Too scary

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So, what happens to society, the economy, financial assets and houses when things change? It’s time we started thinking about it. Change is in the air.

You know conditions cannot stay as they are. A third of all kidults live at home. Most ever. Many are over-educated, under-employed and pissed. Real estate’s basically unaffordable. Wages are stuck. Everybody’s in debt. The wealth divide yawns larger daily. Savings are falling. Taxes are rising. Government’s growing. Jobs are scant. Now we’re blaming immigrants. And most of us walk around like fools in a fog.

“Just don’t understand how people can extend themselves the way that they are,” says Matt from a God-forsaken burb north of the Big Smoke. “We have walked away from houses we like because (we make decent money) we do not want to get into a bidding war and overpay.  One house listed at $800,000 and went for 1.15 million.  Another was listed at $750K, had 2 bids at $850K and the owner would not take less than $1 million. All in Thornhill.

“Anyway, I am interested  in your vision of the future.  When conditions change, (interest rates go up), and people can’t make their payment commitments, what happens?  Will there be a mass retraction in price, will people lose their homes, can mortgage lenders afford defaults, will the government have to intercede?  Will it be like the US in 2008 but not to the same degree?  What does the future look like in your world?”

Good questions. Most folks are afraid to ask ‘em, let alone answer. Every day I’m pilloried for suggesting people should prepare for altered circumstances – which is certainly hard for a sensitive, brooding, feminine-type, bleeding heart like me to take. However, I’ll struggle on. Here’s why: a lot of us are pooched.

Look no further than a BDO (the accounting guys) survey out today. It’s scary.

  • 73% of people have debt, with the worst stats in the 35-54 age category.
  • Over half of us (55%) would have trouble paying routine bills if rates rose. At all.
  • Almost four in ten (36%) say it will take between 20 years and never to pay off what they currently owe.
  • Almost 60% believe their houses will go up in value forever, and save them.

Yikes. So what this pathetic blog’s been warning about for a dog’s age has finally come true. A majority have rolled the dice, absorbed debt, gambled on a one-asset strategy, stopped saving or investing and now live so close to the edge that higher interest costs would push them over. Just like Matt conjectures.

But what are the odds of rates augmenting, which would mean real estate flatlines or sinks? (Remember that the cost of money and the sale price of houses are inversely related.) Apparently they now stand between 34% and 80%. Oops.

Futures markets give 34% odds of a US rate increase in three weeks, a 58% probability of one in July and an 80% weighting for another in the autumn. In the past couple of weeks, these numbers have tripled in some cases, thanks to robust inflation stats, the best-in-eight-years new housing numbers and wall-to-wall indications by the Fed that they have an itchy finger on the trigger. How soon will it happen? We’ll know that next Friday morning, when the latest jobs numbers are released.

But, happen it will. That’s why the US dollar is rising, ours is falling and gold is tanking. Fed officials have been busy prepping the markets for the normalization of interest – a process we should expect to occur over at least the next two years. On Monday San Francisco Fed governor John Williams said two or three more increases this year are “about right” and last week influential New York Fed boss William Dudley said we should expect the kick-off in June or July. More confirmation could come Friday when Fed czar Janet Yellen gives a speech.

If you think this doesn’t matter, good luck. In reality, it’s a watershed moment – confirmation the only central bank in the world that matters is decreeing the days of ridiculously low rates and artificial stimulus must end. Why? Because they create asset bubbles, encourage lousy, greedy, irresponsible behavior and end in tears. Vancouver may be the best example on the planet, where two of the three outcomes are already in evidence.

So, add it up. A third of young adults are launch failures in the family basement, half the population’s unable to cope with higher costs, four in ten have lifetime debt, yet there’s a 70% home ownership rate and surging buyer demand – while change barrels down upon us. How does this end?

Well, it’s unlikely to be a widespread US-style debacle since mortgage securitization has been better regulated here and CHMC backstops a ton of lender risk. So, no banks will topple. Plus, lots of markets in Canada are already slowly deflating. Additionally, most of the country has recourse mortgages, so borrowers can’t just throw the keys to underwater houses at their bankers, and walk. Not only do you lose the house, but you’re personally liable to make the lender whole. Sucks.

Would T2 intervene and bail out the debt-laced derrieres of the house-lusty? Unlikely. After all, the feds will be plunging at least $100 billion into deficit just trying to pay for a few promises and to get the economy kick-started. Besides, even with the trillions it spent trying to reverse the real estate bust in the US, and rescue the middle class, Washington failed. The lesson is simple – once markets turn, the momentum is massive. Finally, trying to reflate a bursting bubble would only risk creating the same conditions for collapse. In other words, when the US raises rates, the Bank of Canada will not drop them. Count on it.

So, a likely scenario is a rapidly decelerating housing market in select cities and regions. You know where. Toronto will be far less impacted than Vancouver, since prices have been somewhat less insane, and the population base is quadruple. Some regional financial institutions, like credit unions, with unprecedented residential mortgage exposure, may need a provincial bailout. Bankruptcy levels will rise. Local economies will be wounded. Audi dealerships will be flooded with lease returns. The decline in land values could be as breathtaking as was the advance.

But, seriously Matt, nobody knows the true consequences. It all seemed somewhat manageable when a Van house cost only a million and F was spanking lenders for too-cheap loans. But lately all market controls have been defeated, as we stare at the biggest changes in monetary policy in a decade.

