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Thursday, May 5, 2011
Wednesday, May 12, 2010
Debts Keep Rising: Keep an eye on your debt level
A slowdown in spending in Canada? What slowdown? Canadian’s continue to spend and find themselves with the highest household debt in history.
"Household spending, particularly in the housing sector, was a mainstay of the economy during the recession. But as interest rates rise – and they will - a bigger percentage of household income may need to be diverting into paying off debt, meaning less cash for other purchases, like autos, appliances, furniture and clothes."
How will an 1% or 2% increase in borrowing rates affect you? How about a 5% increase? Run the numbers and make sure you’re prepared.
OTTAWA - Neither recession, global uncertainty nor growing joblessness appears to have stayed Canadians' appetite for spending money they don't have.
Julian Beltrame, The Canadian Press
A new report by the Certified General Accountants Association of Canada shows that household debt in the country kept rising through the recession and peaked in December at $1.41 trillion.
That's $41,740 on average per Canadian, or debt to income ratio of 144 per cent that is the worst among 20 advanced countries in the OECD.
"This report is another indication of Canadians' readiness to consume today and pay later," says association president Anthony Ariganello.
"The concern is do they understand the full cost of paying later?"
The Bank of Canada has also voiced similar concerns, with governor Mark Carney having repeatedly advised Canadians to ensure they will be able to meet their mortgage commitments once rates increase. Ottawa has put that cautionary principle into effect by stiffening the means test chartered banks must apply when issuing open-ended mortgages.
Most Canadians don't yet share that concern. The accountants' survey found that almost 60 per cent of Canadians whose debt had increased still felt they could manage it or take on more obligations.
But the accountants say many households could find themselves in difficulty when interest rates, as expected, begin to rise.
The report estimates that even a small two per cent increase in rates would mean that mid-income and higher income households would have to cut their outlays on non-essentials by between nine and 11 per cent.
The finding is similar to one reached by the Canadian Association of Accredited Mortgage Professionals in a survey results release Monday.
The survey showed that while Canadians appeared well positioned to absorb higher rates, there would be a significant number that would come under stress. The mortgage professionals estimated that 475,000 households would be challenged if mortgages rates rose to 5.25 per cent, and that 375,000 were already facing pressure paying their bills.
The most likely outcome for a debt squeeze is that households will stop spending on non-essentials, and that could ripple in a general slowing of economic growth.
Household spending, particularly in the housing sector, was a mainstay of the economy during the recession. But as interest rates grow, a bigger percentage of household income may need to be diverting into paying off debt, meaning less cash for other purchases, like autos, appliances, furniture and clothes.
BMO Capital Markets economist Sal Guatieri says that is the flip-side to the Bank of Canada's decision to slash rates to historic lows during the recession.
"That's why we did not experience a great recession," he noted. "That was the intention all along of the Bank of Canada, to get people borrow and spend. The problem is if that continued, Canada eventually would have a debt problem."
But that is why the central bank is preparing to reverse course and start increasing the cost of borrowing, he added.
Most analysts believe Carney will start moving on rates on June 1 with a small quarter-point hike.
"Household spending, particularly in the housing sector, was a mainstay of the economy during the recession. But as interest rates rise – and they will - a bigger percentage of household income may need to be diverting into paying off debt, meaning less cash for other purchases, like autos, appliances, furniture and clothes."
How will an 1% or 2% increase in borrowing rates affect you? How about a 5% increase? Run the numbers and make sure you’re prepared.
OTTAWA - Neither recession, global uncertainty nor growing joblessness appears to have stayed Canadians' appetite for spending money they don't have.
Julian Beltrame, The Canadian Press
A new report by the Certified General Accountants Association of Canada shows that household debt in the country kept rising through the recession and peaked in December at $1.41 trillion.
That's $41,740 on average per Canadian, or debt to income ratio of 144 per cent that is the worst among 20 advanced countries in the OECD.
"This report is another indication of Canadians' readiness to consume today and pay later," says association president Anthony Ariganello.
"The concern is do they understand the full cost of paying later?"
The Bank of Canada has also voiced similar concerns, with governor Mark Carney having repeatedly advised Canadians to ensure they will be able to meet their mortgage commitments once rates increase. Ottawa has put that cautionary principle into effect by stiffening the means test chartered banks must apply when issuing open-ended mortgages.
Most Canadians don't yet share that concern. The accountants' survey found that almost 60 per cent of Canadians whose debt had increased still felt they could manage it or take on more obligations.
But the accountants say many households could find themselves in difficulty when interest rates, as expected, begin to rise.
The report estimates that even a small two per cent increase in rates would mean that mid-income and higher income households would have to cut their outlays on non-essentials by between nine and 11 per cent.
The finding is similar to one reached by the Canadian Association of Accredited Mortgage Professionals in a survey results release Monday.
The survey showed that while Canadians appeared well positioned to absorb higher rates, there would be a significant number that would come under stress. The mortgage professionals estimated that 475,000 households would be challenged if mortgages rates rose to 5.25 per cent, and that 375,000 were already facing pressure paying their bills.
The most likely outcome for a debt squeeze is that households will stop spending on non-essentials, and that could ripple in a general slowing of economic growth.
Household spending, particularly in the housing sector, was a mainstay of the economy during the recession. But as interest rates grow, a bigger percentage of household income may need to be diverting into paying off debt, meaning less cash for other purchases, like autos, appliances, furniture and clothes.
BMO Capital Markets economist Sal Guatieri says that is the flip-side to the Bank of Canada's decision to slash rates to historic lows during the recession.
"That's why we did not experience a great recession," he noted. "That was the intention all along of the Bank of Canada, to get people borrow and spend. The problem is if that continued, Canada eventually would have a debt problem."
But that is why the central bank is preparing to reverse course and start increasing the cost of borrowing, he added.
Most analysts believe Carney will start moving on rates on June 1 with a small quarter-point hike.
Thursday, May 6, 2010
Bonds and interest rates: false safety?
The question all investors have to ask themselves right now about their income-producing holdings: should I stay or should I go now?
Bonds and GICs maxed out with yields of about 4 per cent for five years just recently.
Many know the bond conundrum: Bond or Fixed Income funds fall in price – and will continue to fall in price - as bond yields rise. (Conversely, they go up as rates decline)
If you’re going to hold onto Bond or Fixed Income funds, get used to this sort of thing. Preferred shares behave more like bonds than stocks - they’re considered fixed income by some, but not all, advisers - and most types of bonds will fall in price as we continue moving through the rising rate cycle just begun.
