It's been several weeks of house talk here at TheRichMoose.com. By now you've probably found I believe house prices in Canada are stretched wwwaaaayyyyy beyond what they should be.
From the beginning of this series, I pointed out my belief that the average house has a long-term value that's based on the citizen's ability to afford residential property. This affordability is determined by median household incomes and average mortgage rates. Household incomes have not exceeded the inflation rate since the 1970s, so we know wages are not responsible for today's ridiculously priced real estate.
In Part 2 and Part 3, I talked about interest rates and their relation to mortgage rates. Although interest rates bounce up and down in the short-term, I believe the long-term, low-end interest rate on government bonds for prosperous, stable countries is around 3%. This translates to a mortgage rate of around 5%.
In Part 2 the number I threw out for an average house price on today's 2.6% mortgage rate was $368,000. However, in Part 3 I dropped a long-term expected house price of just $287,500 based on a still-low mortgage rate of 5%. This assumes the average Canadian family saves a 20% downpayment and will spend around 20% of their gross household income on their mortgage payments.
How Did We Get Here?
With a current average house price of more than $475,000 we are 30% above our target current house price of $368,000 with current low interest rates. We're a whopping 65% higher than our long-term expected house price of $287,500 at long-term average mortgage rates.
This huge variation in housing prices has been fueled by two powerful emotions: greed and fear. Millions of homeowners and thousands of investors have greedily borrowed to the absolute max so they can buy residential property at astounding prices. They believe they will see the paper value of their homes and their leveraged equity skyrocket with the help of an asset that "never goes down".
The constant circling of parents, the media, your local real estate teams, and every third TV show suggests if you don't own a house now you: are throwing away your money, are making your landlord rich, are missing out on massive equity gains, are getting priced out of the market, might never be able to own a house again, and you are simply stupid. People are scared to be perceived as stupid, so they follow the crowd out of fear.
In the short-to-medium term, asset prices are the product of human psychology. Higher prices beget still higher prices... until they don't anymore. This is called bubble formation and it happens all the time across different assets: housing is no different!
Ask your parents about gold in the 1970s or tech stocks in the late 90s. Ask your American or Irish friends about their housing in the mid-2000s. Every time these bubbles formed the same narratives appeared. Bubbles always start slow, look bulletproof, and you can come up with creative and seemingly sound reasons for massive price appreciation.
Due to this greed and fear surrounding real estate, Canadians have been stretching themselves to the absolute and unsustainable max to buy, keep, and upgrade their houses. Downpayments? Nope! Saving for the future? Huh?! Work-life balance? Gone! Paying off your credit cards and lines of credit each month? Impossible! Buying anything at all without monthly payments? No one can afford that!
Fortunately (or unfortunately) bubbles work both ways. They inflate grandly and deflate with surprising velocity. Once prices start falling people start panicking and lower prices beget lower prices. Those sound reasons justifying the high prices fly out the window and it becomes so obvious why the asset failed. All of a sudden everyone sees it!
If you're trying to buy a house with multiple bids, when there's no inventory available, and properties are sold with mere days on market you might be stupid. But it sounds like a great time to sell!
"Be fearful when others are greedy and greedy only when others are fearful." - Warren Buffett
What Happens Now?
To move to a long-term average house price of $287,500 in today's dollars, there would need to be a massive equity erasing, country-wide correction of about 40% from current house prices.
Houses are not stocks that can quickly be traded with erratic price jumps; I don't believe houses will drop 40% in months like the stock market can. Rather I believe it will look more like a halt in sales activity, followed by slow price trickles, followed by more aggressive price drops, followed by eventual price stability with increases below the inflation rate. The unwinding process is a painful one that can easily take a decade or more.
As ridiculous as it may sound today, I have little doubt that one day in the coming decades, the average house in Canada will be worth $287,500 in 2017 inflation-adjusted dollars.
Would you hang onto your highly leveraged house when mortgage rates are increasing, you're staring at inevitably higher monthly payments or a massive refinancing once your current mortgage term comes due, houses in your city are dropping by a couple thousand dollars each month, and your equity is shrinking faster than your income?
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