Oh, by the way, 40% of Canadians currently think their kids (in the basement) will be better off than them. Go figure.

Letter of the Day! From Tracy in Van...

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“I emailed you back in 2012.  I have always been a fan of your blog.  Unlike other Vancouver doctors you have featured recently, I have not asked my parents to re-mortgage their home in Burnaby so that I can have a nice “doctor” house on the west side close to where my husband and I work.  After losing out on 5 bidding wars back in 2012, I started reading your blog and decided to find a nicer house to rent.  And here we are 5 years later still renting the same house (for the same price.) We save money every month, we have a well balanced portfolio with an investment adviser we trust.  Our portfolio pays dividends and is growing.

“Lately the daily hype of escalating real estate prices is ridiculous.  I feel like CBC has a vested interest in fueling the “fear of missing out”.  So after reading some ridiculous article on CBC, I then read your blog for some balance.  So after reading today’s blog, I calculated our price to rent ratio.  The most reasonably priced house that we could possibly buy that would somewhat compare to our current rental would be at least $2.5M.  (our rent is $4200).  The actual house we rent was assessed this year at $3.6M but the house 3 doors down of the same vintage just sold for $5.2, so assuming our rental could sell for about $4M in today’s market, our price-to-rent ratio is 79.  I guess we will keep renting.”

The justifying

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Derek lives in Ottawa, thinks the dawn of T2 means house prices there will stop rusting (more civil servants coming) and believes this blog is tragic. At least we agree on one thing.

“I understand that my thinking below runs counter to your theme of housing being BAD, but take a quick look at the numbers,” he says, turning out to be yet another person who badly needs to justify what he’s already done.

“I live in Ottawa and we just bought a 4-Bed, 3-Bath suburban house (around 2,200 sq ft) for around $475K.  To rent the same place would be around $2,200.  So by buying (we paid cash), we will be saving around $26K in rent per year.  Take off $4,500 for taxes and perhaps $5,000 per year maintenance and an extra $500 for insurance and the net savings work out to $16K per year.  So we are basically getting a tax-free 3.3% yield on our money by buying (plus any appreciation- if that happens).  I understand that is not a great return, but as a diversifier (the house will be less than 20% of our net worth), why not?”

For the record, real estate ain’t bad. If it was, I wouldn’t own any. I do. But what it bad is concentrating your net worth in a single asset. Especially one whose value depends on cheap money and HGTV house lust, both of which are now running on fumes. If Derek’s numbers are correct, it sounds like he can afford a house and it makes sense. I just hope he’s not a senior Policy Analyst for the Department of Finance.

First, you can lease an almost-new suburban in an Ottawa burb for $1,600 these days. In fact, rents have been going down. (Here’s one. ) That means the price-to-rent ratio is about 25, even for an “affordable” sub-$500,000 pile. And remember the formula:

  • Price-to-rent ratio of 15 or less – buy the sucker. You’ll save money.
  • Price-to-rent ratio of 16 to 20 – you’ll be money ahead renting.
  • Price-to-rent ratio above 21 – your landlord is a benevolent deity. Or an idiot. Or a realtor with an A7.

And what of Derek’s ‘proof’ that he is actually making a decent ROI by spending $475,000 (no financing) to own a house he could have rented for $19,200 a year? Hmm. Well, property tax, maintenance, insurance, renos and such aside, if he’d invested $475,000 and received a modest 6% return the cash flow would be $2,375 a month. That means (a) his portfolio pays the rent, (b) he keeps his $475,000 liquid and (c) lives in the same house.

In other words, in a market like Ottawa where prices are not hockey-sticking (and never will) there seems to be no financial argument for tying up even a modest half-million bucks on a pile of bricks (actually for that you get metal siding and fake stucco). If the goal is financial independence and the accumulation of wealth, real estate’s no longer a good play, now that we’ve reached the end of the road for ultra-low interest rates. Of course, this ignores the powerful nesting instinct so many people succumb to, or the irrational logic your mom taught you that owning beats renting. It doesn’t.

Well, here’s some news from the Bank of Canada that Derek should also contemplate. As you probably know, the bank did not drop its key interest rate today. In fact, markets now believe this will never happen again. Two months ago the odds of a rate drop some time before the end of 2016 were 40%. Now they’re now heading for single digits. Meanwhile the odds of a US rate hike are traveling hard in the other direction – roughly 60% by summer and 80% by autumn.

Some key language changed in the central bank’s communication this morning. It has long warned about what debt-snorfling piggies we’ve become, but in polite terms – saying household vulnerabilities were ‘edging’ higher. Now they have simply ‘moved higher’. That may not seem to be relevant, but Donald Trump wasn’t either until three months ago. In fact the bank is singling out family debt and cash-flow issues just as a new survey finds a whopping 37% of people are occasionally ‘falling short’ on monthly bill-paying. But has that stopped them from buying trophy houses? Nah.

So we’re at the bottom of the rate curve. Banker dudes know full well any cut would only make those piggies and vulnerabilities fatter, blowing more air into the YVR and GTA gasbags, leading to a landing we’d never forget. Without a doubt the Bank of Canada will resist the upward rate pressure coming from the US for as long as possible, but at the risk of trashing the dollar and goosing inflation. Inevitably, it will move. But long before that, mortgage rates will have reacted. Look for that process to start in weeks.

As always, buy a house if you want.

But don’t use a blog to tell us how smart you are. That’s pathetic.