Should you care as an investor about Bond or Fixed Income funds falling in price? If you’re tightly focused on generating income and can accept a price decline, then no. Bond or Fixed Income funds will continue to pay coupon interest commitments as rates rise, which means the income will flow.
The arguments for selling are that your prime goal is to preserve capital, or that it will drive you to distraction to see the value of CPD (and possibly other income holdings) in decline. After 2008, investors have every right to be sensitive about seeing their stocks fall in value. At the same time, however, one of the lessons of 2008 was that quality income investments continued to deliver cash to investors, even as they plunged in value.
Preferred shares were not immune to the carnage of 2008. You can see this in the fact that Bond or Fixed Income funds price is still down by almost 20 per cent on a cumulative three-year basis.
Expect another rally to begin when interest rates peak and everyone’s looking ahead to rate declines. Will you be around for the rebound of bonds and other income-producing securities? Depends on whether you’re all about income or capital preservation.
Material for this post was obtained from Rob Carrick's recent article
Bonds and GICs maxed out with yields of about 4 per cent for five years just recently.
Many know the bond conundrum: Bond or Fixed Income funds fall in price – and will continue to fall in price - as bond yields rise. (Conversely, they go up as rates decline)
If you’re going to hold onto Bond or Fixed Income funds, get used to this sort of thing. Preferred shares behave more like bonds than stocks - they’re considered fixed income by some, but not all, advisers - and most types of bonds will fall in price as we continue moving through the rising rate cycle just begun.
Should you care as an investor about Bond or Fixed Income funds falling in price? If you’re tightly focused on generating income and can accept a price decline, then no. Bond or Fixed Income funds will continue to pay coupon interest commitments as rates rise, which means the income will flow.
The arguments for selling are that your prime goal is to preserve capital, or that it will drive you to distraction to see the value of CPD (and possibly other income holdings) in decline. After 2008, investors have every right to be sensitive about seeing their stocks fall in value. At the same time, however, one of the lessons of 2008 was that quality income investments continued to deliver cash to investors, even as they plunged in value.
Preferred shares were not immune to the carnage of 2008. You can see this in the fact that Bond or Fixed Income funds price is still down by almost 20 per cent on a cumulative three-year basis.
Expect another rally to begin when interest rates peak and everyone’s looking ahead to rate declines. Will you be around for the rebound of bonds and other income-producing securities? Depends on whether you’re all about income or capital preservation.
Material for this post was obtained from Rob Carrick's recent article
Sunday, May 2, 2010
The Economy and Markets: time for prospective
Greece and Europe, interest rates on the rise, the stock markets up some 70% plus and the global economy moving along. What does this all add up to for our retirement and investment portfolios?
The following is an excellent, albeit somewhat technical, prospective on matters:
Macro Overview: Economy & Markets
It is time to take a big picture look at everything: This is a summation of everything we have discussed over the past month and quarter. Where are we in this particular cycle?
Macro-Economy: The economic backdrop seems to be confusing quite a few people. Perhaps its the psychology of the moment. I keep hearing weak, data free analysis. Here is our 7 point overview:
1. The Economy is recovering; The recession is over: Of that, we have no doubt, as the data is clear. The free fall of 2008-09 is over, and a gradual improvement is seen across the board. Industrial manufacturing, exports, autos, retail sales, durable goods, travel all confirm the economy is “healing.”
2. But, the recovery is “Lumpy”: — Part of the reason some people doubt the recovery story is how unevenly distributed the improvements are. Geographically, much of the country is still soft. In retail, it is pent up demand plus luxury goods. In technology, its mobile devices and consumer products. Financial firms are taking advantage of the steep yield curve and ZIRP to arbitrage profits, as opposed to actually lending. Profits are not evenly distributed either.
3. Government spending is only part of the story: In the midst of the crisis, Credit froze, the consumer panicked, and business spending looked to be going extinct. Uncle Sam temporarily bridged the gap.
But the argument that government spending is the only game in town is overstates the case. Private sector CapEx spending and hiring is improving (albeit slowly); Consumers have come out of their bunkers and are dining out, going to the movies, hitting the malls, traveling.
We have not returned to the Home ATM days of 2004-07 — and probably wont in our lifetimes — but the present environment is a massive improvement from the 2008-09 contraction.
4. Weak Improvement in Employment: The massive labour under-utilization is one of the two biggest drags on the economy (RE being the other). Near record low hours worked suggest that employers can simply increase hours rather than make new hires. Thus, I do not look for a V-shaped employment recovery — forget about 400-500k NFP data — anytime soon.
There are 15 million unemployed, and 8 million underemployed — it will take a long time for them to be re-absorbed into the economy. The 2001 recession took 47 months to return employment to pre-recession levels. This recession will likely take 65-75 months to achieve that goal — if not longer.
5. Real Estate (Commercial and Residential): We do not believe that residential real estate has found its natural price level yet. It remains over-valued. This is due to artificially low mortgage rates, foreclosure abatements and mortgage mod programs. We are probably 10-15% over valued, when measured by Median Sales price to median Income, Rent vs Ownership Costs, and Home Value as a Percentage of GDP.
Commercial real estate tends to lag residential by 18-24 months. It is still adapting to the downsizing of America, particularly retail. The over-investment in commercial real estate of the past decade will take at least another 5 years to resolve, if not longer.
6. Deflation? Inflation?: Well, as my pal Jeff Saut notes, we definitely have “flation.” Just not the type that everyone fears.
As of today, Deflation is a fact, inflation is an opinion. We are still living in a period of falling prices, heavy discounts, wage deflation, asset depreciation and lack of pricing power. The S&P500 is below levels seen in the 1990s; Wages are flat for a decade.
The risk going forward is that the Fed fails to remove the accommodations in time. But they have Japan as an example of Zirp with no inflation. So long as labor under-utilization is near record levels, they can take their time in tightening.
7. The rest of the world: Europe is a disaster, and is likely to remain that way for a while. Asian economies are doing very well, helping to pull the rest of the world along — but China’s market is at 6 months lows, something few people are discussing. The risk in China’s real estate and stock markets has been mostly ignored,. Commodity regions and emerging markets still have strength.
~~~
Market Overview: Unfortunately, most of the commentary we see about markets have been unusually ignorant, myth driven, and based on rationalizing bad decision making.
