Blessed by the Potato

A rolling loan gathers no loss.

I’ve long said that the mortgage default rate has no predictive value in spotting housing market trouble: it’s a lagging indicator. The reason is very common-sense: as prices increase rapidly, even someone with no equity to start with can refinance after a year or two, or sell and be able to cover the transaction costs. There is no reason to default in a rising market unless you’re particularly bad at arranging your finances and can’t even make it a few months to be rescued by the rising tide.

Then I was reading something about the junk bond fiasco of the 80’s and came across another interesting feature of credit bubbles. As you lend to less and less creditworthy people/businesses, your eventual loss rate will increase — those chickens eventually come home to roost. But firstly, rolling loans gather no losses: with loose credit, and increasing valuations on the underlying collateral, it’s very easy to just borrow your way out of trouble for the short term. Even then, the defaults don’t occur immediately except in the most egregious of cases (which did happen at the end of both the junk bond craze and the US subprime debacle). Another feature is that you increase the size of the lending pool as the credit bubble inflates. So if you look at the default rate, it may be flat even though the number of defaults is steadily increasing — just not quite as fast as the denominator (total credit) is also increasing. That makes the default rate look better than it really is, and doubly so when combined with the lag time before a loan defaults. Seth Klarman says that you could have spotted the junk bond crisis before the bust by looking at the default rate and adjusting for the increase in the denominator.

To give a quick example of how that would work, say your default rate is steady at 1% — this is a level you are happy with and for decades in your industry has been a level that indicates there’s no trouble. Then you rapidly increase the size of your loan portfolio, doubling it within say 6 months. You should have zero defaults on the new loans since they haven’t had time to default, so your default rate should be halved now. If it’s still 1%, you have a problem, and may not realize it.

So I went to look up some Canadian mortgage data. As expected, the default rate is low. It was rock-bottom when the 90’s first started, as prices were at their peak there. Then as Toronto’s bubble crashed out and the economy worsened, the default rate increased, topped out at about 0.7%, and then improved. Around the economic crisis and recession in 2008/2009 (also when Alberta prices started their “soft landing”) the rate increased modestly, but is still generally fairly low. That’s the blue line, and is a chart you’ve probably seen many times before.

But in that dataset is also the total number of mortgages, and that has increased much faster than the population growth rate: if you assume that the year 2002 is a “normal” period to start from, and increase the mortgage size with our population growth rate (1.1-1.2% according to Google), then in 2012 we should have just about 3.7M mortgages. Instead, that number is higher by about 16%. If you then take the number of defaults, and compare them to that denominator, you get an adjusted default rate in red — and that is, by the conservative historical standards of our country, fairly high. And this is still a lagging indicator. But on an absolute basis, it’s still pretty low: while the growth in the mortgage pool has been tremendous by mortgage standards, the dilution of the denominator isn’t as dramatic as it was with junk bonds.

To cut it up a different way, consider the situation as separate pools of mortgages. You’ve got say 3.7M mortgages that represents the normal, conservative Canadian lending market that everyone likes to talk about. These are the people that would own their houses no matter what the real estate boards were projecting, many have been in real estate for decades and have significant equity. With times being reasonably good and house prices being at record highs, we might expect the default rate on this pool to be near its lows of 0.1-0.2%. Let’s be generous and say it’s even higher than that — 0.25% — so this pool of mortgages represents about 9300 of our defaults today.

Then we have the 560k new mortgages that represents all the insanity of the past 12 years: demand pulled forward, low downpayments, long amortizations, teaser rates, fuzzy thinking — whatever it was that drew these people into the market that maybe shouldn’t have been there in the first place. Of that pool, 140k were issued just in the last year alone. Since we don’t expect defaults to occur immediately unless there is a huge problem in underwriting, we wouldn’t think of defaults as coming from those. That leaves 420,000 mortgages issued in the last 10 years that would be responsible for 7000 of the defaults, a rate of 1.7%. The default rate separated out for this pool is put in pink on the graph. As an aside, it goes off-scale in 2009 — in part because the fixed 0.25% default rate assumption simply wasn’t true for the regular mortgage pool (times weren’t great), and in part because that’s when house prices stopped going up and actually went down (briefly).

