Thoughts on Toronto’s Real Estate Prices

Preamble and Caveats 

  • The buy vs rent decision is personal and based on a person’s needs/wants
  • There are always outlier examples for unique situations
  • Utilize a buy/rent calculator
  • Personalized decision, yes – but one shouldn’t make what is most likely their largest financial decision without knowing both sides of the debate
  • Take the long view
  • I use points from Alex Avery and Hilliard Macbeth because I found their books to be well thought-out and reasoned. I fill in my own thoughts later in the post.
  • It’s important to note that the debate isn’t an isolated question of whether or not it’s better to rent or buy. One must take his/her given individual circumstances (financial/needs/wants/preferences) and decide if current real estate prices make  sense for his/her situation.

From Alex Avery: 

  • Beware of those who advise you to buy
    • What are their obvious and non-obvious personal interests?
    • Avery’s aim is to include an alternative view to the housing dogma
    • Seek unbiased advice
  • Avoid the cult-like promotion of home ownership (friends, family, government and lenders)
  • Buildings never go up in value; only land does.
  • The return on investment on a piece of real estate is more than just sales price minus purchase price
    • interest on the mortgage
    • taxes
    • maintenance
    • insurance and
    • transaction costs on both ends
  • Over the life of a mortgage, the homeowner shifts from paying rent to the bank to paying themselves.
    • Implicit rent – the opportunity cost of having your money locked up in the house even when fully paid off
  • Renting offers flexibility
    • Liquidity
  • Buying is not necessarily a good investment – either in the short term because of transaction costs or in the long run because of the possibility of lower house prices and the opportunity for higher returns from owning a less concentrated pool of dividend-paying equities
  • Canadian house prices haven’t delivered returns anywhere near those of the Canadian stock market based on 25 years of data, a quarter of a century that represented an incredible period for Canadian house prices
  • Real estate purchases often come with loads of leverage
  • Housing is a consumption item
  • Bottom line – Renting is the more logical, cheap, flexible and low-risk way to go
  • [Re: Vancouver and Toronto] Both markets share a lot of commonality in that they have land constraints so they’re structurally expensive markets. Better off to rent.
  • Important to save and invest the difference between rent payment and mortgage payment

From Hilliard MacBeth:

{via Canada Business} LINK

  • Canadians are carrying unprecedented levels of household debt. All it would take, he argues, is a slight uptick in interest rates — just a percentage point or two — and a large number of homeowners could be pushed over a default cliff.
  • In his view, a perfect storm of factors — low interest rates, laissez faire policies, foreign buyers and alternative mortgage lenders — have set the Canadian housing market up for a big fall. He says it’s already underway in Alberta, Saskatchewan and Newfoundland and will inevitably spread. If it looks anything like the subprime debacle in the United States, the crash would unfold steadily over a span of four year or so.
  • “The bubble will burst, and it will be a hard landing, which means a greater than 20-per-cent decline in house prices,” says MacBeth. In fact, he says, Canadian prices could decline from current levels by 40, even 50 per cent by 2020. “This means some financial institutions will get into trouble. [The Canada Mortgage and Housing Corp.] will lose billions, and there will be a recession.”
  • Consumers are overstretched, they’re paying more than they think; and almost no one makes a profit off their house in the end. One problem is that banks are approving loans for greater amounts than people can afford, he says. MacBeth knows clients who received a mortgage based on their future, not current, earnings. As well, lending is usually based on two incomes, yet he says it’s rare for both spouses to work full-time until they retire. One person often takes time off to raise kids, which makes it harder to make the payments
  • But the biggest risk around our real estate obsession is the way it breaks the cardinal rule of wealth preservation: diversification. Not only are many of us tying up most of our wealth in one asset, but we’re doing so with an asset closely correlated to our poorly diversified financial markets.