Our views:
1. Cyclical Bull, Secular Bear: The secular bear market collapse of 55% was right in line with other such debacles. The collapse was faster and more furious than typical, but the depth was normal. The snapback is also well within the range of bear market rallies — cyclical bull runs that last 6 to 24 months and range from 25% to 135%.
While it is possible that we are witnessing the start of a new 1982-like Secular bull market, the valuations argue against it. Stocks most likely simply did not get cheap enough — or despised enough — to initiate a multi-decade bull run. My best guess about that bottom is its likely 3-7 years away.
2. Snapback: The 75% bounce over a year seems like a lot — until you put it into the context of a six month 5,000 point collapse. we call that the Armageddon trade — Dow 5000! 3000! We’re going to zero! – was a spasm of panic. It has been mostly unwound the past year.
3. Correction coming (eventually): The cyclical bull tends to end with ~25% correction that lasts about a year. So we are always looking for signs that this run is over. Despite the recent turmoil, we have not found confirmation that the bull run is over — yet.
We look at many factors to help identify that inflection point:
4. Liquidity: Institutional fund managers seem to be all in (only 3% cash), while Investors are at only median levels of equity exposure. Liquidity is still abundant, free money abides. Money flow for the past few months have gone into US equities — that is a new element — at about $2B per week.
5. Internals: The market technical/internals remain constructive: Breadth and momentum are positive. New 52 week highs are also strong. Earnings are supporting some of the move, as year over year comparos are absurdly easy. The uptrend remains in place, and until it is broken we maintain an upside bias.
6. Sentiment: The biggest risk is the unusually high level of bulls. Note however that event hat has moderated over the past week. We are not at the sorts of extremes yet that make the contrarian in us scream SELL.
Source: Barry Ritholtz
The following is an excellent, albeit somewhat technical, prospective on matters:
Macro Overview: Economy & Markets
It is time to take a big picture look at everything: This is a summation of everything we have discussed over the past month and quarter. Where are we in this particular cycle?
Macro-Economy: The economic backdrop seems to be confusing quite a few people. Perhaps its the psychology of the moment. I keep hearing weak, data free analysis. Here is our 7 point overview:
1. The Economy is recovering; The recession is over: Of that, we have no doubt, as the data is clear. The free fall of 2008-09 is over, and a gradual improvement is seen across the board. Industrial manufacturing, exports, autos, retail sales, durable goods, travel all confirm the economy is “healing.”
2. But, the recovery is “Lumpy”: — Part of the reason some people doubt the recovery story is how unevenly distributed the improvements are. Geographically, much of the country is still soft. In retail, it is pent up demand plus luxury goods. In technology, its mobile devices and consumer products. Financial firms are taking advantage of the steep yield curve and ZIRP to arbitrage profits, as opposed to actually lending. Profits are not evenly distributed either.
3. Government spending is only part of the story: In the midst of the crisis, Credit froze, the consumer panicked, and business spending looked to be going extinct. Uncle Sam temporarily bridged the gap.
But the argument that government spending is the only game in town is overstates the case. Private sector CapEx spending and hiring is improving (albeit slowly); Consumers have come out of their bunkers and are dining out, going to the movies, hitting the malls, traveling.
We have not returned to the Home ATM days of 2004-07 — and probably wont in our lifetimes — but the present environment is a massive improvement from the 2008-09 contraction.
4. Weak Improvement in Employment: The massive labour under-utilization is one of the two biggest drags on the economy (RE being the other). Near record low hours worked suggest that employers can simply increase hours rather than make new hires. Thus, I do not look for a V-shaped employment recovery — forget about 400-500k NFP data — anytime soon.
There are 15 million unemployed, and 8 million underemployed — it will take a long time for them to be re-absorbed into the economy. The 2001 recession took 47 months to return employment to pre-recession levels. This recession will likely take 65-75 months to achieve that goal — if not longer.
5. Real Estate (Commercial and Residential): We do not believe that residential real estate has found its natural price level yet. It remains over-valued. This is due to artificially low mortgage rates, foreclosure abatements and mortgage mod programs. We are probably 10-15% over valued, when measured by Median Sales price to median Income, Rent vs Ownership Costs, and Home Value as a Percentage of GDP.
Commercial real estate tends to lag residential by 18-24 months. It is still adapting to the downsizing of America, particularly retail. The over-investment in commercial real estate of the past decade will take at least another 5 years to resolve, if not longer.
6. Deflation? Inflation?: Well, as my pal Jeff Saut notes, we definitely have “flation.” Just not the type that everyone fears.
As of today, Deflation is a fact, inflation is an opinion. We are still living in a period of falling prices, heavy discounts, wage deflation, asset depreciation and lack of pricing power. The S&P500 is below levels seen in the 1990s; Wages are flat for a decade.
The risk going forward is that the Fed fails to remove the accommodations in time. But they have Japan as an example of Zirp with no inflation. So long as labor under-utilization is near record levels, they can take their time in tightening.
7. The rest of the world: Europe is a disaster, and is likely to remain that way for a while. Asian economies are doing very well, helping to pull the rest of the world along — but China’s market is at 6 months lows, something few people are discussing. The risk in China’s real estate and stock markets has been mostly ignored,. Commodity regions and emerging markets still have strength.
~~~
Market Overview: Unfortunately, most of the commentary we see about markets have been unusually ignorant, myth driven, and based on rationalizing bad decision making.
Our views:
1. Cyclical Bull, Secular Bear: The secular bear market collapse of 55% was right in line with other such debacles. The collapse was faster and more furious than typical, but the depth was normal. The snapback is also well within the range of bear market rallies — cyclical bull runs that last 6 to 24 months and range from 25% to 135%.
While it is possible that we are witnessing the start of a new 1982-like Secular bull market, the valuations argue against it. Stocks most likely simply did not get cheap enough — or despised enough — to initiate a multi-decade bull run. My best guess about that bottom is its likely 3-7 years away.
2. Snapback: The 75% bounce over a year seems like a lot — until you put it into the context of a six month 5,000 point collapse. we call that the Armageddon trade — Dow 5000! 3000! We’re going to zero! – was a spasm of panic. It has been mostly unwound the past year.
3. Correction coming (eventually): The cyclical bull tends to end with ~25% correction that lasts about a year. So we are always looking for signs that this run is over. Despite the recent turmoil, we have not found confirmation that the bull run is over — yet.
We look at many factors to help identify that inflection point:
4. Liquidity: Institutional fund managers seem to be all in (only 3% cash), while Investors are at only median levels of equity exposure. Liquidity is still abundant, free money abides. Money flow for the past few months have gone into US equities — that is a new element — at about $2B per week.
