The current issue of Maclean’s features a typically provocative cover on “Real Estate 2008.” The “Buy? Sell? Panic?” headline caught my attention because I am currently selling a place in Ottawa and moving to Toronto.
The story inside Maclean’s is far more soothing, suggesting that there is no risk of a real estate crash in major Canadian cities because: sub-prime mortgages are rare here, real estate is still much cheaper here than in other countries, and housing is still more affordable than during previous peaks.
The final point refers to the cost of servicing the mortgage on an average-priced home as a percentage of an average family’s income. In Toronto, the current figure of 27% is well short of the 40% reached in 1990. In Vancouver and Calgary, the current figures exceed the circa 1990 peak but remain below the circa 1980 peak. The implication is that, since housing is still relatively affordable, housing prices are unlikely to drop.
I do not find these comparisons particularly convincing. The short-lived 1980 and 1990 peaks in mortgage costs were driven as much by rising interest rates as by high real-estate prices. The current spike almost entirely reflects increasing real-estate prices.
The Maclean’s comparison is like arguing that, if cars cost twice what they used to but interest rates are half what they were historically, then the “automotive affordability index” has not changed. Certainly, low interest rates leave more room for increases in the price of big-ticket items that are often bought with borrowed money. However, this relationship does not mean that the prices of real estate or new cars should rise proportionally as much as interest rates fall.
Put another way, low interest rates and the advent of 40-year mortgages may give Canadians the means to keep bidding-up real estate prices for some time. However, they do not guarantee that Canadians will, in fact, choose to do so.
The comparison that I would like to see is between buying and renting. Imagine that a one-bedroom condo in downtown Toronto costs $300,000 and that condo fees, plus property taxes, plus utilities amount to $6,000 per year. Assuming that 6% is the mortgage interest rate and the opportunity cost of cash put in, owning the property would cost $24,000 per year.
By comparison, one could rent a one-bedroom apartment in downtown Toronto for about $12,000 per year. In this case, the financial argument for buying depends entirely on expectations that the property’s value will increase substantially after it is purchased.
Imagine that its value rises by 6% per year, exactly offsetting the interest payments and/or opportunity cost of funds. The benefit of ownership would then be the difference between rent and condo fees, plus taxes, plus utilities. This annual sum of $6,000 amounts to 2% of the principal value.
One would do just as well to rent an apartment, obtain $300,000 at an interest rate or opportunity cost of 6%, and invest it in the stock market for an 8% return. In this case, the financial argument for buying is based on the notion that real estate is safer than the stock market. However, this notion depends on the view that real estate is not currently overvalued.
Historically, I think that real estate has averaged less than 6% and stocks have averaged more than 8%, reflecting their greater riskiness. I am not advising anyone to go out and borrow hundreds of thousands of dollars to play the stock market. Indeed, few financial institutions would provide such a loan. My point is that similar caution would be warranted before taking out a mortgage of this magnitude.