Now, this is all back-of-the-envelope and full of room for error. This is not the one peg I’d hang my housing bear hat on (that would be price-to-rent). But it is another way of looking at things that I hadn’t come across before.

Over at CMF user Uranium101 asks when the correction to Canada’s housing bubble will come. He wants to buy a house. I’ve seen similar questions around, or people saying things like they’ll wait a year or a few months or whatever before buying. I’ve been fairly vague on timing for the most part, focusing more on valuations, but it’s a topic worth addressing.

You’ll have to be very patient. On the one hand, we don’t have jingle mail and all the other positive feedback elements that sped up the US crash; on the other, after witnessing that wreck the common buyer may be a little quicker to slam on the brakes, slowing things faster here once the correction does start. Assume the two factors roughly cancel and our unwinding will proceed at about the same rate as the US.

So if you’ve spotted the bubble with good timing near the top (and weren’t early like myself or Mike Burry or whatever), then for the US experience that would be sometime around 2006, maybe even as late as 2007. When is the time to buy? It’s still not clear if the US market has bottomed yet, but maybe around 2011/2012 you agree that even if there is more downside, the fundamentals are back in line and that it’s worth the risk to buy again.

That’s a good 5 years or so. More if you were early in spotting the trouble. Maybe you figure once the major declines started to peter out in 2009 was close enough; that would still be 3 years from the peak you’d have to wait.

Similarly, if in Toronto you had spotted the problems close to the peak in 1989, you’d have had to wait 3-4 years before you’d want to pencil “house shopping” into your day planner.

Real estate is not a fast-moving, efficient market, so patience will be required. But a 30% correction on a $600k house is $180k, and that savings can be even greater if renting is cheaper while you wait. Plus you expose yourself to less risk. Sitting out the insanity will require finding a nice rental you’ll be happy in for several years and patience, but you’ll be very well rewarded for it.

There has been a real barrage of articles about the housing bubble in the MSM lately. Perhaps because January is both a slow news period and a slow real estate period, so it’s a good time to get it all out, or perhaps because the topping process has begun, and the awareness of the problem has started to spread from gloomy spreadsheet addicts like myself to society at large. Based on some very non-scientific mining of Google’s news search, mentions of a housing bubble started to increase about a year before the top in the US, and really were flying wild when the prices finally turned the corner. Here, stories about a Canadian housing bubble roughly doubled last year, to about 500 hits in 2011. There have been over 200 hits already in 2012 — just one month!

Alongside the stories that warn of the danger are ones that try to explain it all away, including two recent ones by Larry MacDonald (who I respect) and Mark Weisleder (who, well, let’s just say he makes these kinds of mistakes a lot). Together, they make a few basic points:

• House prices have been stable.
• Immigration.
• Interest rates are low, and even if/when they do rise, they will be accompanied by job growth.
• Recourse mortgages.
• Low foreclosures.
• High valuation metrics… but, like, so what?
• Bears only call for a bust due to recency bias, because we just saw a housing bust in the US.

So, to the point-by-point rebuttal machine!

Though some are shared, Mark’s arguments are obviously much weaker than Larry’s. Only he would make the point that housing has been stable and the GTA is nice, so it’s an attractive buy. Of course the converse implies that if housing does start to turn, it will turn badly because that point in favour of buying goes away, and instead becomes a point in favour of selling.

Similarly for his immigration argument: we do get a steady influx of immigrants to Canada (and the GTA in particular). Beyond just immigrants, babies will still be born, teenagers will still turn into twenty-somethings, and people will still move out of their parents’ basements. That was as true in 1992 as it is today. For that matter, it was as true in 1989 as it was in 1992. These things are all true, have been true for a long time, and mean absolutely nothing when it comes time to deciding whether now is a good time to buy a house in Toronto. It means your house won’t be completely worthless, but doesn’t mean a painful 10-35% correction isn’t in the works — as witnessed first-hand by buyers in Toronto, 1989.