5. Internals: The market technical/internals remain constructive: Breadth and momentum are positive. New 52 week highs are also strong. Earnings are supporting some of the move, as year over year comparos are absurdly easy. The uptrend remains in place, and until it is broken we maintain an upside bias.
6. Sentiment: The biggest risk is the unusually high level of bulls. Note however that event hat has moderated over the past week. We are not at the sorts of extremes yet that make the contrarian in us scream SELL.
Source: Barry Ritholtz
Tuesday, April 27, 2010
How is your path to a prosperous retirement?
We financial planners preach the merits, virtues and practical common sense of “planning for that eventual day of retirement”. But it is still truly amazing how many people choose not to adhere to these basic tenants, or, worse, do not take the time to meet with an accredited financial planner to set a path to prosperity.
A recent poll by Ipsos Reid shows some staggering results. The key concerns for Canadians over the age of 50 are:
- Inflation and taxes the biggest worries.
- Inflation and taxes are among the top concerns for retirees, with 35% worried that inflation will negatively impact their retirement income, compared to 43% of pre-retirees.
- Sixty-two per cent of retirees worry about taxes on their income, with 66% believing the percentage of their income required for taxes will rise in the next 10 years. Retirees say they are currently living on 56% of their pre-retirement income, indicating that spending drops significantly in retirement.
- 22% of respondents entered retirement with a mortgage on their primary residence.
- The majority of retirees (70%) feel it is still important to be able to save part of their income, yet 28% have acquired new credit products since they retired.
- “It's not uncommon to be concerned about maintaining a sustainable level of income in retirement, but costs you never counted on may also arise,” adds Davies. “For example, our poll found that almost one-in-five retirees spend over $1,000 annually on prescription drugs. Working with a qualified advisor can help you prepare for taxes, inflation and unexpected costs that may impact your retirement goals.”
Many Canadians enter retirement with debt: poll
Four-in-ten Canadians over the age of 50, who have assets of at least $100,000, retired with some form of debt, according to a new poll released by Royal Bank of Canada (TSX:RY).
The first annual Retirement Myths and Realities poll, which examines Canadians' expectations and experiences in retirement, also found that 22% of respondents entered retirement with a mortgage on their primary residence.
The majority of retirees (70%) feel it is still important to be able to save part of their income, yet 28% have acquired new credit products since they retired.
“More and more, Canadians are carrying debt into retirement, which is not necessarily a bad thing,” says Lee Anne Davies, head, retirement strategies, RBC.
“Having access to credit in retirement can be beneficial to managing income and cash flow and provide additional flexibility. To help make your retirement dreams a reality, our advice is to start early and prepare a comprehensive financial action plan that will keep you focused on paying down debt and saving, as well as establishing a budget for both your pre- and post-retirement years.”
The poll was conducted by Ipsos Reid from March 10-19, 2010. For this survey, a national sample of 2,143 adults aged 50 and over with household assets of at least $100,000 from Ipsos' Canadian online panel was interviewed online.
By IE Staff
A recent poll by Ipsos Reid shows some staggering results. The key concerns for Canadians over the age of 50 are:
- Inflation and taxes the biggest worries.
- Inflation and taxes are among the top concerns for retirees, with 35% worried that inflation will negatively impact their retirement income, compared to 43% of pre-retirees.
- Sixty-two per cent of retirees worry about taxes on their income, with 66% believing the percentage of their income required for taxes will rise in the next 10 years. Retirees say they are currently living on 56% of their pre-retirement income, indicating that spending drops significantly in retirement.
- 22% of respondents entered retirement with a mortgage on their primary residence.
- The majority of retirees (70%) feel it is still important to be able to save part of their income, yet 28% have acquired new credit products since they retired.
- “It's not uncommon to be concerned about maintaining a sustainable level of income in retirement, but costs you never counted on may also arise,” adds Davies. “For example, our poll found that almost one-in-five retirees spend over $1,000 annually on prescription drugs. Working with a qualified advisor can help you prepare for taxes, inflation and unexpected costs that may impact your retirement goals.”
Many Canadians enter retirement with debt: poll
Four-in-ten Canadians over the age of 50, who have assets of at least $100,000, retired with some form of debt, according to a new poll released by Royal Bank of Canada (TSX:RY).
The first annual Retirement Myths and Realities poll, which examines Canadians' expectations and experiences in retirement, also found that 22% of respondents entered retirement with a mortgage on their primary residence.
The majority of retirees (70%) feel it is still important to be able to save part of their income, yet 28% have acquired new credit products since they retired.
“More and more, Canadians are carrying debt into retirement, which is not necessarily a bad thing,” says Lee Anne Davies, head, retirement strategies, RBC.
“Having access to credit in retirement can be beneficial to managing income and cash flow and provide additional flexibility. To help make your retirement dreams a reality, our advice is to start early and prepare a comprehensive financial action plan that will keep you focused on paying down debt and saving, as well as establishing a budget for both your pre- and post-retirement years.”
The poll was conducted by Ipsos Reid from March 10-19, 2010. For this survey, a national sample of 2,143 adults aged 50 and over with household assets of at least $100,000 from Ipsos' Canadian online panel was interviewed online.
By IE Staff
Tuesday, April 20, 2010
Mortgages: To lock-in or not?
With all the hype around mortgage rates increasing, as opposed to writing directly about this I found a great piece from Ed Rempel. He really covers the “to lock-in or not” debate very well.
Avoid the 5-Year Fixed Mortgage Trap
Should I go short or long; fixed or variable with my mortgage?
“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra
Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.
They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.
That is why we call it the “5-Year Fixed Mortgage Trap”.
I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.
If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.
“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:
3 Mortgage myths about 5-year fixed mortgages:
1. They are safer
A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.
If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?
2. Rates may go very high like in the 1980s
I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!
Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.
3. Your mortgage payments will stay the same
Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.
Top 4 reasons to stick to short or variable mortgages:
1. Save thousands
On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!
2. Low risk
With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!
3. Flexibility
Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.
4. Negotiating power
The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!
The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.
Conclusions:
1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.
2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.
3. Never take a mortgage term longer than you expect to stay in your current home.
We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.
Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.
Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.
Avoid the 5-Year Fixed Mortgage Trap
Should I go short or long; fixed or variable with my mortgage?
“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra
Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.
They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.
That is why we call it the “5-Year Fixed Mortgage Trap”.
