REAL ESTATE AND BOBBY FLAY

So you’re walking through the aisles of the grocery store, debating on whether you should make spaghetti for the third straight night or pretend to be Bobby Flay, and opt to attempt to make a pot roast in red wine sauce. You figure why not. I can cook a roast. I’ve watched the food network before. I’m more than qualified. With your head held high, certain that you are bound for success, you head to the butcher’s corner. You approach the butcher and ask for the best cut he has. He starts asking you about the type of cut, fat content, how you’re going to cook it, what type of pan you will use to sear it, and you begin to immediately regret your decision, recognizing: a) you didn’t even know you had to consider fat content when making a roast, and b) you are not Bobby Flay. Embarrassed to accept the fact that you are in way over your head, you make a completely impulsive, uneducated decision. Congrats! You are now the proud owner of a $60 piece of meat that you have no clue how to cook.

How did you decide in the first place that buying that pot roast was a good idea? It was probably Bobby Flay’s fault.

A lot like the impulsive idea to buy that pot roast, several of my friends and family have arrived at seemingly empty conclusions regarding the hot real estate markets in Toronto and Vancouver. They’ve heard their neighbours discuss housing prices and have seen a few scattered statistics on TV which have influenced their thinking without even realizing. Next thing you know, they’re making investment decisions based on what they hear, rather than doing a bit of digging.

Investment decisions made on limited information are a lot like buying that pot roast after watching Food Network; you hear everyone from the new’s anchor to your cousin (the financial equivalent of Bobby Flay) talking about how the real estate market has appreciated 20% year over year and that prices can’t go down. Naturally, this leads you to conclude that you should buy that real estate linked index fund or a second property (this is your financial pot roast) because what you saw on TV made the real estate market look like an undeniably simple and sure way to make money.

In this case, instead of being stuck with an overpriced piece of meat that you don’t know how to cook, you now own an overvalued condo off of the lake shore that you can’t afford. While you can get away without knowing much about how to cook a pot roast, you can’t get away with being misinformed about the largest real estate boom in Canada in the past 20 years. This is where red meat and real estate diverge.

THE ECONOMICS OF CANADA AND HOW THE REAL ESTATE BOOM MANIFESTED

We need to ask a fundamental question here: what is causing Toronto and Vancouver’s real estate market to climb at such a high rate?

There is no simple answer to this question. To provide a simple single answer would vastly oversimplify the real estate market as a whole and the market mechanisms at play. However, a good starting point to look at would be interest rates. This will give us an idea of the big picture.

Simply put, interest rates can be understood as the cost of borrowing money. The lower the rate of interest charged on a loan, the more affordable the loan becomes and the greater the incentive to borrow money. To put that into perspective, if you were to borrow $400,000 at a 3% rate or borrow $200,000 at 6%, they would cost you the same amount (.03 * $400,000 = 12,000$ vs .06 * $200,000 = $12,000 ). Obviously you would choose to borrow the larger sum because it will allow you to purchase a bigger house, invest more money and have more cash on hand all for the same cost. Thus, low interest rates result in cheaper borrowing, greater consumption and more investment.

Now that we have a basic understanding of interest rates and how they impact our spending, let’s get an idea of how they compare to the historical average.

Canada’s interest rate currently sit at 1.75%. For a lot of us millennials, without any reference to historical figures, this can seem like an average number, but for just about everybody born before 1990 these rates are far below anything they’ve ever seen. The below graph shows how just how far we have deviated from the norm.

To provide some context to understand how abnormally low interest rates currently are, the average interest rate that has persisted in Canada has hovered around 7%. This means that the cost to borrow money is 14x cheaper than it usually is. As the example demonstrated, if loans and mortgages are so cheap, why not borrow money when it is most affordable? This is where we begin to see the effects of low interest rates on asset prices.

Say you could borrow money at 3% and get a 6% return on the money you invested, would you do it? Of course you would, because the cost to borrow money is half of what you could make on your investment. If borrowing costs are lower than returns, then there is a large incentive to borrow that money. This is the exact logic the Canadian government is employing by depressing interest rates to record low levels. They want the general public to save less, buy more and invest more so that they can continue to grow the economy! This economic philosophy has been employed in a response to the 2008 Global Financial Crisis. The sole purpose of low borrowing costs has been to keep people buying goods and investing money in assets so that the economy can continue to grow at an acceptable rate.

While this is a well intentioned policy by governments, it can have adverse effects like high levels of debt and the misallocation of capital. In fact, Canada has the largest debt to income ratio (think of this as the percentage of an individual’s gross income that goes towards paying debt) of any G7 nation, with the average Canadian spending 167% of their salary on debt payments. Another way to think of this is for every dollar we earn, we owe $1.67! To give you some context as to how enormous that is, at the height of the U.S housing crisis in 2008, their debt to income ratio was 147%. Due to cheap borrowing costs and rapidly rising real estate prices, a lot of Canada’s debt has been used to buy assets like real estate. Of the total $2 trillion in outstanding Canadian consumer debt, an unbelievable 71.6% of it is held as mortgage debt. It’s fair to say Canadians have built up quite an unhealthy appetite for real estate!