The point about low interest rates is also not particularly strong. Even with the recent deals on fixed 5 and 10-year rates, you will be exposed to future rates for a long time when buying a house. After all, the typical mortgage is 25 or 30 years long. It is much better to buy at higher rates and a lower price than to scramble to buy at high prices and low rates. Think of the possible outcomes: if rates move lower, you get a gift and can pay off your mortgage faster. If rates move higher, you face a hardship. If rates are as low as they’ve ever been, the odds are this is as good as it will get, with likely hardship to follow.

Now Larry makes a point about higher rates being accompanied by higher employment, which should offset the price declines that higher financing costs would bring. But to that I simply say: invert it. Prices were up 10% in Toronto last year, and apparently the economy is still just limping along, warranting low rates. So how big of a driver is employment vs interest rates for house prices? To me, that indicates that while there may be a bit of tempering if employment and wages gain along with increases in rates, those are not going to have a large enough effect to counter the decrease in prices that will come from the higher rates. Rates trump jobs when it comes to our housing market.

Recourse mortgages is a common reason thrown around to explain why Canada may be different than the US. It’s an interesting one, too. Sure, if the bank can come after you for your other assets you’re going to be less likely to strategically default and walk away from the house. That’s going to slow the positive feedback cycle, but there’s very good evidence that it’s not realistically that big of a factor. To point out the real-world evidence, again, just look at Toronto, 1989: mortgages were recourse then, too. Didn’t stop the bust. Many US states also had recourse mortgages (including Nevada, one of the few states to escape the housing meltdown — oh, no, my mistake, it’s one of the hardest-hit).

Let’s consider that point in a little more detail. Why doesn’t the recourse action save the housing market? At the core level, the simple answer is because it doesn’t fix anything in the fundamentals: the only way for price-to-rent and price-to-income to come back into line is for price to fall or rents and incomes to rise. So having recourse mortgages may stem the tide and positive feedback cycle of strategic defaults and foreclosures, but doesn’t bring any new buyers to the market. But even then, how much of the tide does it stem?

To answer that question, we have to get an idea of how many strategic defaults there might be vs. bankruptcies. If you can’t pay the mortgage, if you’re severely underwater, and if you have very few other assets, there is really no difference between a strategic default and a bankruptcy — and we still have bankruptcy here. You give the house back to the bank and you start over with nothing. Many people — far too many — have bought in recent years with nothing down and are house poor: aside from their house (with just a thin slice of equity in that), they have very few savings and investments. So to them, there’s no difference between a strategic default and full bankruptcy. If someone has a lot of other assets, then they may have considered a strategic default, but how many of those people are there who also have so little home equity that they’d be willing to trash their credit and walk away, if only it weren’t for that damned recourse mortgage? I’d bet not terribly many. Not enough to matter anyway.

So recourse mortgages aren’t going to stop a housing bust, and are certainly no reason to go out and buy now (if anything, it should give you pause as a buyer).

Hmm, low foreclosure rate. Let’s see, prices in Toronto were up about 10% year-over-year last year. Why are there any foreclosures? Even a 5%-down buyer could sell the place, repay their mortgage, and cover all the sundry transaction fees, taxes, and penalties if they ran into financial trouble in this market. They just had to stay solvent for a year. No, foreclosures are a lagging indicator: only when the housing market is already flat or going down and people are getting into financial trouble does the rate go up, because all other options have been taken away.