I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.
If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.
“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:
3 Mortgage myths about 5-year fixed mortgages:
1. They are safer
A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.
If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?
2. Rates may go very high like in the 1980s
I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!
Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.
3. Your mortgage payments will stay the same
Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.
Top 4 reasons to stick to short or variable mortgages:
1. Save thousands
On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!
2. Low risk
With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!
3. Flexibility
Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.
4. Negotiating power
The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!
The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.
Conclusions:
1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.
2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.
3. Never take a mortgage term longer than you expect to stay in your current home.
We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.
Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.
Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.
Tuesday, April 13, 2010
Home Ownership: A Good or Bad Investment?
Why home-buying is a great investment
I have little to add, this is a good piece for anyone who owns a home or is pondering a purchase or sale. Full credit goes to John Kelleher and Joe Castaldo
John Kelleher responds to Joe Castaldo's story "Why buying a house is a bad investment."
I refer to your cover article “Why buying a house is a bad investment” by Joe Castaldo in your March 15, 2010 issue (see below for full article).
This article is not a serious discussion of the topic that it purports to cover. It misses the most critical issues involved in understanding whether a home is a good or bad investment and confuses the topic with some misleading charts and facts.
Let me try to illustrate the errors in the article by referring to a summary chart the author shows on top of page 28 [not shown online] — a chart that compares housing returns in various cities to stock market returns. The chart and the article contain the following errors:
1. Exogenous benefits of an “owner lived in” housing investment. When an owner buys a home and lives in it, the owner receives what economists call “exogenous benefits” — meaning that (in addition to being an investment that you can buy and sell for a profit) a home is something that one can live in. You can’t live in a stock or a bond, so this “exogenous benefit” makes a home that you purchase to live in quite different. Simply put, the owner doesn’t have to pay rent to live somewhere else. This benefit is very large, yet is not quantified in the returns when one buys and sells a home. So comparing housing returns to stock returns without considering this issue is misleading and wrong. For example – let’s say I lived in a home for five years and sold the house exactly for what I bought it for — so I didn’t lose any money but I didn’t make any either. It would not be correct to compare the 0% return that is seemingly earned in that case with an 18% return on stocks and say that the house was a bad investment. The owner of the house had a roof over their head for five years! That benefit could easily be worth hundreds of thousands of dollars but isn’t reflected in the numbers because the owner is effectively “paying rent” to himself. This error is a serious one and should have stopped the article’s publication on its own.
2. Principal residence tax exemption. Amazingly, the article fails to mention the principal residence tax exemption on housing in Canada. Gains on housing are tax free, while the gains on investments are taxed! This is another huge miss that should have been caught and another reason why the chart and the article are wrong. By comparing pre-tax returns on stocks to what are effectively post-tax returns on housing, the article makes a critical error. So when an investor has a gain of $100 on a principal residence they keep $100. When an investor has a gain of $100 on stocks the homeowner keeps only about $77. (assuming cap gains tax of about 23%). This is another error that should have stopped this article’s publication.
3. Comparing investments with totally different risk profiles. One of the most basic principles in finance is that one should never compare returns on investments that have different risk profiles. Investing in stocks is generally more risky than investing in real estate — so you can’t make a chart like the one on page 28 and conclude (as most of your readers surely did) that housing is a bad investment because the returns appear lower than the returns for stocks. The author should have compared each asset to its own risk benchmarks (risk-adjusted returns). This is another huge miss that leads to a misleading conclusion.
4. Fees, commissions, and capital expenditures. Fees, ongoing capital expenditures, and commissions for a housing purchase are large and materially impact the attractiveness of a house as an investment. The friction associated with other investments is generally a lot lower. The author’s chart makes the comparison before all of these expenses which again makes the comparison silly. It is true that he chooses to mention this issue in the body of the article, but makes no attempt at quantifying this issue or estimating how it impacts returns. This would not have been hard and would have made for a more substantive contribution.
In addition to the errors above, the article uses poor examples to make points. These examples actually support the opposite view to what the author suggests! The author might have realized this if he had taken five minutes to run the math. Take the article’s assertion that leverage allows a buyer to make a $50,000 profit given a 20% down payment on a $500,000 house where the asset’s value appreciates to $550,000 in two years. Since mortgages don’t come free, this point is wrong, and materially so. Let’s do some work for a moment. If I assume just a 4% mortgage on the $400,000 of debt in your reporter’s example, the hypothetical profit drops from $50,000 to about $20,000 (yes, you have to pay about $30,000 in interest in those first two years). Now if I add in commissions, land transfer taxes, property taxes and so on the profit actually turns in to a loss. This is why it generally doesn’t make sense to buy a house for only two years. I respectfully suggest that these examples need more thinking and more homework.
Overall, the misses and errors in this article are really disappointing.
When a person buys a house to live in, it is actually an incredibly complex financial transaction. It is akin to a leveraged buyout of a company where the new owner lives in the corporate offices (thereby avoiding the need to rent elsewhere) and where the gains on the sale of the company can be enjoyed tax free. Many variables impact the true return on this decision and the only way to understand that return is to model it. Doing so requires some careful work and some basic training on financial principles.
Regards,
John Kelleher
Why buying a house is a bad investment
Interest rate hikes are looming, and talk of bubbles abounds — so what's with the real estate buying frenzy?
By Joe Castaldo, a staff writer for Canadian Business.
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.
Canadians are clearly more than willing to take major financial risks to buy a home. What's ironic is that real estate price gains can be somewhat of an illusion when inflation is taken into account. "People get fooled by nominal numbers," Milevsky says. Long-term returns in real terms are less than spectacular. Harvard economics professor Edward Glaeser looked at the returns in more than 300 metropolitan areas in the U.S. between 1970 and 2000 (before the unsustainable credit-fuelled boom) and found prices increased on average only 1.7% annually. Yale School of Management professor Roger Ibbotson and a colleague examined returns between 1978 and 2004, a period including part of the U.S. housing bubble, and found residential real estate provided an annualized return of 8.6%. The S&P 500 significantly topped that with a 13.4% return.
Housing in Canada hasn't behaved much differently. In 2004, Milevsky examined the compounded annual returns on residential real estate in a dozen Canadian cities over the past 25 years. Toronto provided the best return at 5.75%. But the TSX provided an 8.64% return over the same period. The S&P 500 index did even better during that period, at 13.85%. The drawback, of course, was that stock indexes were far more volatile than real estate, although in some markets, the difference was not so pronounced. Real estate in Vancouver, for example, provided only a 3.68% compounded annual return with nearly the same level of volatility as the S&P 500.