General Rebuttals 

  • People will always need somewhere to live. You can’t sleep in your electronic shares of Walmart. Having real estate is sort of like a forced savings plan. Without it, many would save nothing for retirement.
    • All true – but not true for everyone and for every personal situation. Again, it comes back to what your requirements (what do you need?) and do current prices make sense. Alternatively, what other investment opportunities do you have and do you have the ability to take advantage of those?
  • Why pay someone else’s mortgage? Alt – why throw away money when you could be building equity?
    • Irrelevant. What matters are the costs incurred to live in a place.  Renting is not throwing away money, it is incurring a cost in order to have a place to live. Building equity just means turning some of your money into a house. It’s one of many ways you could invest your money.
    • Don’t forget there are additional costs with ownership including maintenance, taxes and insurance.
  • Interest rate debate – rates will never go up significantly
    •  The statement completely ignores history
    • From a risk management perspective it is still important to stress test your budget should interest rates rise (if you own)
    • Are you aware of what drives interest rates?
    • Interest rate raises are not the only reason a housing crash can happen. Take for example the States, interest rates were not raised substantially prior to the collapse in 2006.
  • Buy. They ain’t making anymore land.
    • True (let’s ignore the man-made islands). But any asset becomes dangerous at certain prices.
  • Look at how much money I’ve made. Best investment ever. Prices always go up.
    • Yes, you may have made a lot of money but would you have been better off financially if you invested elsewhere? Real estate traditionally tracks inflation and while true real estate has gone up over time so have other assets that have far outperformed real estate. If you buy any asset at an inflated price you risk lower or even negative returns in the future.
    • Historically, real estate investments were a cash flow game while capital appreciation was the kicker. Nowadays, the equation has flipped. Is this the new norm or is something amiss?
  • My house is a hedge against inflation.
    • True. But during times of inflation interest rates rise and can rise rapidly. If your mortgage is substantial your ability to service the debt could erode just as rapidly.
  • Buying a house with a small downpayment maximizes my leverage and gains. Where else can I make these kinds of gains?
    • You’re presuming the value of real estate always goes up. Historically, the value of real estate moves in lockstep with inflation which means in the long run the value of the equity will be the same as it is now in 20 years (purchasing power).
    • Leverage works both ways. If you overpay for the asset, a downturn could wipe out your equity and you are left in a position where if you had to sell your house for less than your mortgage value.
    • In a worst case scenario –  if the above happened with increasing interest rates – you’re stuck with potentially a mortgage you can no longer afford and the selling price would result in a huge loss
  • Let’s assume housing prices never go down – what possible benefit is there to renting?
    • Testing out a new neighborhood, mobility, avoiding overpriced homes vs rent
  • Toronto and the surround areas are still cheaper than other major cities like London, Hong Kong, New York and San Francisco
    • This tackles one of my pet peeves which is lazy thinking and comparisons and complete avoidance of 1st principles of what you are trying to say
    • The absolute prices may be cheaper in Toronto but without context its kind of meaningless. London, Hong Kong, New York and San Francisco citizens all have higher incomes compared to Toronto. So really this is a question of affordability.

Home Ownership Positives 

  • Forced Savings through the mortgage payments
  • Tax incentives (home buyers plan, capital gains exemption on principal residence)
  • Leverage (double edged sword)
  • Feelings (pride, settling roots in a neighborhood, control over the property)
  • For many people real estate has been their greatest appreciating asset of their lifetimes
  • Stability – can’t be kicked out by a landlord, rents can go up substantially, ability to customize your dwelling

Other Thoughts 

  • In this section I go through several components of a mental model list I have to see how it applies to the current real estate situation in Toronto. Note there are overlap/connections with a lot of these.
    • Lack of inversion – failure to consider disconfirming evidence
      • What’s the flip side; what can go wrong that I haven’t seen?
    • Failure to consider the range of likely future outcomes
    • Failure to consider probabilities
    • Failure to consider how consensus psychology is affecting prices
    • Failure to distinguish from process and outcome.
      • Example: “People have been saying the housing market is overvalued for years and look how much I’ve made on my house so far.”
    • Always be willing to see both sides of every argument or investment stance you take.
      • I’ve found that people often times try to impart their ‘wisdom’ on you but they themselves do not understand both sides of the story.
    • Failure to consider history.
      • No asset always go up all the time. Bubbles exist and do pop.
    • Pascal’s wager – In making decisions under conditions of uncertainty, the consequences of being wrong must carry more weight than the probabilities of being right. You must focus on how serious the consequences could be if you turn out to be wrong: Suppose this doesn’t do what I expect it to do. What’s going to be the impact on me? If it goes wrong, how wrong could it go and how much will it matter? Pascal’s wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.
    • Failure to use a decision making model.
      • What is the best thing that can happen if I do this?
      • What is the worst thing that can happen if I do this?
      • What is the best thing that can happen if I don’t do it?
      • What is the worst thing that can happen if I don’t do it?
    • Failure to consider the short-term and long-term consequences of your action/decision. What is the opportunity cost?
    • Failure to consider the ‘outside view’. The outside view asks if there are similar situations that can provide statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and if so, what happened.
    • Moral hazard of financial lenders (especially in a bull market)
      • Financial lenders lack skin in the game as CMHC insures mortgages against default and taxpayers take on the majority of all mortgage risk
      • Consider what happened in the States in 2007-2009
    • Failure to consider tail-events or ‘black swans’
    • Shiller’s Bubble List
      • Rapidly increasing prices.
      • Popular stories that justify the bubble.
      • Popular stories about how much money people are making.
      • Envy and regret among those sitting out.
      • Cheerleading by the media.
      • Don’t confuse market cycles with bubbles. Bubbles of a particular asset class don’t come back.
    • What matters most is not what you invest in, but when and at what price
      • The less care with which others conduct their affairs, the more care with which you should conduct yours. When others are afraid, you needn’t be; when others are unafraid, you’d better be
    • Recency bias – human tendency to overemphasize more recent data
      • Example: “Look at how much prices have gone up – they’ll continue to do so!”
    • Crowd folly – the tendency of humans, under some circumstances, to resemble lemmings. Mimicking the herd invites regression to the mean.
    • Envy/jealousy tendency – a completely wasted emotion that a person should work hard to avoid. Major problems arise from envy because people increase risk when they envy the financial success of someone else.
    • Herd instinct – also known as fear of missing out – such investor behavior can often cause large, unsubstantiated rallies or sell-offs, based on seemingly little fundamental evidence to justify either. Herd instinct is the primary cause of bubbles in finance.
    • Margin of safety
      • Overpay and overleverage could have disastrous results for individuals and families