Both Mark and Larry touch on valuation metrics. Part of Larry’s point is valid: they don’t tell us about when the correction will come. I’ve been bearish for years precisely because the metrics have been out of line for years. But that said, severe over-valuations like this rarely correct neatly, with a long period of modest negative real returns — “crashes” or “corrections” are the norm. Mark’s point… does Mark have a point? If you don’t like averages, fine, use medians. But don’t compare the nominal number with one method to the nominal number from another: what was the median Toronto income to the median Toronto house price historically, and what is it now? You can’t try to hand-wave the fundamental imbalance away like that Mark, I’m too perspicacious for that.

Finally, to Larry’s point about recency bias: I disagree. I think the recency bias is not clouding the vision of the bears, but rather the bulls like Mark. The last crash in Toronto real estate was 1989, when many current first-time buyers were kids, or gametes. All they’ve known for recent history has been rapidly increasing prices with no risk.

Asides: Mark has a few other points that aren’t even remotely relevant, but I figured I’d rake him over the coals a little more.

His final bullet point about debt ratios shows how clueless he is about what these population measures are showing: for a given person, a debt-to-income ratio of 150% is nothing. Hey, a 25-year-old making $50,000/year who just bought a $400,000 house with nothing down except the closing costs would have an 800% ratio, and people still wouldn’t look at him funny. That person should be able to handle the payments and has lots of time. But what about a retired 70-year-old who has a pension of $40,000 and is $60,000 in debt? That’s only 150%, yet is clearly a much worse situation than the young guy at 800%. So the important thing with these population measures to see how they change over time. The Bank of Canada isn’t worried about one particular Joe having 150% debt-to-income, it’s worried that for a long time that ratio stood at 100% and over the last few years has climbed to 150%. I wonder how Mark would interpret a stat like the average family has 2.3 kids? He must be one of the ones envisioning whole neighbourhoods hiding kids with only a third of a body in the basement.

The closing message about the US not allowing the economy to fall apart in an election year is face-palm worthy. 2008 was an election year, Mark. The reality is that the US government, for all its nuclear missiles and predator drones, is helpless to stop a housing collapse. Ours will be even more impotent since we’ve already burned up the government mortgage guarantee, low rates, RRSP raiding, and extended amortization options.

I mentioned a few times that it’s important to look at a range of different assumptions before making a large decision, such as deciding whether to rent or buy. It can sometimes take a fair bit of research to get to those assumptions in the first place (what’s an appropriate range? Why can’t I just assume 20% returns or no inflation?).

But as handy as a spreadsheet/calculator is for figuring that stuff out, it’s hard to show multiple outcomes, so here is a little graphical depiction of when it’s better to rent vs when it’s better to buy after 20 years, and by how much, under various assumptions — holding the others constant with the “base case” numbers. It’ll give you an idea of how sensitive the analysis is to various factors.

The “base case” being the numbers I put into the rent-vs-buy calculator spreadsheet in this post: namely, 2% rent inflation, 2% house appreciation, 7% investment return, mortgage rates of 2.8/4.5/5.5% over the first 5, second 5, and remaining years, and of course, a price-to-rent multiple of approx 215X.

The shaded green areas show where it’s better to rent, and by how much, while the shaded purple areas show where it’s better to buy, and by how much. I’ve put them all on the same scale for easy comparison. You can see there’s a lot more green than purple. Yes, purple does exist, and there are scenarios where buying is better (high house price appreciation, high rent inflation, low investment returns, low price-to-rent, etc). But based on what I think are the likely range of outcomes, it is much more likely that renting will be better for us, and by fairly significant margins.

Here’s the impact of different outcomes for appreciation, with all the other factors as in the speadsheet posted before (i.e. 215X price-to-rent multiple, etc). You need to be quite bullish for quite a long time to get into the purple region at the right side of the chart (in effect saying that you think a $500k house today will be $1.3M 20 years from now).