Homeowners can easily argue that while the returns are modest, at least they are building wealth rather than paying rent to a landlord. Leverage can also make a huge difference on returns for homeowners if they choose to sell. In crude terms, assume a 20% down payment on a $500,000 house that is sold a few years later for $550,000. After paying back the mortgage, the seller is left with a $50,000 profit, or a return of 50% on the initial down payment. As far as investments go, that is an eye-popping return. But leverage is damaging when prices fall. A homeowner can end up with outstanding mortgage payments worth more than the house.
There are also a slew of egregious fees associated with real estate that affect returns. There are home inspection and appraisal fees, which can total hundreds of dollars each, not to mention land registration fees, legal fees and perhaps title insurance to purchase. Real estate agents take a commission, too — expect to pay at least 2.5% of the purchase price of the home. Regular maintenance has to be done for the home to maintain its value, and that can quickly add up. Canadian personal finance authors Eric Tyson and Tony Martin say a home usually needs to appreciate about 15% in order for the buyer to recoup all of the transaction and maintenance costs.
A society of renters is also more mobile. Andrew Oswald, an economics professor at the University of Warwick in England, found that high unemployment goes hand-in-hand with high rates of home ownership. In Britain, unemployment doubled since 1950 as the share of the population that rented dropped from 60% to less than 10%. Oswald found similar relationships in other countries, such as Finland and Spain. The Netherlands and Switzerland, by contrast, had lower unemployment and a lower rate of home ownership. Oswald theorized that, while homeowners are often stuck with their property through tough labour markets, renters can more easily relocate to find work, which lessens structural unemployment. His theory has been criticized for placing too much emphasis on a causal link between home ownership and unemployment, but it does echo Fed economist Pence's concern about the correlation between home prices and the job market. Prices fall when the labour market tanks. Everyone needs financial security during those uncertain times, but for homeowners, their greatest asset won't necessarily deliver.
In December of last year, CIBC economist Benjamin Tal estimated home prices in Canada to be about 7% overvalued, which he deemed to be a "modest overshooting" that did not necessarily portend a dramatic price correction. Economists at TD Bank Financial Group put the overvaluation at 12%, adding it could rise to 15% this year as buying activity rages on. David Rosenberg, the chief economist and strategist now at Gluskin Sheff + Associates who called a U.S. housing bubble back in 2004, has a more pessimistic take. He says home prices in Canada are between 15% and 35% overvalued, and could plummet as far as 20% from current levels. "That isn't cataclysmic, but believe me, that would hurt a lot of people," he says. A drop that steep would wipe out virtually all of the gains made in the past year and could leave some Canadians who bought at the top of the market with negative equity in their homes.
Housing has undergone painful corrections in the past. The current crop of homebuyers is likely too young to remember the housing bubble that burst in 1981, and the slow recovery that followed. According to data from the Centre for Urban Economics and Real Estate at the Sauder School of Business in B.C., the average real home price in Vancouver took more than 10 years to get back to its peak, before dipping again in the mid-1990s. Calgary fared even worse. Home prices didn't return to 1981 levels until the first quarter of 2006. Toronto homebuyers experienced a similar pain when a speculator-driven bubble burst around 1989. In real terms, prices didn't recover until 2007.
A wait that long can be brutal for those who bought at the top of the market. It can also thwart retirement plans for those expecting to sell their homes and use the profits to downsize and fund their golden years, particularly if they've neglected to save by other means, such as with an RRSP. Canadians have a significant portion of their wealth tied up in real estate — roughly 48%, according to the Vanier Institute of the Family, the highest level in two decades. The fact that real estate markets do fall highlights the need for Canadians to prepare for wild swings in the economy. That message is perhaps more important than ever as the buying rush continues, and the market looks increasingly pricey. "If you're going out buying a home today, understand that you're not following the doctrine of buy low and sell high," Rosenberg says. "You're doing the exact opposite."
The problem for policy-makers — and buyers trying to figure out the best time to enter the market — is that the existence of a bubble is impossible to know for certain until it pops. Gregory Klump, chief economist for the Canadian Real Estate Association, argues we are not yet in bubble territory. "I would describe this as a micro-cycle where demand is outstripping supply," he says. Housing starts are rising, which will help to satisfy demand. Higher prices are also bringing the sellers back to the market who disappeared in 2008 when sales activity dropped, all of which will lead to a more balanced market later in the year. There are signs of optimism elsewhere, such as in the Canadian house-price forwards market operated by Teranet and the National Bank Financial Group. The market allows investors to essentially place bets on where prices are headed, and the index reflects their collective sentiment. As of January, the index showed investors expect a bump of up to 9% in residential real estate by 2014. (Those investors have been wrong before, of course; last year, the index showed a potential nosedive of more than 20%, the exact opposite of what transpired.)
Not everyone is so sanguine about the market. "We're not in a classic bubble yet, but some of the pre-conditions are certainly in place," says Douglas Porter, deputy chief economist at BMO Capital Markets. One of his concerns is that the central bank is not going to raise interest rates any time soon. Carney pledged to keep rates steady until at least mid-year, and that could mean several more months of frenzied buying. The longer home prices continue to rise out of sync with the rest of the economy, the more worrying the situation becomes. Prices have already skyrocketed while incomes have barely moved, and the home-price-to-income ratio in Canada is at its highest level since the early 1990s.
Scotia Capital economist Holt sees a few possible outcomes as the temporary factors supporting the housing market start to wane. One is a "soft landing," where activity cools gradually. The other is a rapid decline. Holt says the speed at which the market recovered since last year lessens the odds of a soft landing. "We've had four or five drivers of the housing market leading toward strong house price gains in a very short period of time, and I think they all come off simultaneously," he says. "That points to just as quick a descent." The new federal mortgage changes will cause the housing market to "turbo-charge" over the next while, according to TD Securities' chief economics and currency strategist Eric Lascelles, as buyers rush to get in ahead of the implementation date in late April. Once that day passes, the new rules become just another factor that, in Holt's view, will contribute to lower prices and sales activity in the months ahead.
