MoneySense Magazine, September/October 2010
Look out below!
House prices in Canada are officially falling—and they could fall for some time. Here’s how to protect yourself, whether you’re a homeowner, seller or potential buyer.
This article was first published in the September/October 2010 issue of MoneySense.
It’s a dangerous time to be in real estate. Home prices have risen to record levels, and mortgage rates and housing inventory are creeping up. After years of marvelling at the surge that just won’t quit, newspapers are changing their tone. Gone is the euphoria of earlier this year when buyers rushed in before the introduction of the harmonized sales tax in B.C. and Ontario. Now unfamiliar phrases such as “cooling market” and “slowing sales” are being dusted off for headlines.
Real estate in Canada appears to have reached the tipping point. According to the Canadian Real Estate Association, sales activity was down by a whopping 30% this July over last, and prices fell by 3.5% from the previous month. Insiders are warning that plunge could continue in the months and years to come. CIBC World Markets suggested prices could fall by as much as 10% in two years, while Gluskin Sheff + Associates economist David Rosenberg is even more pessimistic. “By many measures, home prices on average are overvalued right now by between 15% and 30%,” he recently wrote, adding later that “even if prices remain flat for the next few months, we estimate that year-over-year trends will be in negative territory by the fall.”
Such forecasts worry Rose and Chris Nagle of Lloydminster, Alta. The couple, who have three children under 6, moved from Corner Brook, Nfld. to Alberta after Chris got a better job offer three years ago. Upon arrival, they spent a whopping $575,000 for their four-bedroom bungalow just outside of town. Now the couple is worried. With rising interest rates, rising unemployment and talk of declining prices in real estate, the Nagles (whose names we’ve changed to protect their privacy) wonder if they have overextended themselves financially. “We have three kids and it’s going to be expensive raising them and paying for all their activities and university educations,” says Rose, 33, an office manager at a local medical clinic. “What happens if we can’t make the mortgage payments, or have to change our lifestyle drastically to make ends meet?”
The manufacturing plant where Chris works has been laying workers off recently, and although his job appears secure for now, his turn could come soon. “We’ve talked about selling this house and moving to a less expensive one, but we’re not sure,” says Rose. “We don’t know what to do.”
Historically, one of the greatest allures of home ownership was that it represented a great way to build wealth. If you bought a house and hung on to it for 15 years, you could sell it for a huge profit. But now, in many parts of the world, instead of making money on their homes, people are losing a bundle. “Real estate is a two-headed hydra,” says Alan Silverstein, a Toronto real estate lawyer. “It’s a place to live as well as an investment. But the market isn’t red hot anymore. The only home you should be buying now is the one you can afford to carry.”
During boom times, real estate is a marvelous way to build wealth. But booms never last forever, and over long periods of time, housing isn’t such a great investment. Yale University’s Robert Shiller, the world’s leading student of housing bubbles, famously found that over exceptionally long periods of time, such as between 1890 to 1990, the after-inflation rate of return on residential real estate is close to zero.
Many people will tell you that an extreme drop in real estate prices—such as the 50% drop many states in the U.S. saw in just three years—won’t happen here. They’re probably right. They’ll tell you that Canada has good fundamentals and tighter government regulations, including legal requirements that don’t allow most buyers to walk away from homes once they’re worth less than your mortgage. In most of Canada, if you end up in such a situation and lose your home, you are responsible for paying back the difference between the foreclosure price and what you actually manage to sell it for.
Unfortunately, that still didn’t prevent an almost 20% price drop in real estate prices in 1991. Many people in Alberta (the only province where you can walk away from your mortgage and assume no liability) simply mailed the house keys back to their lender.
In Canada, we’ve smugly looked on as housing crashed in the U.S., leaving our housing market unscathed. But now our good fortune seems threatened. “If you sleep next to an elephant, you’re bound to get bumped,” says Silverstein. “There has definitely been a slowdown in housing these past few months and it will probably continue for a while.”
Luckily, there are some commonsense things you can do to protect yourself, whether you’re a buyer or a seller. Take the following precautions, and you’ll sail through the next few years unharmed, whether the market crashes or not.
If you’re a potential buyer …
Remain a renter for now. The best thing you can do if you are considering buying a home right now is wait. “If you don’t have a good down payment—20% or more—and would need to take on a huge mortgage to buy your first home, then wait,” says Silverstein. “The panic is off. The market is swinging back to a buyer’s market. Take a couple of years to build up a bigger down payment and to allow for some of the air to be let out.”
Resist the monster home. With falling prices, you’ll want to keep your housing-related expenses to a minimum. Look at how much space you really need—not want—and limit your search to homes that are roughly that size. “This notion that you should max out the size of your house to a maximum number of bedrooms that you can afford is a recipe for unhappiness,” says Richard Florida, author of The Great Reset and director of the Martin Prosperity Institute at the University of Toronto. “Not only does it limit your financial flexibility, but it also forces you to spend time keeping up space that you don’t use or need. Your home should be a place that makes you more happy and productive, not a burden to keep up.”
