Interest in Housing
Don’t miss our previous article where we break down the findings and recommendations of the Ontario Ministry of Finance report on Financial Planning and Advisory practices.
I usually like to make these articles about something that is not being talked about enough such as high investment fees, patience in investing and good financial planning. However this month I am going to talk about something that everyone is talking about, the high prices of housing.
First off, let’s get it out of the way, I have no idea whether prices are headed up or down in the short term or long term. These prices are driven by three basic things: low interest rates, supply, and greed. Demand is a fourth, but demand is steady and present thus somewhat normal. Sure, overseas demand is contributing but outsiders are certainly not alone in paying these very high prices. The last 18 months have mostly been a story of conflict between supply and greed. This current game is being played out on top of the foundation of overall low interest rates.
Supply and Greed
Economic theory tells us that a shortage of supply will cause prices to rise; then trigger an excess supply which will result in normalizing prices again. So why has that not worked yet? Prices just keep rising faster and faster. Well the answer must be in the supply. Within Toronto and Vancouver, supply is constrained by geography and government. Think of Toronto’s greenbelt. Most major empty areas left within are already under planning or building. The markets for most commodities are forward thinking and if the shortage is coming, prices will rise now and not later at the time of the final shortage. This shortage is seen as extensive, and with no answers in sight, prices started rising fast. And then came the greed. Often supply is met by people choosing to sell and leave the market. Currently you will find many potential sellers hanging in. Why? Price increases have been so dramatic that individuals see that the way to even greater wealth is to hang on and not sell yet. Waiting one more year to sell has been bringing 15 to 25% extra. This greed has caused the shortage to be extreme and with supply from building constrained by time and location, prices have zoomed beyond any economic models.
Low Interest Rates
We must not forget that all of this game is being played on top of low interest rates. Low rates make money cheap with interest as its inherent cost. As a result, the low interest rates allow ALL asset prices to rise. It is not just housing, though it may feel that way because of the supply versus greed struggle. Stocks are expensive, bonds are very expensive, businesses to buy are expensive and in fact almost anything you want to buy has been made easier by cheap money. So whether it be houses, stocks, cars or washing machines it is easier to buy them even at higher prices.
How Can They Afford It?
I have many clients telling me that their children cannot afford houses. When I point out that it is easier for their kids to pay a million dollars for a home or 2 and ½ times the $400,000 home they may have bought in the past, they are incredulous. It is interest rates. At 10 to 12% interest, we paid mostly interest each year. Over the life of the typical 30 year mortgage, we paid 2 and 1/2 times what we bought the house for. It was a great incentive to pay your mortgage faster and get rid of it. Today’s 2.5% rates mean most of a new purchasers payments goes to principal. Over the life of their mortgage, they will only pay an extra 20 to 25% of the value of their home. Not the 250% extra you paid. Therefore, there is not much of an incentive to pay the mortgage faster.
Sell or Stay Put
The next thing not considered by most people I talk to is, whether they are actually better off selling their home for $1 million, retiring and investing their money to help support their lifestyle. If they were selling their home for $400,000 it would be because interest rates were much higher. $400,000 invested at 5%, which was historically easy to get on a five year GIC, would yield $20,000 income to spend. That new million dollars will struggle to deliver $20,000 safely today. All investment returns will be lower going forward if interest rates remain low. So are you better off selling at a higher price if your investment of those funds produces no more?
So let’s summarize. Our kids can afford these homes, if interest rates stay low. They can acquire all the things they will need for their families if interest rates stay low. You are no better off than an investor with less capital if interest rates stay low. Stocks need not go down, houses need not go down, bonds need not go down, if interest rates stay low. So do not let the conversations about high housing prices steer your focus away. Pay attention to interest rates and where they may or may not go. They are the entire story currently. Housing prices are a symptom not the disease. Encourage your children to work hard to get rid of their mortgage, just like you did. Encourage them to save before buying, just like you did. Do not have them fear the purchase of a home, but do everything they can to mitigate the effect of a change in interest rates. If interest rates stay low over the long term and there is ample reason to believe they can buy, then our children are not stupid to consider buying a house on the next big pull back when it comes. Lastly remember, if interest rates stay low for a long time, higher housing prices may not have made it any easier to enjoy our retirement, unless after a sale you are willing to take the risk of spending your capital not just the interest.
Financial Planning – A review and analysis of a person’s current financial and personal circumstances, present and future financial needs, priorities and objectives, the risks associated with his or her current circumstances, future needs, objectives and priorities which can but need not include the establishment of strategies to address and mitigate these matters whether or not a formal financial plan is prepared. – Per the Expert Committee to Consider Financial Advisory and Financial Planning Policy Alternatives