The different outcomes for investment returns:

With several time points to pick from (0-5 years, 5-10 years, 10-20 years) it’s tough to make a fully-featured chart, but here are a number of options. Even assuming very low rates lasting for a very long time (2.0/3.0/3.5) only barely nudges owning ahead; in the green triangle, no truly scary rates are featured (nothing above 6%). The impact of mortgage rates:

I was a little surprised to see that the outcome was so sensitive to rent inflation:

And how the outcome changes with different price-to-rent multiples (the base case was 215X in the previous posts, more on that below the figure):

Perhaps unsurprisingly the biggest single factor is the price-to-rent ratio. Fortunately, this is the one with the least uncertainty: identify your comparables — your living arrangement options — and then you’ll have the two prices to use rather exactly. I was attempting to be generous in the original post, using “just” a 215X multiple when I have seen plenty of examples in the 250X-275X range, and could probably cherry-pick even higher. I thought 215X was more defensible: though there may be some outliers, that seems to be about the floor in Toronto, so I could trust that you could go out and do your own comparisons and find similar or higher multiples. The original point was that even with generous assumptions, it’s hard to make the case for owning.

So maybe even though I thought I was being realistic, you thought the investment return assumption was a little high, or the long-term appreciation a little low — that’s fine, since the price multiple is a huge factor that may trump those smaller quibbles. Especially when a more realistic multiple for Toronto may be 250-275X.

Oh, and BTW: Wayfare has found out from the old landlord that indeed, the place did not get rented out at the original asking price of $2100, but rather $1950 (after a few months of vacancies chasing that higher rent). Plus she also says I’m way too conservative on the valuation (that was the lowest priced listing in 2010, again to be conservative/generous) and that $550+k would be more fair, i.e. a price-to-rent of 280+X. Our current place would be about 270X.

So how big of a difference does that make? Below I’ve created a little matrix looking at how the outcomes change based on different scenarios, here focusing on different house appreciation assumptions across in columns, and different investment portfolio returns down the rows. The cells have been colour-coded green (renting better by $100k or more after 20 years), yellow (either choice within $100k of the other), or red (owning better by more than $100k).

You can see that for a 215X multiple — the example used in the previous post — my base case scenario would be in yellow (2% appreciation, 7% investment returns). Being off by just two points (5% investment returns, 4% appreciation, or one percent to each) can flip the outcome from renting being better to owning being better. Enough that if you’re concerned about negative equity, or a flat-lining housing market, renting may indeed be a better choice. But not the hands-down outcome you may have been expecting given how important I feel the topic is. Perhaps I shot myself in the foot with my “even being generous to owning” strategy by giving people an out there.

So then look at how it all changes with a 275X multiple: very few scenarios where owning is better. At that price, you need to be both very pessimistic on equities and very optimistic on house prices to be dipping your toes into the real estate market. Again, you can find parameters where owning will yield a superior outcome, but how likely are those parameters? How big is the pain if you’re wrong?

*Wall of text hits for 500 points. It’s super effective!*

Ok, as long as I’m on a roll, Mike asks via twitter: “Should I sell my house and rent?”

I responded: “I am physiologically incapable of answering that in 140 characters. Yes, possibly, or no, maybe. Beware the wife always.”

To put up another wall of text:

TL;DR: Yes, sell and rent.

In truth, it depends. First off, the situation is not quite symmetric with the earlier case of someone starting out and deciding whether to purchase their first place or to continue renting because there are significant transaction costs — financial and otherwise. As a young person if prices decline even just 10%, that’s huge — you may not even have 10% as a down payment as a first-time buyer, so that’s more than your entire life savings to date. For someone who already owns, 10% is a transaction fee. It can also depend on what your opinion is regarding using your house as an investment: do you want to get the most value out of it, or are you content on missing out on opportunities if it means you get to stay put? Your family situation can really play into that.

So let’s say you run through some calculations, and find that you live in an area where housing is significantly over-valued, and that you’d be better off renting. Further, let’s say that you go through some rental listings and find a nice place that you could see yourself living in. What do you consider next?

