, and certain cities like Vancouver and Toronto appear to be “off the affordability charts,” and in fact are among the world’s 15 most expensive cities (see Figure 6 below, which points out how unaffordable Australian cities have become).
One caveat that we should highlight in the “price to median income” ratio is that it measures the incomes of the residents in the particular country/city, but does not include the incomes of foreign buyers.
In the case of Vancouver and Toronto, foreign investors represent a reasonable proportion of the buyers (especially for high-end homes and investment condos), many of whom are multi-millionaires and billionaires from Asia. Thus, their high incomes are not accounted for in these measures, which may overstate the price to income ratio, and therefore the true affordability in general. However, foreign investors can leave almost as quickly as they come, so more weight should be given to the incomes of permanent residents.
There are a number of other key factors that may drive prices as follows:
Interest Rates: Mortgage interest rates are obviously a key driver in housing affordability and, thus, home prices. According to a recent CIBC report, a 2.0% drop in interest rates over the last five years can explain a 24% increase in home prices, which is exactly the same price increase of the Teranet-National Bank House Price Index over the same time period.
Interest rates are now at all-time lows, and while we don’t believe rates will rise too significantly in the near term, rising rates will eventually hurt many home owners who have over-extended themselves. This headwind will be compounded by the recent reductions in the maximum mortgage amortization from 40 years to 25 years, which effectively increases one’s mortgage payment by about 26% for those who must re-qualify for a 25 year mortgage!
Access to Credit/Household Debts: Along with reductions in the mortgage amortization, the Department of Finance and OSFI (Office of the Superintendent of Financial Institutions) have recently come out with a number of new rules to make it harder for borrowers to qualify for CMHC (Canada Housing and Mortgage Corporation) insured mortgages, which restricts overall access to mortgage credit. These changes will primarily affect first time home owners and real estate investors, two key demand sources for condos.
The government is clearly worried about the overall debt levels of Canadian households, which is now higher than U.S. households at the peak (see Figure 7). Rising interest rates will eventually make this debt difficult to service and pay off.
Household Debt as a Percentage of Disposable Income
Immigration to Canada and foreign investors have also been a key driver of home prices (especially in Vancouver and Toronto), as Canada is rightfully viewed as a relatively safe place in which to live and invest.
In fact, a recent study suggests that 46% of Chinese millionaires want to leave China for security, education and financial reasons, and of that group approximately 37% want to come to Canada. Thus, foreign buyers may continue to be a strong force and keep demand and housing prices elevated.
The question is: how long will this continue at the current pace, and will an economic slowdown in China, Europe and the U.S. curtail ongoing demand for Canadian housing? Many local realtors are already confirming demand from Asian buyers is waning compared to previous years and sales are down sharply in some markets (e.g. September housing sales in Vancouver plunged 32.5% compared to last year, and was 41.6% below the 10-year September average; falling sales generally lead to lower prices).
Housing Supply/Demand: Obviously a key fundamental in any marketplace is supply and demand. Some Canadian regions have significant supply constraints (e.g. Vancouver), while others have some room to grow (e.g. the prairies). On the demand side, Canadian home ownership just hit 70%, which is an all-time high according to a recent Scotiabank report.
Interestingly, housing prices peaked in the U.S., U.K. and Australia when home ownership reached 70% (there will always be a proportion of the population that will choose to rent rather than own, so there is a natural limit to home ownership).
While Vancouver and Toronto are experiencing a condo boom, we believe the supply of homes continues to be reasonably balanced to absorb natural population growth and immigration, and we do not forecast that Canada will face significant over-supply problems as was the case in the U.S., Ireland and Spain.
In summary, current home prices in Canada are, by some measures, some of the most unaffordable in the world, and demand for homes will likely be more subdued going forward due to high household debt levels, rising interest rates (eventually), and potentially lower access to credit and foreign investment. However we do not see any major catalyst for a sharp housing crash in the short-term.
NWM’S HOME PRICE OUTLOOK
While no one knows for certain what home prices will do in the short-to-medium term, our expectation is that average prices will fall approximately 5% to 10% across Canada over the next few years, with potentially more significant price declines in overheated markets like Vancouver and Toronto (in particular for luxury homes and the condo market).
The prairies may be the exception to this and may continue to grow assuming commodity prices do not decline materially.
Given that many of our clients live in British Columbia, they may be particularly interested in what we think might happen to home prices in the Lower Mainland. Again, no one knows for sure, and it will vary depending on where you live (West Side versus Westbank) and the type of property (luxury, condo).
There are many scenarios that we can envision happening (and some outcomes that perhaps we could not have envisioned; the “known unknowns” if you will), but the three most plausible outcomes can be summarized as follows:
Scenario #1: Prices Soften and then Move Sideways
Our “base case” (or primary) forecast looking at current valuations and other factors discussed above, is that average home prices will fall 15% to 20% from the 2011 peak and will then trend sideways for a number of years (perhaps as long as a decade). This outcome is consistent with how real estate cycles have behaved over the long term.
