ROBERT CHAMPION
The Globe and
Mail
Robert
Champion is vice-president of client services for Toronto-based Sprung
Investment Management.
A recent
Globe and Mail series explored the risks associated with rising household debt
in Canada. One risk associated with our addiction to cheap money is its effect
on home prices.
Low
interest rates have encouraged home buyers to take on larger mortgages. That
has led to a dramatic rise in home prices over the past 20 years. The wealth
effect caused by rising home prices has also encouraged homeowners to take on
additional debt through home-equity lines of credit.
There
has been much debate as to whether house prices in Canada, particularly in
Toronto and Vancouver, are overvalued – and if so, by how much. Many wonder
whether this purported bubble is likely to burst in the near future. The
reality is that there is no way to know whether a bubble in house prices, or
the prices of any asset class, exists until it actually bursts.
Given
that uncertainty, what do we know about house prices? Looking at Toronto house
prices from 1970 to 2014, it’s easy to see (from the grey line in the chart)
that the long-term trend for house prices has indeed been up.
A
second observation we can make is that for extended periods of time, house
prices rise significantly above the long-term trend. These periods of
above-trend prices are followed by extended periods of below-trend prices.
Why
does this happen? Anyone who has a memory of current events will likely recall
that during the mid-1970s, the oil crisis wreaked economic havoc, while the
selloff at the end of the 1980s was caused by the U.S. Federal Reserve Board
ratcheting up interest rates to slay inflation.
But
there is a more general reason that the prices of houses and other assets tend
rise and fall over time. It’s called reversion to the mean (often mistakenly
called “regression” to the mean).
Reversion
to the mean says that extreme values are more likely to be followed by less
extreme values. Think of it this way: Performance that is well above average
usually doesn’t stay there forever; it typically comes back to earth.
Performance that is well below average often gets better. If you’re a golfer,
you have likely experienced this phenomenon.
How can
we use this information to guide decisions about housing?
Most
people who are considering buying a house look at the rising prices, and assume
that they will continue to rise. They believe that they must buy now before
they rise even higher. In reality, periods of rapid house price appreciation
are eventually followed by extended periods of declining prices (see the red
line in the chart).
Prospective
buyers may be better off to rent now and wait for lower prices. The Economist
recently reported that Canadian house prices are 89 per cent overvalued compared
with rents. That means it is significantly cheaper to rent than own. Potential
home buyers should likely consider the option of continuing to rent and save a
larger portion of their income.
For
many older Canadians, their home is their single largest asset. As we age, many
of us sell our homes and use the proceeds to help fund our retirement. Knowing
that we will need to sell our homes at some future date, we look at the rising
house prices and assume that they will continue to rise. We believe that we
will benefit from deferring the decision to sell. That could be a huge mistake:
If you choose not to sell your house in the near term and prices decline, a
health or financial crisis could force you to sell at a much lower price.
For
older homeowners, here is the key takeaway: The historical data show that when
house prices decline, it takes 10 years or more for them to recover. Younger
homeowners have time on their side; they can afford to wait for prices to
recover. Older homeowners may not have that luxury.
Buying
and selling a home are the biggest financial decisions most of us are likely to
make in our lifetimes. Our behavioural biases mean that we tend to make
decisions based on recent data that fit our view of events, rather than
incorporating long-term historical data. We base our decisions on the fact that
house prices have risen significantly in recent years and ignore that fact that
they declined by 30 per cent in the 1990s. It’s different this time, right?