Don’t overspend. That means that no more than 40% of your gross household income should go towards housing-related expenses, which include property taxes, maintenance, insurance and mortgage payments. That way, if house prices fall, you’re never in a position where you have to sell your home to make ends meet. If you find you’re already feeling stretched financially, then consider renting out a room or basement apartment. “That could get you an extra $600 a month and be enough to prevent you from having to sell your home in a bad market,” says Alfred Feth, a fee-for-service adviser in Waterloo, Ont.
Wait until Christmas. It’s a well-known fact that house prices are cheapest just before Christmas—up to 10% cheaper. That’s because during the holiday season, buyers are scarce, so motivated sellers are desperate for offers. Real estate experts agree that December is one of the best times of the year for negotiating a good real estate deal. “So if house prices go down 5% to 10% in the near future, you have a financial cushion to fall back on,” says Silverstein. “You’ve already paid 5% to 10% less than what you would have had you bought at another time of year.”
Stick to the tried and true. Get good value for your money. Make a substantial down payment—20% or so of the asking price if you can. Look for a home on a quiet street. The house should be in a good location near schools, shopping and transportation. Also think about how long you plan on staying put. If you’re going to be there for 15 years, and you can afford your mortgage payments, you’re going to be just fine, no matter what the market does in the short term.
If you’re a homeowner thinking of selling …
Flippers beware. Be careful if you’re planning to sell just to cash in on the surge in the market. Even if you think real estate prices are poised for a steady decline and want to lock in some of your gains, don’t forget to take into account all the costs involved in selling. There will be land transfer costs, taxes, moving expenses, legal fees and real estate commissions to pay. “Stop and ask yourself, ‘If I move to another place are there really any savings?,’” says Marc Lamontagne, a fee-for-service adviser with Ryan Lamontagne in Ottawa. “If not, it probably makes sense to stay where you are.”
Lower your price. Now is not the time to test the waters with a high price. It’s a competitive market and home values are falling. If you must sell, and you live in one of the cities where prices are softening, don’t waste precious time by listing your home at a price that’s so high it won’t be supported. There are fewer buyers out there and you want to do everything you can to get as many in to see your home as possible. Nothing does that better than listing your home at a fair asking price.
Rethink downsizing. It probably won’t save you money. Sellers start out with the best of intentions. They tell themselves that once they sell their big, expensive home and lock in their gains, they’ll downsize to something more modest and invest the difference. But Tsur Somerville, director of the University of British Columbia Centre for Urban Economics and Real Estate, says that usually isn’t what happens. “When people downsize, they downsize in size, but often not in value.” They’ll move to a condo that’s smaller—but more luxurious. Unless you’re relocating to a new area with much lower real estate prices, downsizing, by definition, means moving to a place that’s not as nice as the one you’re used to. It’s tougher to do than you think.
Sell privately. When house prices are tumbling, you want to squeeze as much money out of your home as you can. Consider selling it yourself. “If you have the time and inclination to sell privately, then tens of thousands of dollars could go in your pocket instead of the real estate agent’s, perhaps even making up for a lower selling price,” says Lamontagne. “It’s worth the time and effort.” Saving 4% in commissions on a $400,000 home could see you pocket $16,000 that would have gone to agents.
Boost your mortgage payments. The biggest problem for homeowners during periods of falling prices is not that prices are falling (although that can certainly take a psychological toll). It’s that you may go into a negative equity position. When that happens, it means you owe more on your mortgage than your home is actually worth, so in essence, you no longer have sufficient collateral for the loan.
If you lose your job, get sick, or see your income drop to the point where you can’t make your monthly mortgage payments, you may be forced to sell your home at a loss. To prevent that, start increasing the equity in your home right now, while mortgage rates are still relatively low. “If I had $20,000 sitting in a savings account, I’d be at the bank at 9 a.m. tomorrow morning to put it towards my mortgage,” says Feth. “This is a foolproof financial strategy whether real estate prices are going up or down. It will give you a cushion against further declines in prices and lowers your expenses if one of you loses your job, making life less stressful.”
Visit your lender. If you’re having trouble making mortgage payments because of a financial setback, before you consider selling, go see your mortgage lender. “You need a place to live to ride out the storm if you can handle it,” says Silverstein. “Canadian bankers want to keep people in their houses.” If you owe $1,000 a month, but you can only afford $800, don’t let yourself fall into arrears. Ask your lender if you can temporarily lower your payments and make it up later. “I know bankers don’t advertise this, but if you go in with a plan and you are determined to keep your home, they will help you come up with something acceptable to both parties.”
Lay off the renos for now. If home prices keep falling, you probably won’t recover the cost of your reno when you sell. “The only time you should really consider renovating for payback when prices are falling is when you need to do some updating to sell a home,” says Silverstein. “But be careful.” Unless it’s a reno like a modest new bathroom or refreshed kitchen, you’ll probably lose money on it in the long run.
