Last week, the Bank of Canada’s Governor said that the housing market is OK. Très bien! Nothing to see here but rainbows and unicorns. I suppose this assessment is accurate when seen through the rosy prism of the Bank of Canada’s hierarchy as well as those in the financial or home lending industry in general. Business after all, has never been better. That said, if we take a moment and think about things rationally, Canada’s housing market is terribly ill, and investors are beginning to realize these problems. TD has long been one of the world’s most shorted stocks after all. I think Canadian Real Estate is in a huge bubble at the moment, and I am going to give you some reasons why.

1. Recency Bias

The biggest reason why real-estate is a bad investment is the more you pay for something, the lower your subsequent returns are going to be. That’s just an economic fact. Let’s illustrate things better with an example. In April 2008, according to TREB, condo’s in Toronto cost on average CAD$245,400. In April 2018, the average condo in Toronto costs CAD$588,000. If you bought a condo in April 2008 and sold it in April 2018, you would have made 139% return on a price-to-price basis. This ignores any property taxes (which would have increased as your property is periodically re-evaluated by the municipality), taxes on home income (if applicable), profit taxes, closing fees, renovation costs, insurance, etc., because it seems like any time we talk about real-estate, these costs magically go away. I will admit, 139% is a great return on an investment if this scenario describes you. But here’s the catch; if you are the April 2018 buyer, for you to make a 139% return on your property in 10 years, that condo which you are buying today will have to be worth CAD$817,320. Does this amount seem reasonable to you? If you know anything about property, that’s just impossible; it’s not going to happen. The return expectations for people buying now have to be tamed a little bit. I know that many of you are going to post comments saying that you bought a property 5 years ago or 10 years ago and did really well. This is not relevant to someone who doesn’t have a time machine. If you are buying property today, you are going to have lower returns going forward than people who bought property 5 or 10 years ago.

2. Household Income

For the next reason why I think real-estate in Canada is in a bubble, I would like to borrow a quote from Yogi Berra. “That neighbourhood is so expensive, no one can afford to live there”. That’s really what is going on across Canada. According to the OECD, the gap between income and house prices in Canada are too high to be sustainable. The OECD is calling for a 28% correction in Canadian real-estate. Personally, I think that estimate is very conservative, but that is what they are saying. Here’s the point of it; over time, taking Toronto as our example of Canadian real-estate, house prices tend to stick within a range between 3.5 and 4 times median household income. Median income in Toronto right now is about CAD$58,000 dollars, which suggests that house prices are massively inflated in the Toronto real-estate market. Given that lending rules are starting to tighten; it was recently let known that only those with a six-figure salary will qualify for mortgages going forward, this will accomplish one thing, and one thing only. It’s going to bring the price of real-estate down. That is another reason why people who purchase a home today are going to have poor or dare I say catastrophically negative returns on their investment going forward.

3. The Real Economy

After the US housing market meltdown, and we are well aware how many economists failed to analyze that correctly, we understood that real-estate can’t grow more in price than productivity and inflation. So, at some point, what is happening in the real economy matters to real-estate. What we are witnessing right now is a big disconnect between real-estate prices and what is happening in the economy. In the last ten years, Canada’s GDP, what we produce overall as a nation, has actually decreased. In 2008, Canada’s GDP stood at $1.549 Trillion Dollars. Today, that GDP is down to $1.53 Trillion Dollars. During that time, Canada’s GDP grew at about 1.5% per annum, while inflation averaged about 1.3% during the same period of time. Using the Toronto Condo price averages from above, condo prices increased by about 9% per year. Canada’s labour productivity growth rate in 2017 was just 0.8 percent, not an impressive return by historical standards. If as a nation, we are less productive and are growing at a slower rate today than in 2008, the peak of the last bubble, why are housing prices rising disproportionately? Eventually, the economy will weigh down housing prices.