Well, first off, think of what you paid for your house. That figure does absolutely no good when discussing whether I should buy or rent, because I have to pay today‘s price, but you got to pay the price of whatever time you bought at. So let’s say that you managed to buy at some point where it would make sense to buy rather than rent, like 5 or 10 years ago. This is important because one of the benefits of owning is that you get to quasi-lock-in some of your housing costs at the time your purchase. I don’t mention that much because it’s a con, not a benefit, when prices are high — you’re locking yourself into being house poor. But if you’ve already locked in a low house price (e.g.: your current monthly cash costs may indeed be lower than rent), then your risk tolerance will come into play: do you want to take on the risk of higher shelter costs for the ability to lock in your gains, and make more by investing in equities?

It’s also a little different if you bought before the boom than the situation now: if house prices do go down, then for you, it would be like you bought low, it went higher, but then came back down. A missed opportunity, but other than some paper gains and reminiscing it doesn’t really affect your day-to-day life. On the other hand, buying high does: your daily costs are higher because you paid more, impacting your ability to save and afford other things in your life; and after prices go down you may find you’re underwater and can’t move, or can’t get favourable rates upon refinancing.

A list of considerations:

• If you do sell your primary residence, any gains will be tax free.
• You just won a leveraged bet. That’s a hell of an opportunity.
• On the other hand, opportunity costs are psychologically different than cash costs.
• The future path of prices: selling is a hell of a smart idea if a crash is coming. Could set yourself up for life. But over-valuation could fix itself via a long period of stagnation. That can still work out well for you — and for someone who has to pay today’s price, the path doesn’t matter as much. Nonetheless, soft landings a rare. If there is a crash and you chose to hang on, how will you feel? Even mortgage-free with no plans to sell, the knowledge that your house is depreciating can be trying.
• Are you at risk of negative equity if there is a correction?
• Risk tolerance: you’ll be trading partially locked-in housing costs and real estate investments for stocks and rent inflation. IMHO, a smart bet, but not one undertaken lightly.
• Subjective factors: emotionally, it’s a lot easier to choose between renting and buying when you don’t already live in your “forever house”. If you’ve been living somewhere for years, it can be hard to decide to pack up and leave it.
• Renting stigma: it’s undeserved, unfair, and perhaps doesn’t actually come up all that often in your life, but to some there is a social status hit when renting rather than owning.
• Where you will go. While you only need one rental, they are admittedly rarer than houses for sale in the detached house market. You could try to find a speculator who wants to buy your house and lease it back to you (in many respects, the ideal situation). Or, you could sell and move to a cheaper area. That may be particularly appealing to those who are in a position to take (early) retirement.

So what are your basic options?

1. Sell and rent (which may include finding an “investor” to buy your house and rent it back to you so you don’t even have to move). In this case, you get to take out a potentially huge tax-free profit, and diversify into equities, bonds, etc. You may face higher cash housing costs, especially if you were mortgage-free, but the returns of your investment portfolio should, in the long-run, more than make up for that. If house prices go up a lot more, you’ll feel like a dummy, but IMHO the risk of that is very small now. If house prices stagnate, you’ll come out ahead with your large investment portfolio. If housing prices go down, you can buy back in after a few years, and keep the profits. You become famous for your daring putting-your-money-where-your-mouth-is attitude and timing, and may get invited to write a book or give lectures.
2. Stay put. If prices go down, you missed out on an opportunity to sell out, but it doesn’t really affect your day-to-day life, since you were already paying the same or less than current rents. Best of all, the wife will be happy, which may be worth a few hundred grand.
3. Sell and move. So you like owning, but you don’t want to own in bubbly Toronto or Vancouver. That’s fine, you still have options. Let’s say you bought 10 years ago at $400k, and your Toronto house is now at $750k. You could sell it and move to a less-bubbly outskirt, like London, Hamilton, Guelph, etc. and get a nice house equivalent to what you had in Toronto for $300k, and pocket the $450k difference. Sure, you have to uproot a bit, but it’s not so far to go and visit your friends, and several hundred thousand dollars is a hell of a lot of money, tax-free. It would take the average person years to save that much. You may still have to work, or, depending on the rest of your situation, may be able to take early retirement. If the bubble pops, you may suffer as well in the outskirts, but odds are not as much, and then you may be able to buy back in Toronto if you really want to — though once you escape the traffic congestion, and see how much cheaper car insurance and other expenses are outside the city, there may be no dragging you back.