Updates as of April 7, 2017

  • Based on the March average price, a house in Toronto cost 11.7 times the median total family income. Back in the day, it was said that a house was affordable when it cost three times your income.
  • Not only to have home prices in the GTA now absorb an unprecedented 13 years of median family income, but to have 30 per-cent-ish run-ups against a backdrop of a 2 per cent inflation rate, wages that are barely going up 2 per cent as well, and nominal GDP growth of around 4 per cent. This should put 30 per cent into some sort of perspective when we conclude that what we have on our hands is a near three standard deviation event. LINK
    • Rosenberg acknowledges there is a supply issue which is feeding the strong competition among buyers
    • a “balanced market” sees a months’ supply figure around 6.0
    • the sales-to-new listings ratio sits well into “sellers’ market” territory at 70.8 per cent, which compares to 69.4 per cent a year ago — a ratio between 40 per cent and 60 per cent is considered indicative of a “balanced market.”
    • A house is an asset indeed, but should never be compared to a stock or a bond or even other investable properties. It is a place to live.
    • So there are indeed some supply and demand fundamentals that are underpinning prices. Insofar as the demand is rising because people think they are investing in something hot just because of the accelerating momentum, well, these people are going to end up being pretty big losers.
    • Not even in the late 1980s, did housing get this expensive on this basis, and we know all too well how the Bank of Canada ultimately reacted and what happened next.
    • So while Toronto residential real estate is indeed expensive for the locals, it is far less so for foreign investors, especially for Americans who can buy Canadian assets at a 25 per cent discount from a currency perspective.

Updates as of March 22, 2017

  • In October 2016, lawmakers ratcheted up their interventionist efforts with a restrictive mortgage “stress test.” This measure now requires all homebuyers with less than a 20-per-cent down payment to have enough income, after all household debt and expenses are taken into account, to qualify for the same mortgage at the Bank of Canada’s five-year posted rate — 4.64 per cent at the time of writing.
  • To qualify for mortgage insurance under the new rules, a borrower’s gross debt service ratio (mortgage payments, taxes and heating costs as a percentage of income) must be no more than 39 per cent. A borrower’s total debt service ratio (the carrying costs of the home and all other debt payments as a percentage of income) must be less than 44 per cent.
  • The maximum amortization period for an insured mortgage has been slashed from 40 years to 25. And government-backed mortgage insurance is available only on properties that have been purchased below $1 million. Moreover, to discourage a spate of foreign buying, a property must be owner-occupied to qualify for mortgage insurance.
  • In October, the CMHC — for the first time in the Crown corporation’s 68-year history — issued a “red” alert for our national housing market. “High levels of indebtedness coupled with elevated house prices are often followed by economic contractions,” Evan Siddall, CMHC’s CEO, warned in a Globe and Mail article published October 17, the same day that new federal mortgage rules came into effect. “The conditions we now observe in Canada concern us.”
  • Homeowners who sell residence are now required to report it in their tax returns
  • The government appears to be favouring the idea of sharing the risk on insured mortgage debt between lenders and taxpayers.
  • Household debt has been identified as a key risk for the Canadian economy.

Price-to-Rent Ratio

From an economic standpoint the price-to-rent ratio can assist in determining whether or not it makes more sense to buy or rent a place.

The ratio is calculated using the following inputs:

Price of home/annual rent = price-to-rent ratio

Rules of thumb:

Price-to-rent ratio of 1 to 15 would mean it makes more sense to purchase than to rent.
Price-to-rent ratio of 16 to 20 would mean it’s typically better to rent than to buy, but this is the grey area where a lot would depend on the particular market and situation.
Price-to-rent ratio of 21 or higher means it’s much better to rent than to buy

What I like about the ratio is it helps put into perspective whether or not it’s best to buy or rent purely based on the relative values of comparing rent vs the asset price. This avoids making general statements about the market in general or at a national level.

What the ratio doesn’t do though is take into consideration your own personal situation. For example, do you need mobility or how long you plan on staying in one location. It also doesn’t take into consideration your mortgage payments (can you handle it?), interest rate movements and other economic inputs.

Finally, the ratio does not factor into maintenance costs and generally ignores the question of if you rent and it’s less than the general mortgage payments what should you do with the difference.

A simple solution to that is a rent vs buy calculator (google search it-there’s many out there). This will take into consideration mortgage payments, maintenance and investment returns (the spread of mortgage and rent payments are invested) to determine which makes more sense.