Ultimately, all of the uncertainty and concern around residential real estate is likely not going to deter many people from purchasing a home. A house is much more than an investment, after all. It is firstly a place to live. Even Milevsky, the finance professor at Schulich, caved and bought a house after resisting for a while. "We have a large family, and they wanted somewhere to call their own," he says. If prices fall, a home still provides a roof over one's head, unlike a stock portfolio. The danger comes when people link the idea of a house as a home with the idea of a house as an investment, particularly if they stretch their finances with the expectation of getting rich in a few short years. "There can be long periods of time where the real appreciation of housing is negative," Milevsky says. "All of that means is caution is warranted."
I have little to add, this is a good piece for anyone who owns a home or is pondering a purchase or sale. Full credit goes to John Kelleher and Joe Castaldo
John Kelleher responds to Joe Castaldo's story "Why buying a house is a bad investment."
I refer to your cover article “Why buying a house is a bad investment” by Joe Castaldo in your March 15, 2010 issue (see below for full article).
This article is not a serious discussion of the topic that it purports to cover. It misses the most critical issues involved in understanding whether a home is a good or bad investment and confuses the topic with some misleading charts and facts.
Let me try to illustrate the errors in the article by referring to a summary chart the author shows on top of page 28 [not shown online] — a chart that compares housing returns in various cities to stock market returns. The chart and the article contain the following errors:
1. Exogenous benefits of an “owner lived in” housing investment. When an owner buys a home and lives in it, the owner receives what economists call “exogenous benefits” — meaning that (in addition to being an investment that you can buy and sell for a profit) a home is something that one can live in. You can’t live in a stock or a bond, so this “exogenous benefit” makes a home that you purchase to live in quite different. Simply put, the owner doesn’t have to pay rent to live somewhere else. This benefit is very large, yet is not quantified in the returns when one buys and sells a home. So comparing housing returns to stock returns without considering this issue is misleading and wrong. For example – let’s say I lived in a home for five years and sold the house exactly for what I bought it for — so I didn’t lose any money but I didn’t make any either. It would not be correct to compare the 0% return that is seemingly earned in that case with an 18% return on stocks and say that the house was a bad investment. The owner of the house had a roof over their head for five years! That benefit could easily be worth hundreds of thousands of dollars but isn’t reflected in the numbers because the owner is effectively “paying rent” to himself. This error is a serious one and should have stopped the article’s publication on its own.
2. Principal residence tax exemption. Amazingly, the article fails to mention the principal residence tax exemption on housing in Canada. Gains on housing are tax free, while the gains on investments are taxed! This is another huge miss that should have been caught and another reason why the chart and the article are wrong. By comparing pre-tax returns on stocks to what are effectively post-tax returns on housing, the article makes a critical error. So when an investor has a gain of $100 on a principal residence they keep $100. When an investor has a gain of $100 on stocks the homeowner keeps only about $77. (assuming cap gains tax of about 23%). This is another error that should have stopped this article’s publication.
3. Comparing investments with totally different risk profiles. One of the most basic principles in finance is that one should never compare returns on investments that have different risk profiles. Investing in stocks is generally more risky than investing in real estate — so you can’t make a chart like the one on page 28 and conclude (as most of your readers surely did) that housing is a bad investment because the returns appear lower than the returns for stocks. The author should have compared each asset to its own risk benchmarks (risk-adjusted returns). This is another huge miss that leads to a misleading conclusion.
4. Fees, commissions, and capital expenditures. Fees, ongoing capital expenditures, and commissions for a housing purchase are large and materially impact the attractiveness of a house as an investment. The friction associated with other investments is generally a lot lower. The author’s chart makes the comparison before all of these expenses which again makes the comparison silly. It is true that he chooses to mention this issue in the body of the article, but makes no attempt at quantifying this issue or estimating how it impacts returns. This would not have been hard and would have made for a more substantive contribution.
In addition to the errors above, the article uses poor examples to make points. These examples actually support the opposite view to what the author suggests! The author might have realized this if he had taken five minutes to run the math. Take the article’s assertion that leverage allows a buyer to make a $50,000 profit given a 20% down payment on a $500,000 house where the asset’s value appreciates to $550,000 in two years. Since mortgages don’t come free, this point is wrong, and materially so. Let’s do some work for a moment. If I assume just a 4% mortgage on the $400,000 of debt in your reporter’s example, the hypothetical profit drops from $50,000 to about $20,000 (yes, you have to pay about $30,000 in interest in those first two years). Now if I add in commissions, land transfer taxes, property taxes and so on the profit actually turns in to a loss. This is why it generally doesn’t make sense to buy a house for only two years. I respectfully suggest that these examples need more thinking and more homework.
Overall, the misses and errors in this article are really disappointing.
When a person buys a house to live in, it is actually an incredibly complex financial transaction. It is akin to a leveraged buyout of a company where the new owner lives in the corporate offices (thereby avoiding the need to rent elsewhere) and where the gains on the sale of the company can be enjoyed tax free. Many variables impact the true return on this decision and the only way to understand that return is to model it. Doing so requires some careful work and some basic training on financial principles.
Regards,
John Kelleher
Why buying a house is a bad investment
Interest rate hikes are looming, and talk of bubbles abounds — so what's with the real estate buying frenzy?
By Joe Castaldo, a staff writer for Canadian Business.
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.
Canadians are clearly more than willing to take major financial risks to buy a home. What's ironic is that real estate price gains can be somewhat of an illusion when inflation is taken into account. "People get fooled by nominal numbers," Milevsky says. Long-term returns in real terms are less than spectacular. Harvard economics professor Edward Glaeser looked at the returns in more than 300 metropolitan areas in the U.S. between 1970 and 2000 (before the unsustainable credit-fuelled boom) and found prices increased on average only 1.7% annually. Yale School of Management professor Roger Ibbotson and a colleague examined returns between 1978 and 2004, a period including part of the U.S. housing bubble, and found residential real estate provided an annualized return of 8.6%. The S&P 500 significantly topped that with a 13.4% return.
Housing in Canada hasn't behaved much differently. In 2004, Milevsky examined the compounded annual returns on residential real estate in a dozen Canadian cities over the past 25 years. Toronto provided the best return at 5.75%. But the TSX provided an 8.64% return over the same period. The S&P 500 index did even better during that period, at 13.85%. The drawback, of course, was that stock indexes were far more volatile than real estate, although in some markets, the difference was not so pronounced. Real estate in Vancouver, for example, provided only a 3.68% compounded annual return with nearly the same level of volatility as the S&P 500.