Scenario #2: Major Bear Market
Given that Canadian real estate is supposedly 54% overvalued from long-term averages (Figure 4) we cannot discount the probability that prices will revert to the mean and fall significantly, perhaps 35% to 50%. Of course we feel this will only occur if we experience a major global recession, with a drop in demand from Asian buyers (in fact, foreign buyers become net sellers).
Given the economic woes in Europe and the fiscal mess in the U.S. and Japan, this outcome is not unthinkable. A significant spike in mortgage interest rates could also cause prices to crash, although we do not believe rates will rise materially for a number of years and thus believe this is a low risk event in the medium term.
Scenario #3: Up Up and Away!
Some market bubbles can remain irrational longer than one can predict (or for speculators betting against the market, longer than they can stay solvent), and thus there is always the possibility that this party is not yet over. Maybe affordability measures and basic fundamentals no longer matter…“this time is different.” Perhaps, but this is not where we would place our bets.
In summary, we believe the Canadian residential real estate is overvalued and declines are expected, with cities such as Vancouver and Toronto leading the way down.
We caution home buyers and speculators from overextending themselves to real estate at this time (especially first time home buyers with small down payments) and for those Baby Boomers who need/want to downsize in order to spend part of the equity in their homes in retirement, they might want to do so sooner rather than later. Renting in the short-to-medium term has never looked so attractive.
As always, please speak to your financial advisor before making any major decision with respect to your real estate holdings to ensure it is appropriate for you based on your unique financial position and objectives.
OPPORTUNITIES IN REAL ESTATE
OK, so now that we have made our case that one should be cautious within the residential real estate market, does this mean that we feel “real estate is dead”? Far from it.
All the data we have presented thus far has focused on Canadian residential real estate in arguably over-valued cities such as Vancouver and Toronto. While we cannot make a case for speculating in residential real estate based on current rents and prices (again, prices are supposedly 77% overvalued relative to rents), we continue to hold and acquire high quality commercial real estate in Canada and the U.S.
Our investment approach to real estate has been to allocate a reasonable portion of our clients’ wealth (and our own personal assets, of course, as we always invest alongside our clients) in income-producing real estate such as office, retail, industrial and self-storage properties.
While we like real estate as a hard asset and a long-term store of wealth (generally appreciating at the rate of inflation), we primarily own real estate for its sustainable and predicable cash flow from rents. Capital appreciation – or growth – is a secondary consideration.
Conversely, many speculators in residential real estate seem satisfied to forego cash flow and focus on short-term capital appreciation (e.g. by frequently “flipping homes”).
While the Canadian commercial real estate is far from cheap, we are seeing more attractive yields than what we could otherwise obtain from owning a rental condo.
As an example, if one purchased a two bedroom condo downtown today for $500,000, after paying maintenance fees and property taxes the net pre-tax rental income yield might only be 2% to 3%. And if any leverage (mortgage) is being utilized, the cash flow quickly becomes negative, which to us is not a great investment relative to the inherent risks.
Conversely, commercial real estate is generally yielding 5% to 8% (unlevered) which we feel is a more attractive outcome, especially when we can diversify among the various real estate sectors (office, retail, industrial, multi-family and self-storage) and geographically (Western Canada and the U.S.).
Our clients are able to gain exposure to real estate investments in their portfolios through our Real Estate Fund, which holds primarily publically traded Real Estate Income Trusts (REITs), and through SPIRE and SPIRE U.S., two of our Limited Partnerships.
SPIRE L.P. (Canada) currently owns $315-million worth of office, industrial, residential, retail and self-storage real estate in Western Canada, where we believe the long-term growth will be due to the availability of good paying jobs in the commodity sector.
SPIRE U.S. L.P. was created in 2007 to capitalize on the troubled U.S. real estate market by acquiring quality assets at distressed prices, and currently owns 32 multi-family residential properties in the southern U.S. states, five office buildings in downtown Seattle and two in San Francisco, collectively worth over $137-million.
The geographic allocation of the properties held in the SPIRE Limited Partnerships is depicted in the map below (San Francisco properties not yet illustrated as they are being purchased as we go to press).
In summary, we are very excited about the ongoing opportunities that our real estate team is uncovering in the commercial real estate space. Our commitment is to preserve our clients’ capital over the long term, and equally as important, to structure the portfolios to provide a sustainable and growing income so that our clients can continue to meet their unique financial objectives.
This document is not intended to provide legal, accounting, tax or specific investment advice. Information contained in this document was obtained from sources believed to be reliable; however Nicola Wealth Management does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information. Please speak to your advisor for personalized advice based on your unique circumstances.