Why House Prices Can’t Keep Climbing

Edited Photo. Source: Flickr - EyeTunes

Overall as a country, house prices in Canada are relentlessly climbing higher from already unaffordable numbers.

While some major markets have taken a small hit or have slowed down (think Calgary, Edmonton, Winnipeg, and some east coast cities), others are still racing head (most of B.C. and southern Ontario).

The average aggregate benchmark price in Canada is close to an enormous $600,000. Around 10x higher than net household income.

The big question on most people's mind is: how long will prices continue to go up?

A majority of Canadians, as shown by several recent polls, think house prices will never drop. But I strongly believe we are very close to a housing correction.

In fact, in many markets I think Canadians would be much better off in the long run to sell now, invest the proceeds in a good portfolio, and rent.

Buyer's Suicide

Given the current prices, buying a place in the greater Toronto region or southern B.C. is financially suicidal. Mortgage payments alone will suck up most of the your household net income. Nevermind maintenance, property taxes, utilities, good food, oversized vehicles, hockey fees, craft beer, rye whiskey, and other important household expenses.

Basically, it's impossible to accumulate an appropriate downpayment (20%), make the mortgage payments, save enough for retirement, have a safety cushion, and maintain a good quality of life when a decent place sets you back 10x your net income on the low side.

Buying a house with enormous payments will tie your financial future 100% to your house. If the value of your house goes up and you can make the payments, you will scrape along OK; if the value of your house drops or you can't make the payments, your whole financial picture is toast.

I'm seeing it here in Alberta where thousands of people are financially strapped and "stuck" in their houses after a small life hiccup. They can't sell their house because they owe more than it's worth, but they can't stay because they're going deeper into debt being there. All this stress and hardship after a 5-10% drop in house prices!

Know the Value of Housing

Always remember, the intrinsic value of a house is limited to the value of the its shelter. If it makes much more financial sense to rent a place (which provides equivalent shelter value), renting is logically the current better long-term choice.

Homeownership in Canada has become a status symbol because of its connection to wealth illusion. That in itself is a strike against homeownership for a Moose; we don't follow the herd.

There is no special medal, no increase in life quality, no road to wealth, and no wisdom in choosing pricey homeownership over sensible renting. The value of housing lies in what it provides, not the form of possession in which it is obtained.

How This Housing Obsession Occurred

Decades ago house prices were reasonable. In the 80s, and even in the early 90s, one could buy a house without selling their firstborn. In most markets, it made financial sense for a gainfully employed family to buy a house.

Since this time period we have seen an enormous drop in interest rates. Arguably interest rates have never been this low since the organization of mankind. In Canada our governments borrow cheap, our homeowners borrow cheap, our banks get money cheap, our provinces borrow cheap, and our largest corporations borrow cheap.

So cheap in fact that asset prices are actually increasing at a higher rate than the interest on borrowing. Translation: borrowed money is basically free.

As a result, house prices go up despite our largely stagnant incomes. And when people see prices going up on an asset they don't really have to pay for, well... they get excited. This causes asset prices to increase even more, detaching from normal fundamental constraints.

While it starts slow, the lure of easy wealth begins to burn hotter. By the time we got into the mid-2000s, things were getting really hot. The Financial Crisis shut down housing markets around the world, but in Canada and a few other countries our governments acted quickly to prop up housing markets with low rates, enabling longer borrowing terms, dropping downpayments, and encouraging foreign money pouring into our real estate markets.

This combination of incentives was liking spraying gasoline on a bonfire. House prices in key markets went nuts. Annual price increases have tripled, quadrupled, and went up 10 times our wage growth. Home-owning Canadians in these markets got filthy rich by mowing their lawns, barbecuing in the backyard, and shoveling snow like they always have.

There is no increase in productivity, no great fundamental economy with awesome job growth, and no great leaps in innovation. In fact our sans-housing economy has been comatose for years. All this wealth has been riding on the price inflation of a single, unproductive, dead asset: four chipboard walls and an asphalt roof.

Why the Party Will End

Here's the thing though... cheap borrowing, the major catalyst for this asset bubble, is coming to an end. The US Federal Reserve Bank--the bank of banks for the capitalist world--has started inching up interest rates. This means mortgage rates in Canada will also go up over time.

Also, prices simply cannot continue rising faster than inflation--we're already past the point of affordability given our larger economic situation. Even if homes go up at a rate just 2% higher than inflation, in 30 years the average house in Canada will cost over $1 million. Vancouver and Toronto will be $1.6M--in today's dollars.

Even if interest rates went down to zero, the payment on a million dollar mortgage would be $3,500 a month. If interest rates normalized to around 5%, the payment would be a massive $5,800 a month--24% higher than net monthly household income!

The only, and I mean only, way house prices can continue to increase faster than the inflation rate over the long term is if one factor changes: household income. Given the lack of productivity growth, I am sceptical that incomes will materially increase relative to inflation.

Given the facts, I believe 30 years from now house prices will be lower than they are today after adjusting for inflation.

Asset price euphoria can only continue for so long. The longer it lasts, the more exciting it is, and the harder and more painful the correction will be. After all, asset bubbles are like a good frat party.

Always do the math and compare to renting before buying a place. Never ignore maintenance/depreciation costs, even if it's a new home. Don't eliminate your required retirement savings just to buy a house--paying down your mortgage a fraction at a time is not a substitute for a healthy investment portfolio. If you must buy, always follow the Moose Rules.

Come back Friday for the next step of Smith Manoeuvre.

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