There are options within each of those scenarios. Once you’ve decided to move, you can choose to downsize for instance. I’ve talked with my parents about that a bit: with my brother and I moved out, and my sister at university 8 months of the year, they really don’t need a 4-bedroom house, let alone one walking distance to the subway when they never go downtown. They could sell now and downsize (either rent or buy). Even if they buy, having $800k in stocks and $400k in real estate is better than the other way around if/when the correction comes. If they downsized and rented, the rent may be less than just property tax, insurance, and maintenance now.

Or, you can choose to upsize. Sell your house and rent a nice luxury mansion, or a place closer to the subway, or better on whatever metric you want to pay up for for a few years. Even at $5500/mo, it’ll take years to burn through that tax-free gain on your old place; like a HGTV extended vacation. Especially nice if you had been planning to move up, but found the ever-increasing prices made it hard to make the jump. Live like damned hell-ass kings for a while: you deserve it, you made a fortune in accidental real estate speculation!

So, what do I think Mike should do? Sell and rent. I’m pretty sure he lives in Toronto, and I know that he bought his place 12 years ago and owns it free-and-clear. Toronto prices have doubled since then. The average price of a detached house in the 416 is approx. $750k now, which means he’s likely sitting on a not-insubstantial tax-free gain of something like $375k (depending of course on where in the GTA he lives, how far above or below the average his house falls, etc). It took him 12 years to pay off that mortgage: I’m sure it was 12 years of scrimping and sacrifice, since that’s a very short time to get it done in. And he could double it in just one quick move by selling now. Assuming the mortgage payments now go towards the retirement fund, that could cut something like 7 years off the retirement timeline*. A nest egg of $750k using even a very conservative 4% rate of return would produce $2500/mo, which gets you a pretty decent family home in Toronto (i.e.: about equivalent to one that costs ~$650k). Any return above that, plus all the money he’s spending now on taxes, maintenance, and insurance, is gravy — or money that can be used to rent an even nicer place. If those costs of a paid off house run another ~$1000/mo, that’s real money.

I made another spreadsheet for Mike to play around with, looking at how a renter would do vs. continuing to own over the long-term. Assuming $3k/mo gets you the equivalent of a $750k place; using a generous 3%/yr appreciation in house prices, and 6% for the investment portfolio, you come out ahead by several hundred thousand by bailing now. And that’s with the ~7% it’ll cost in transaction fees to get out. Any decline in prices just makes that look better.

There are risks and emotional costs. He avoids the risk of a housing downturn (indeed, as a blogger he can profit from it by driving traffic to his site with stories of his brilliance), and gets away from the usual risks of ownership (mostly repairs, since he no longer fears negative equity or lack of mobility). But he trades housing risk for stock market/bond market risk — Mike’s a smart guy, and a personal finance blogger to boot, so he probably doesn’t see that as much of a downside, but you do need the stomach for it.

He trades having most of his housing costs locked-in for the vagaries of the rental market, and also that intangible benefit of being able to be in one place for 12 years (not that renters can’t stay put, but it’s not as certain) — again, something that is not necessarily of benefit to a young person without an established career like myself, but may be to someone with a family like Mike. I’m more likely to need to move than to be annoyed that my landlords sold the house out from under me — as small as that risk is.

