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More than two centuries ago, the economist Adam Smith produced his landmark tome, An Inquiry into the Nature and Causes of the Wealth of Nations, in which he wrote, "a dwelling-house, as such, contributes nothing to the revenue of its inhabitant." The father of modern economics placed housing in the same category as clothing and furniture — useful consumer goods that do not generate wealth. For the homeowner, a house is a "part of his expense, and not of his revenue." Were Smith alive to make such a statement today, he would no doubt be regarded as a heretic.
These days, home ownership is widely heralded as the ultimate financial achievement and one of the surest forms of wealth creation available. Homeowners aren't throwing away money on rent, the common thinking goes, but instead putting it toward an asset that can only appreciate in value. Indeed, home prices have more or less climbed steadily for decades. For these reasons, at least two generations have grown up with the same abiding principles when it comes to real estate: save for a down payment, buy a house, and work hard to pay off the mortgage. And you better get in soon, because God's not making any more land.
Nowhere is that mentality more prevalent than in the current market, where housing has soared to record highs after a brief — but gut-wrenching — drop just over a year ago. Existing home sales fell 40%, and prices 12% from their peaks in late 2007 during the turmoil of the recession. But the average home price in January roared back to $328,537, according to the Canadian Real Estate Association, a jump of nearly 20% from the year before. Ultra-low interest rates are providing an unprecedented opportunity for young Canadians to buy their first homes. At the same time, there is a shortage of houses on the market, fuelling intense competition and bidding wars. "Some people don't even balk at paying thirty, forty, fifty thousand dollars over asking now," says Evan Sage, a real estate agent in Toronto. Many factors motivate people to buy property, but one nearly universal reason is for the economic benefits. "Every single decade, prices have gone up," says Sage. "The one consistent thing is real estate."
But a hard look at real estate returns shows that Adam Smith probably had the right idea after all. Viewed purely as an investment, an owner-occupied home has more than a few undesirable traits. In January, during a panel discussion at the annual meeting of the American Economist Association, Karen Pence, head of the Federal Reserve's household and real estate finance division, pointed out a few of the drawbacks buyers tend to overlook. For instance, a house can't be divided up and sold, like a stock portfolio, and it is highly correlated to the job market. Also, a house is undiversified; instead, its future is tied to a single neighbourhood.
Moshe Milevsky, an associate professor of finance at the Schulich School of Business in Toronto, has a similar take. "This blind devotion to investing in a house as being a very, very good idea might not make sense when all is said and done," says Milevsky, who held off purchasing a home for his own family for some time. He believed it was not a smart way to allocate money. In fact, it flies in the face of what decades of portfolio allocation theory have shown. "It's like a stock portfolio that consists of one stock," he says. "If I could buy a house where the bedroom is in Toronto, the kitchen is in Vancouver, and another bedroom is in South America, then that's a diversified house."
But the dream of home ownership is so deeply ingrained, and the belief that real estate is the ticket to wealth so strong, that Canadians are increasingly willing to put their economic well-being on the line for the sake of four walls and a roof. This fact is reflected in the growing levels of debt. The average household in Canada now owes $96,100, according to a study released in February by the Vanier Institute of the Family, an increase of 5.7% over the past year. The same report found that mortgage debt is at a record high.
The euphoria around home ownership crowds out some of the unpleasant truths about real estate: mainly, that long-term returns are often modest at best. Some studies have found that stock indexes actually outperform housing. More worrying is that real estate prices can and do fall — and they can take a long time to recover. Canada has not been immune to severe price corrections in the past, and we could be on the verge of another one now. With interest rates set to rise and curb affordability, and with economists speculating about a bubble, staking one's entire financial future on a home is not necessarily a wise bet. In fact, a house just might be one of the most overrated investments around.
The final months of 2008 were a difficult time for Vancouver real estate agent Peter Raab. His clients simply weren't interested in buying houses, and the market was tumbling. Raab prepared for the worst, cancelling his vacation and cutting expenses. His practice slowed down so much that he didn't get a paycheque for five months. "Everyone was trying to put on a brave face. It weeded a few people out of the industry," he says. But Raab didn't have to wait long for a recovery. His business started to pick up again in March of last year, as it did for agents across the country.
A number of circumstances brought buyers back. Canadians recognized the economy was not headed for disaster, and rock-bottom interest rates were too enticing to ignore. Buyers who had been waiting for the economy to smooth out before buying have started looking again, and others who may have waited until later in the year to purchase are acting now to avoid rate increases. The effect has been compounded in Ontario and B.C., where the introduction of a harmonized sales tax in July will increase the costs around buying and selling homes. Factor in a lack of housing supply and too many buyers, and it would appear prices have shot up alarmingly in a short amount of time, sparking plenty of debate over whether homes are overvalued now, and how they'll adjust in the future.
"There's a unique confluence of factors that has driven house valuations up this sharply," says Derek Holt, vice-president of economics at Scotia Capital. "They're all temporary, and that's a house price bubble that could be pricked as we go off into the next year." The rate of growth in home prices for the past 10 years has in fact been out of line with prior decades, pointing to lofty valuations today, according to Holt. Prominent Canadians such as money manager Stephen Jarislowsky and former Bank of Canada governor David Dodge have also sounded the alarm recently on today's unusually rich home prices.
Although both federal Finance Minister Jim Flaherty and Bank of Canada governor Mark Carney have said they do not believe Canada is in the midst of a housing bubble, they are clearly watching closely. Carney warned about rising levels of debt late last year, as the household debt-to-income ratio reached a record high of 145%. Flaherty took steps to cool the market in mid-February by changing some of the rules around government-backed insured mortgages, most notably with the provision that all borrowers now must meet standards for a five-year fixed rate mortgage, even when opting for a lower rate and a shorter term.
The change was to ensure Canadians don't take on more mortgage debt than they can handle, but impending increases to interest rates still pose a danger to recent homebuyers who took advantage of the cheap credit available over the past year. Even a one percentage point change in a mortgage rate can increase the monthly payment by hundreds of dollars, and it's unclear how homebuyers will cope down the road. A study by CIBC in December said less than 4% of Canadian households would be vulnerable to rate increases, whereas the Bank of Canada estimated the number was considerably higher, at 5.9%. But so strained do Canadians feel that a survey from the Canadian Payroll Association in September found nearly 60% of the respondents said they would have trouble making ends meet if their paycheque was delayed by even one week. This group included many first-time buyers.
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