Sunday, January 11, 2015

The Myth of the Property Ladder (A Warning to Young Canadians)

Parents are great, they spend thousands of dollars and countless hours on their children and get almost nothing in return. Joking aside, my point is that parents usually mean well. There is one area however where I believe Canadian parents are leading their precious children astray, real estate.

The property ladder refers to when buyers attempt to get their first house, where they can than save up and subsequently trade up to a better house. The whole idea, is just to get on the first rung and according to baby boomers you'll be on your way. But just as getting good grades and a good University degree was once a sure fire way to success in the past, what worked for one generation might not work for the next.

Real Estate for most young Canadians is a leveraged investment. Well not just leveraged, but very leveraged. My generation is quick to scoff at the executives from the financial crisis who ran investment banks at sky high debt to equity ratio's of 20:1+. Yet, they think nothing of putting 5% down on a house (which of course is the exact same amount of leverage). A measly 5% drop in house prices and you are wiped out. That's if you can even put 5% down in the first place. Many can't. This is where the parents step in. 

Beyond the emotional push to buy a first house with the common (yet ridiculous argument) of "why pay somebody else's rent?"  I have seen many of my friends' parents routinely gift the 5-20% of the down payment of their first house. No, they are not just giving them free money but rather giving them the money on the condition of a house purchase (and saddling them with massive mortgage debt). It's kind of a like a drug dealer offering free cocaine but only once you get addicted. It's a terrible system so why do parents do it?

The biggest reason is because it worked very well for them.  There is a very stark difference however that will dramatically effect these housing returns going forward: interest rates.   Baby boomers have ridden a three decade wave of falling interest rates. This low cost of financing has lead to the record high price to income ratio. With the end of quantitative easing in the US these low rates are very possibly coming to an end. (Remember Canadians don't have 30 year fixed mortgages, they reset after 5 years for most people.) An even bigger concern would be deflation where incomes fall and debt remains the same!

This house price to income ratio chart on the right is from a September 2014 Bank of Canada presentation. Note that although it once cost just a little over 2x your annual income to buy a house, now it is 5x. 

What is actually most disturbing about this chart  though is not the record high number but the linear trend line that the authors were so 'kind' to add. The price to income ratio over time will revert to its mean. If it didn't, you would have house prices continue to outpace incomes and consume well over take home pay. That's what makes this dotted black line so deceptive. To the casual observer (say the CMHC board which has a deep conflict of interest with its ties to the construction and finance industry) it makes it seem like 'everything is on track' when in reality the dotted line should stay relatively flat over time. Charlie Munger would probably call it 'bullshit graphing' or something along those lines. Anyways, if this graph were to revert to any where near its historical level there would be big problems for Canada and its record high debt binge.

Moral of the story to Canadian millennials: Don't let ma and pa get you unknowingly hooked on the debt cycle, a mortgage will ultimately be your debt, not theirs. Borrow accordingly or better yet, rent until prices make sense. 


Jamie Montpellier said...

Dear OP,

I absolutely agree that if a couple is relying on their parents' help to purchase their first home, they might just want to wait a little while and save up a larger sum of money.

That being said, I can't help but feel a sense of unfairness with the following :

"Yet, they think nothing of putting 5% down on a house (...) . A measly 5% drop in house prices and you are wiped out."

Since when does one purchase a "home" as an investment. Whether my home drops 5,10 or 15% in value in the next 10 years, I feel is irrelevant really. I need a place to live, where I have my own backyard, great neighbhours, and a 5 minute drive to work. Sure, house prices have exploded in the last decade but that's why we call it a cyclical industry. If I live in that home for the next 30-40 years, I'm indifferent to what's going on in the world around me. I'm not looking to buy a home in order to capitalize on it, I'll invest in rental properties and the stock market if that's my goal.

However, we both know that many go in the purchase of a home too soon and do not have an idea of what awaits them in the next 5 years and so perhaps renting is the ideal situation for them.

Thanks for the article, it's a thought provoker.


Anonymous said...

J very valid point, you are right that it doesn't matter. If you are financially secure, don't care about making money and building your net worth and just living in your life, prices are irrelevant to you. The reason I bring up being wiped out is because if there were ever a situation where you had to sell for any reason (lost job, family emergency, higher mortgage payment that you are unable to pay) then the current market price will be very relevant to you and you could be wiped out.

To all the readers. There seems to be a lot of interest about housing in Canada from readers. I post very infrequently so follow me on twitter instead (where I post frequently, although mostly about investing).

Rick said...

J, if your house drops below the equity you've invested and you have to sell (moving for example), you'll have to write a cheque to your bank. Where's that money going to come from?

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