SO WHY VANCOUVER AND TORONTO?

If you were to strip away Toronto, Hamilton, Vancouver and Victoria markets, house prices are falling in Canada. If you’re like me, this may prompt you to ask yourself a question: ‘Why are Toronto and Vancouver housing prices rising so fast when the rest of Canada is falling?’ The answer to this question can be understood by examining the composition of the Canadian economy.

Canada’s economy is largely driven by commodities like oil and lumber. Of Canada’s $402 billion in exports, $231 billion can be attributed to natural resources. The vast majority of the production of these natural resources occurs in the prairie provinces, northern territories and the maritime provinces; whereas the majority of the financial, technology and service industry is primarily concentrated in cities like Toronto and Vancouver.

As of late, the Bank of Canada’s Commodity Price Index has indicated that commodities have reached their lowest price level since the midst of the financial crisis in 2009. As experienced in cities like Edmonton, Regina, and Saskatoon, plummeting oil prices have resulted in massive layoffs ultimately increasing unemployment rates and destroying real estate prices.

Though oil and commodities have experienced significant price declines, cities like Vancouver and Toronto remain largely unaffected. The reason for this is primarily rooted in the idea that both Vancouver and Toronto act as global cities characterized by their important role in the global economic system and highly diversified economies. Both of these cities are driven by finance, media, technology and tourism, meaning that depressed commodities prices have had little effect on their economic health and have allowed them to continue to grow. So when compared to the rest of Canada, it becomes clear why Toronto and Vancouver’s economies have attracted far more interest and investment than others.

ARE PRICES SUSTAINABLE?

Given the state of the rest of Canada’s real estate market, we can begin to understand why both foreign and domestic investors are showing interest in the Vancouver and Toronto real estate market. While this is the case, we need to ask the question, Do the underlying economics justify the degree of asset appreciation? Is the trend of increasing real estate prices sustainable? Let’s take a look at a few key numbers to form an understanding.

First and foremost, affordability in both Vancouver and Toronto has never been worse. For a home to be considered ‘affordable’ it would require 40% or less of an individual’s household income to be spent on housing (includes mortgage payments, taxes and utilities). RBC’s affordability index shows that 64% and 92% of household income is spent on housing in Toronto and Vancouver, respectively, and it’s continuing to increase! Real estate has not been this unaffordable since 1990 when interest rates were 14%! What makes this even more unstable is that both cities have seen enormous price appreciation, while incomes have remained relatively stagnant, demonstrating a serious disparity between housing costs and incomes. This trend of increasing unaffordability is reaching a dangerous point that leaves both Toronto and Vancouver susceptible to instability.

There is also a growing sentiment in both Vancouver and Toronto that there is a lack of supply of housing. It is believed that this lack of supply is forcing house prices higher. While there is truth to the notion that depressed selling activity is creating upward pressure on home prices, as indicated by finance minister Bill Morneau, I believe it is only a part of the equation. Record household debt fuelled by mortgages and low interest rates coupled with foreign investment have played an instrumental role in creating Toronto and Vancouver’s real estate issue.

Additionally, a Canadian dollar that has been hammered by a depressed commodities market has created an economic environment that is ideal for foreign investors. Explained simply, when the value of the Canadian dollar goes down relative to other foreign currencies, the purchasing power of those currency increases. This means that foreign investors are able to convert their currency to the dollar more cheaply, incentivizing foreign investment in Canadian assets. This has driven an influx of foreign investment into Canada’s hottest market- real estate. While an increase in foreign investment is typically viewed as a positive economic phenomenon, adding more fuel to Toronto and Vancouver’s already bubbling real estate market only increases its instability and vulnerability to external global economic events.

Our steaming housing market has started to even worry global financial institutions like the Bank for International Settlements (BIS), an international financial institution which serves as a bank for central banks. In a quarterly review, the BIS flagged Canada for vulnerabilities connected to credit, property prices, and the likelihood of rising interest rates. The study continued to state that Canada’s credit to GDP ratio (a comparison of current debt levels to the long run trend of debt in Canada) of 17.4% signals early warning signs for financial crisis. They went on to say that two thirds of all banking crises are preceded by credit to GDP ratios that break the threshold of 10% for 3 years or longer, a number that Canada has far surpassed.

WHERE ARE WE HEADED?

Remember when you were a child, and you and your friends would race down the steepest hill in your neighbourhood on your bikes and skateboards to see who could make it down the the fastest? Looking back, do you remember how dangerous that was? You would eventually be travelling so fast that you weren’t able to control yourself, and eventually fall flat on your face. That is the perfect metaphor to compare the Toronto and Vancouver real estate markets to. They are appreciating at such an incredible and unsustainable rate that they are either going to crash or a regulatory body will be forced to pump the breaks by enacting any number of different measures and interest rate hikes. All indications are pointing to a significant correction. While I hope we, as Canadians can escape unscathed and with a full set of teeth, we may already be travelling too fast.