4. Household Debt

Speaking of the real economy let’s look at debt; Unlike Europeans or Americans who are lowering their debt loads, Canadians are piling on debt like never before. On a ratio of income to debt, Canadians are sitting on somewhere between 170% of debt: this means that for every dollar Canadians earn, they got a 1.70 debt outstanding. Why is this relevant to real-estate? If Canadians are maxed out in the parlance of our time, they are less likely (more like less able) to get a mortgage, and mortgages are really important to real-estate. So our capacity to service mortgages, our capacity to get mortgages really drives the price of houses and real-estate and if we can’t do that because we are too broke, that’s going to accomplish one thing, and one thing only. It’s going to bring the price of real-estate down.

5. Rent To Mortgage Ratio

Here is another interesting argument for why real-estate in Canada is overpriced – It’s actually getting cheaper to rent. Never forget this; the real-estate market is a function of rent. Canada’s price-to-rent ratio is among the highest in the world, indicating that it’s cheaper to rent a house rather than buy. The Economist puts out this metric every year, where they compare the price of owning certain property to the price of renting that same property or very similar property. The costs of ownership are way out of whack with rent.

Believe me, I’ve heard all the arguments against renting and if you just repeat what you are getting ready to write in the comments to yourself, renting is not throwing your money away. Let me deal with that argument in a couple of ways. First, if you take a look at the amortization table of a 25-year mortgage, the first 15 years is mostly interest. So in a sense, you are just pouring money down the drain when you have a mortgage. You are not actually building any equity. All that is happening during times of ultra-low interest rates. When your capacity to repay that debt is being subsidized by Government in effect (as a little aside to this point, please read more here). The idea that you are building equity by paying down your mortgage assumes that the price of the property you are paying down does not fall in price (and also stays ahead of inflation). As an example, let’s say you have a CAD$100,000 mortgage (I wish), and 20% equity in it. That leaves us a $CAD80,000 dollar mortgage to pay off. If the price of that house drops to CAD$70,000 dollars, your equity is wiped out and any amount that you have paid off gets wiped out. Your asset becomes pure debt at that point. So the idea that renting destroys value and owning a house at whatever price creates value is not only naive; it is nonsense.

6. Rising Interest Rates

The next reason why I believe real-estate is overpriced is I don’t trust mainstream economists. There is no shortage of economists in Canada that suggest that owning a house in Canada or maintaining a mortgage in Canada is pretty affordable. This gets to one of my big criticisms of economics in general; they use a device called “ceteris parabus”. It means roughly holding all things constant, or keeping everything the same. The argument these economists make – who also happen to work for institutions with huge mortgages on their books that make huge profits by lending people money to buy houses they can’t afford, their idea is if everything remains the same people can actually afford the mortgages that they have now. The problem is, and there is lots of history to suggest this is true, an economy changes over time. There are peaks and valleys. Interest rates change over time. Employment changes over time. You can’t really coral everything but just one variable in a constant. It’s a silly and dangerous idea that people can afford mortgages at these ratios over time. Real-estate is a long-dated asset, which means you are going to hold on to it for many decades, and in multiple decade periods the economy is going to go through different interest rate regimes. So mortgages may appear affordable now, or in a model which forecasts low interest rates, this doesn’t mean the mortgage is affordable when interest rates normalize. Not if they rise, but when they rise.

Final Thoughts

Why is this relevant to all Canadians? Even the smart Canadians like me who aren’t speculating in the real-estate market? There are certain types of bubbles (cryptocurrency) that only affect the people who speculate in the asset class in question. It won’t impact the rest of us that much so the bubbles are not that destructive. In the case of real-estate, it will impact the real economy because it will impact what is called the wealth effect. More importantly and directly, it is going to impact the construction and home renovation sectors. The number of jobs that are heavily dependent on the real-estate bubble is enormous. Ontario alone has about 10,000 mortgage agents.  It isn’t just jobs – Pension investment in property has more than doubled in 5 years. It will impact the Canadian economy on a huge percentage basis, and so when those jobs and the wealth effect go away, that is going to have a spillover effect to the rest of the economy and its going to hurt people who are innocent parties in my view. People who did not have anything to do with participating in speculation This is why I think every Canadian should pay attention to what is happening in real-estate. Because it is clear to me our policy makers are either ignorant to the risks or simply choose to ignore them.

On a risk reward basis, somebody is better off doing something else with their money. You can’t buy a piece of real-estate that by every metric under the sun is overvalued today and expect that in the next 10-15 years.