And of course, he has to convince his family to move, which can be emotionally taxing, especially if there’s a lot of sentimental feelings about the house where the kids grew up. Sure, you can bribe them: “Honey, I’ll buy you a bloody car if you just pack up your things within 60 days”, but it’s still going to be an upheaval. That said, people move all the time, and for worse reasons. You’ll adapt. It’s been 12 years, you’re probably about ready anyway (my those kids must be getting big… do they have their own rooms?). Or maybe you’ll get lucky and find an investor that wants to keep you as tenants in your own home.

On the other hand, maybe he paid off his mortgage in 12 years because he makes $500k/year, and realizing a $400k gain is not worth it to him: while it’s a tonne of money to me, it may be peanuts next to his investment portfolio, and not worth the hassle of hiring movers.

As for my parents? We had this talk, and they decided not to sell and rent or downsize. Primarily because my mom is emotionally attached to the house: they’ve been there 25 years now. Partly because they don’t need the money: they’ve been retired for years (if you ask, my dad won’t say he’s retired, but he has at least long since hit findependence**), and they’re not the type to take exotic vacations: if they’re not spending their money on their house, what would they spend it on? Now, if the stock market had stayed as bad as it got in late 2008/early 2009, that would have been a different story, and if the market gets bad again there will be a downsizing. But you can see how even if it’s the financially optimal thing to do, they may choose not to.

So, what does the future hold? That’s very tough to say. In the near term, damned near anything could happen. My opinion:

• Equity returns will be decent in the long term (20+ years), 4-5% real returns should be very realistic (6-8% nominal with 2-3% inflation).
• Rent increases will be in-line with inflation: the current overvaluation is not due to abnormally low rents IMHO.
• House prices will increase very modestly when averaged over the very long term, basically in-line with inflation over 20+ years.
• There is a good chance in the medium term (next say 7 years) that house prices will be lower in Toronto: I think it’s the most likely way to correct the current over-valuation. I’d say a 90% chance that prices are 10-20% lower 5-7 years out. We could have stagnation or a soft landing, but I just don’t see it as terribly likely. There’s a decent chance of a spectacular crash, too, particularly in the condo area: say a 50% chance that prices are 30-40% lower in 5-7 years. I’d say with very high certainty that 7 years from now, house prices will not be higher — we’ve done 0-down, we’ve done government mortgage guarantees, we’ve done first-time buyer tax credits, and we’ve done low interest rates. Other than direct subsidies, lowering the age of majority, fully mature adult cloning, dissolving marriages, massive lifespan extension, and forced relocations, there isn’t any more fuel to throw on this fire. That said, it’s not going to be quick — there are people asking if they should wait 8 months, or maybe 12 before buying a house, and it’s just not going to play out that quickly.
• The opportunity cost of holding real estate in Toronto is very high: the rent savings of having all that capital sunk in your house is only yielding 2-3% — about what you can get in safe fixed income (though granted, tax free) — while you may expect double that from other investments that really aren’t any riskier than a house.

Add it all up, and selling and renting/moving out of the city is a smart move. If prices do go lower — which I think there is a very good chance will happen — you’re a hero. Even if they don’t, you’ve got a good chance of out-performing housing. And you can set yourself up for some interesting opportunities, like early retirement, freeing up capital to start your own business, or escaping the city and finding a house with a conservatory***. Just be ready to stick with it for a long time: the stock market could crash again next year, and it may take six years for even the smallest correction in Toronto house prices. The future is always uncertain, but the long-term expectation looks heavily skewed in favour of those who sell to invest and rent.

* – Less than 12 because now compounding is working for you instead of against you. Plus if he has other savings (i.e.: it’s likely Mike was saving before in addition to paying down the mortgage aggressively) then the retirement timeline reduction isn’t quite as dramatic.
** – Damnit, now I owe Jonathan Chevreau a nickle.
*** – Some time ago, Wayfare was looking at house porn in London. For what a middle-of-the-road house in Toronto costs, you can get a mansion in London, with a living room, dining room, den, solarium, library, and conservatory. I couldn’t even really say what a conservatory was — a music room maybe? — but we knew that it meant this house had so many rooms they must have started to run out of things to name them.