Feth agrees. “There’s nothing wrong with upgrading your home for yourself. A good quality kitchen and bath may still make sense. But it doesn’t make good financial sense to do much more than that.” Apart from anything else, unless you have paid off a significant amount of your mortgage, borrowing more money against your home to do a reno now increases your chances of ending up under water.
Hedge yourself against the fall …
We’re often asked by homeowners if there are some financial plays they can use to hedge their net worth against falling home prices—and there are a few. But before we get into those, we should repeat that the best hedge by far is to simply pay down your mortgage as quickly as you can. It’s not as sexy as using financial instruments, but it’s much more effective, and it should always be your first move. After you’ve done that, though, consider the following:
Diversify your holdings. If your house makes up a big chunk of your net worth, you probably don’t want to devote much of your financial portfolio to real estate too. If real estate crashes, you’ll lose money on your home and in your investments. Instead, “build yourself a conservative investment portfolio of exchange-traded funds (ETFs) or index funds that follow the equity and bond markets,” says Norm Rothery, founder of StingyInvestor.com. “Or, simply put your money in a low-cost balanced fund. The trick is to keep costs low. Returns won’t be spectacular but you’ll do fairly well.”
Can you short the market? Once you’ve built up your investment portfolio to a value roughly equal to that of your home, then you can consider using more advanced financial tools to hedge the investment in your home.
Theoretically, one such tool would be shorting the futures market on housing prices, allowing you to profit on falling prices. This would allow you to hedge the investment you made in your home, so you would make a dollar in the markets for every dollar you lost on the value of your real estate.
In the U.S., investors can short the market by using S&P/Shiller Home Price Index Futures, which are sold on the Chicago Mercantile Exchange (CME). These futures are based on the Case-Shiller Home Price Index, as well as several individual metro area indices. If you lived in Las Vegas, for instance, and expected local house prices to decline, you could short a futures contract based on the S&P/Case-Shiller Metro Area Home Price Indexes for Las Vegas. If you were right, and the index price dropped below an originally agreed-upon price, you would make money on the difference.
Unfortunately for us, though, Canada doesn’t have a similar product for small investors—yet. There is a house price index in Canada, called the Teranet-National Bank House Price Index, but individual investors can’t access futures based on that index.
Simon Côté, managing director of property derivatives at National Bank, says the index was set up to allow forward contracts to be bought and sold based on Canada’s home prices (forward contracts are like futures, but they are sold over the counter). However, right now, only big institutional players can buy such products.
A mass-market product linked to the index would be needed to allow worried Canadian homeowners to protect themselves against falling prices, says Côté. But he says his bank probably won’t be introducing one anytime soon. The reason? “In the U.S., MacroMarket launched securities linked to the Case-Shiller Index on the New York Stock Exchange specifically aimed at small investors,” says Côté, “but the securities were delisted for lack of trading activity. There just wasn’t enough interest from the public.” Côté says his bank is uncertain whether there would be enough demand in Canada either, so they’re holding off for now. “There may be something available someday,” he says, “but nothing is planned as of yet.”
The indirect hedge. Still, there are some backdoor methods that allow you to profit on a falling housing market. Rothery suggests, for instance, that you could consider shorting shares of the Big Five banks, allowing you to profit if their stock price declined. “Ask yourself, if the real estate market goes down 20%, then what’s going to happen to other things,” says Rothery. “For instance, the banks could be shorted because they have huge investments in residential mortgages. They’ll probably take a hit. Companies that depend on strong housing figures for their revenues will also suffer, such as Rona and Leon’s.”
In the future, Canadians may also be able to buy insurance-like products that help them lock in the value of their property—in effect, protecting you against falling house prices. There are a number of companies in the U.S. which, in return for a one-time premium ranging from 1% to 2% of the value of your home, will allow you to protect the value of your property for a set number of years.
Say, for instance, that you bought home price protection from EquityLock Financial in Utah when you bought your new home. If, five years later when you go to sell it, you find that you can only get 90% of the price that you paid, EquityLock would cover the lost 10% (as long as local housing indexes also showed a 10% drop in house prices). Such contracts could make an intriguing option if financial institutions decide to bring them to the Canadian market.
At the end of the day, whatever happens to housing prices, there’s no need to panic. As long as you’re not struggling to make your mortgage payments, you can simply wait it out. Like the Nagles from Lloydminster, you and your family need a comfortable place to live first and foremost. Your home’s contribution to your net worth comes second.
Once you’ve paid down your mortgage to the point where you’re feeling secure, it may be time to stop worrying about the value of your home, and focus on other things. Take part in your local community, reconnect with your network of family and friends, and give thanks for the roof over your head. Sure that roof may be worth a bit less a year from now, but as long as it’s keeping you dry, you’re doing just fine.
MoneySense Magazine, September/October 2010