Housing: Rent or Buy (Part 3)

Over the last two weeks, I've delved into housing: that creator of infinite wealth which has consumed Canadians. Using data from 1985, we learned that several decades ago Canadian families spent about 20% of their gross income on mortgage costs.

They actually cared about saving, investing, and good retirements in the 80s, so the average family saved about 15% of their gross income. This compares to us spending more than 26% of our gross income on housing payments today while saving just 5% of gross income for a pathetic future retirement.

It is my belief the long-term value of housing is based on the average family's ability to pay for the average house: an equation of median household incomes and average interest rates.

Incomes tend to rise fairly evenly. In fact, since the 1970s, the median household income has grown alongside the inflation rate. This means although our incomes on paper have doubled every 30 years, that rise has not translated into more purchasing power.

As I discussed in Housing (Part 2), interest rates have dropped substantially since the 1980s. In 1985, your 5-year mortgage rate would have been around 12.5%. Today 5-year mortgages are sold for around 2.6%.

This has made housing much more affordable, causing prices to rise. It is my belief adjusting for current interest rates, household income, and maintaining a mortgage cost at 20% of gross income, the fair value of the average house in Canada today should be around $368,000.

The expected value of a house today using today's ultra-low interest rates does not reflect the long-term value of housing using long-term average mortgage rates.

Average Bond Rates

Mortgage rates are determined by bond markets—not the big banks. There has generally been a stable 2% spread between 5-year Government of Canada bond yields and 5-year fixed mortgage rates. This is not random.

The Canadian government has never defaulted on its debt, but every year thousands of Canadians go into foreclosure on their mortgages. This costs the lenders money. Unlike the mortgage lender, when in a pinch, the government can raise taxes, cut spending programs, or promote inflation to pay debts. Households have much less flexibility.

Bond History

Information on mortgage rates is relatively recent and offers limited insight into average yields. However, knowing the historical spread between mortgage rates and government bonds, we can look way back in history on government bonds and extrapolate rates on secured loans using that data.

Reliable data on the Venetian prestiti bonds date back to the 1200s C.E., Netherlands 10-year bonds go back to the 1500s C.E., and British consol bonds have data from the 18th century.

The Venetian prestiti was a floating perpetual bond that often yielded as little as 5% in calm, prosperous periods but jumped as high as 20% when Venice went to war or was struck by trading issues. (As a trading state, these often coincided with each other). Noticeably the yield was very erratic despite Venice being a well-run, wealthy society by the standards of those times.

Netherlands bonds by comparison were much more stable. In the 1500s, bonds yielded as much as 20% interest, but those yields dropped steadily approaching the Dutch Golden Age. For a time, Dutch bonds yielded as little as 2%. Over the last 200 years, the yield generally floated between 4% and 6% with the odd spike due to the World Wars and inflationary 1960-1980 period. Dutch bonds are now yielding just 1%, an all-time low never seen in 500 years, even during the most prosperous and comparatively advanced periods in Dutch history.

The British consol bonds yielded 3-5% during the British Golden Ages and eras of world domination and market control. Before the First World War, at the height of British world dominance and wealth, yields came close to 2%. Again yields spiked during the wars and inflationary periods before settling near 2% today.

While this bond information doesn't paint a complete picture, there are three clear takeaways:

  1. Current government bond yields at less than 1% have never been seen before. Even 2% yielding government bonds are not at all common during the wealthiest and most stable eras in history where one country would often stand miles above the rest in wealth, governance structure, and relative safety of their citizens.
  2. Bond yields jump up suddenly and quickly with bad news. It's thoroughly naive to believe yields will continue to drop forever or that they will remain stable at these levels for any significant time period.
  3. Bond yields in the range of 3-6% are historically common for well-run, relatively advanced societies with good financial systems and protections in place.

A Wake-Up Call

Given this historical knowledge, I believe mortgage rates will average at minimum 5% in Canada given our current position in the world. That translates to a 3% Canadian government bond yield plus the 2% premium for private, secured loans.

Factoring mortgage spending at 20% of gross household income, a 20% downpayment, and 5% mortgage rate, the value of the average dwelling in Canada should settle around $287,500 in today's money. The average house may need to be smaller and lot sizes may need to be smaller in urban areas to achieve this number, but median income earners can only afford median dwellings over the long term. Any difference has to be closed by gifts from the Bank of Mom, sacrificing savings rates, or meagre spending in other areas.

Interestingly, the average price of a house in the U.S.A—another massive and prosperous country—is around $275,000 USD right now. That's in a country with almost the exact same disposable household income as Canada (adjusted for healthcare costs).

If the average house in Canada moves to a median value of $287,500 in today's dollars over the next decade or two as interest rates normalize, this would translate to a massive 40% drop in value. I'm not banking my financial well-being on real estate, are you?

Read Part 4 on emotions, property, and inevitable correction.

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