Homeowners can easily argue that while the returns are modest, at least they are building wealth rather than paying rent to a landlord. Leverage can also make a huge difference on returns for homeowners if they choose to sell. In crude terms, assume a 20% down payment on a $500,000 house that is sold a few years later for $550,000. After paying back the mortgage, the seller is left with a $50,000 profit, or a return of 50% on the initial down payment. As far as investments go, that is an eye-popping return. But leverage is damaging when prices fall. A homeowner can end up with outstanding mortgage payments worth more than the house.
There are also a slew of egregious fees associated with real estate that affect returns. There are home inspection and appraisal fees, which can total hundreds of dollars each, not to mention land registration fees, legal fees and perhaps title insurance to purchase. Real estate agents take a commission, too — expect to pay at least 2.5% of the purchase price of the home. Regular maintenance has to be done for the home to maintain its value, and that can quickly add up. Canadian personal finance authors Eric Tyson and Tony Martin say a home usually needs to appreciate about 15% in order for the buyer to recoup all of the transaction and maintenance costs.
A society of renters is also more mobile. Andrew Oswald, an economics professor at the University of Warwick in England, found that high unemployment goes hand-in-hand with high rates of home ownership. In Britain, unemployment doubled since 1950 as the share of the population that rented dropped from 60% to less than 10%. Oswald found similar relationships in other countries, such as Finland and Spain. The Netherlands and Switzerland, by contrast, had lower unemployment and a lower rate of home ownership. Oswald theorized that, while homeowners are often stuck with their property through tough labour markets, renters can more easily relocate to find work, which lessens structural unemployment. His theory has been criticized for placing too much emphasis on a causal link between home ownership and unemployment, but it does echo Fed economist Pence's concern about the correlation between home prices and the job market. Prices fall when the labour market tanks. Everyone needs financial security during those uncertain times, but for homeowners, their greatest asset won't necessarily deliver.
In December of last year, CIBC economist Benjamin Tal estimated home prices in Canada to be about 7% overvalued, which he deemed to be a "modest overshooting" that did not necessarily portend a dramatic price correction. Economists at TD Bank Financial Group put the overvaluation at 12%, adding it could rise to 15% this year as buying activity rages on. David Rosenberg, the chief economist and strategist now at Gluskin Sheff + Associates who called a U.S. housing bubble back in 2004, has a more pessimistic take. He says home prices in Canada are between 15% and 35% overvalued, and could plummet as far as 20% from current levels. "That isn't cataclysmic, but believe me, that would hurt a lot of people," he says. A drop that steep would wipe out virtually all of the gains made in the past year and could leave some Canadians who bought at the top of the market with negative equity in their homes.
Housing has undergone painful corrections in the past. The current crop of homebuyers is likely too young to remember the housing bubble that burst in 1981, and the slow recovery that followed. According to data from the Centre for Urban Economics and Real Estate at the Sauder School of Business in B.C., the average real home price in Vancouver took more than 10 years to get back to its peak, before dipping again in the mid-1990s. Calgary fared even worse. Home prices didn't return to 1981 levels until the first quarter of 2006. Toronto homebuyers experienced a similar pain when a speculator-driven bubble burst around 1989. In real terms, prices didn't recover until 2007.
A wait that long can be brutal for those who bought at the top of the market. It can also thwart retirement plans for those expecting to sell their homes and use the profits to downsize and fund their golden years, particularly if they've neglected to save by other means, such as with an RRSP. Canadians have a significant portion of their wealth tied up in real estate — roughly 48%, according to the Vanier Institute of the Family, the highest level in two decades. The fact that real estate markets do fall highlights the need for Canadians to prepare for wild swings in the economy. That message is perhaps more important than ever as the buying rush continues, and the market looks increasingly pricey. "If you're going out buying a home today, understand that you're not following the doctrine of buy low and sell high," Rosenberg says. "You're doing the exact opposite."
The problem for policy-makers — and buyers trying to figure out the best time to enter the market — is that the existence of a bubble is impossible to know for certain until it pops. Gregory Klump, chief economist for the Canadian Real Estate Association, argues we are not yet in bubble territory. "I would describe this as a micro-cycle where demand is outstripping supply," he says. Housing starts are rising, which will help to satisfy demand. Higher prices are also bringing the sellers back to the market who disappeared in 2008 when sales activity dropped, all of which will lead to a more balanced market later in the year. There are signs of optimism elsewhere, such as in the Canadian house-price forwards market operated by Teranet and the National Bank Financial Group. The market allows investors to essentially place bets on where prices are headed, and the index reflects their collective sentiment. As of January, the index showed investors expect a bump of up to 9% in residential real estate by 2014. (Those investors have been wrong before, of course; last year, the index showed a potential nosedive of more than 20%, the exact opposite of what transpired.)
Not everyone is so sanguine about the market. "We're not in a classic bubble yet, but some of the pre-conditions are certainly in place," says Douglas Porter, deputy chief economist at BMO Capital Markets. One of his concerns is that the central bank is not going to raise interest rates any time soon. Carney pledged to keep rates steady until at least mid-year, and that could mean several more months of frenzied buying. The longer home prices continue to rise out of sync with the rest of the economy, the more worrying the situation becomes. Prices have already skyrocketed while incomes have barely moved, and the home-price-to-income ratio in Canada is at its highest level since the early 1990s.
Scotia Capital economist Holt sees a few possible outcomes as the temporary factors supporting the housing market start to wane. One is a "soft landing," where activity cools gradually. The other is a rapid decline. Holt says the speed at which the market recovered since last year lessens the odds of a soft landing. "We've had four or five drivers of the housing market leading toward strong house price gains in a very short period of time, and I think they all come off simultaneously," he says. "That points to just as quick a descent." The new federal mortgage changes will cause the housing market to "turbo-charge" over the next while, according to TD Securities' chief economics and currency strategist Eric Lascelles, as buyers rush to get in ahead of the implementation date in late April. Once that day passes, the new rules become just another factor that, in Holt's view, will contribute to lower prices and sales activity in the months ahead.
Ultimately, all of the uncertainty and concern around residential real estate is likely not going to deter many people from purchasing a home. A house is much more than an investment, after all. It is firstly a place to live. Even Milevsky, the finance professor at Schulich, caved and bought a house after resisting for a while. "We have a large family, and they wanted somewhere to call their own," he says. If prices fall, a home still provides a roof over one's head, unlike a stock portfolio. The danger comes when people link the idea of a house as a home with the idea of a house as an investment, particularly if they stretch their finances with the expectation of getting rich in a few short years. "There can be long periods of time where the real appreciation of housing is negative," Milevsky says. "All of that means is caution is warranted."
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