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The wrong plan

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  By Guest Blogger Sinan Terzioglu

A survey by the Ontario Securities Commission found 45% of Ontarians 45 and older are relying on their home to fund their retirement. It also revealed close to 60% have little or no retirement savings.  As real estate values have been in a upward trend supported by the tailwinds of declining and now historically low interest rates, this sort of thinking has become more common and increasingly risky.

Many rationalize real estate is always a good buy as the population continually grows, land is scarce and because property has been a good hedge against inflation.  As many increasingly overleverage themselves to purchase real estate, however, they’re making dangerous assumptions and paying too much. Gains of the last several years are not sustainable, so planning a retirement based on a continuation of these increases over the coming decades is very risky.

It’s all about cycles

The cycle in real estate has a lot in common with other cycles.  Positive events lead to greater optimism and increased activity. Inevitably this causes many to think the cycle is unstoppable, so more and more risk is taken on with little thought about what can go wrong. This is very dangerous particularly for those that are borrowing wildly and relying on a one asset strategy to fund their retirement.  Real estate in Canada has never been more expensive from any valuation metric you look at.  As prices have increased buyers have become more and more comfortable with the risks because they extrapolate the gains into the future, but the reality is there has never been a riskier time to purchase property in many parts of the country.

Since the onset of COVID-19 governments and central banks globally have spent some $20 trillion to backstop credit markets and stimulate economies.  This is more than three times the amount spent during the financial crisis of 2008-2009.  Economic theory suggests all this increased money supply could lead to higher inflation, already in evidence.  Some will argue that supply chain disruptions of the last year have been a big contributor to the price increases and as the world economy normalizes so too will inflationary pressures. But higher inflation would lead to increasing interest rates and this could impact real estate much more than many realize.

Over the last several months properties listed in the GTA around $1M have sold for significantly more.  For those trading up with their increased equity and/or family help the risks don’t seem concerning, but for the first time buyers with no family help and average household incomes the consequences of over paying can dramatically impact long term financial security.  The outcome can be life-altering as increased monthly carrying costs significantly strain cash flows and the ability to save.

Consider a couple in their mid-30s with a household income of $200,000. They’ve been renting a house for $3,000 per month and are ready to purchase a property so they start looking around. Their savings of $325,000 are spread across a non-registered account, TFSAs and RRSPs.  They have been searching for a few months and have been outbid multiple times.  The plan is to spend no more than $1M with 20% down and to retain liquid financial assets but after being outbid multiple time the process has taken an emotional toll. They are determined to not be outbid again when the right property appears.

After seeing a home they like listed at $1M they decide to make an offer but based on comparable sales their agent tells them it will likely not sell for less than $1.2M.  In order to avoid being outbid again they offer $1.25M and their offer is accepted.  Emotions and fear of missing out have caused them to spend $250K more than they initially planned and now their down payment is going to be $250K – but with land transfer tax and closing costs their total initial outlay is closer to $300K which will essentially require most of their assets.

This couple has gone from having over $300K in liquid financial assets growing at a healthy rate to having only $25K in financial assets, a seven figure debt and an overvalued asset. They have gone from a position of strength to one that could have very negative consequences if interest rates start moving higher.  A $1M mortgage at a rate of 2% amortized over 25 years would cost over $4,200 a month.  During the initial 5-year term interest payments would total over $91,700.  However, if the environment changes and interest rates move higher over the next 5 years and their new rate at renewal went to 4% this would result in their monthly mortgage payment to be nearly $5,100 so over 20% more.  Not only would this put further pressure on their monthly cash flow but also impact real estate values as the cycle and psychology changes.  During the second 5-year term total interest paid would total over $150K.

Never forget real estate is rate-dependent

If interest rates were to rise as described in this scenario real estate values could very easily drop 15-25%.  A property purchased for $1.25M could fall in value to $1M yet the debt would remain.  As a result this couple would have seen their initial equity of $250K go to $0, however the lost opportunity cost over the following 25 years would be significantly more.  Had the couple avoided the emotional decision of chasing overvalued real estate, stayed the course with their $300K invested while only adding annual TFSA contributions earning an average 7% per year this portfolio would be worth over $2.4M by the time they hit 60.  This pot of liquid financial assets would comfortably provide an income of over $10K a month without depleting the capital.

The point of this example is not to suggest one should not purchase real estate.  As Garth says, if you can afford real estate go ahead and buy but do not make the mistake of assuming it is the only financial plan you need or that it is a good investment.  If you are a first time buyer or wanting to trade up I recommend being patient and not putting all of your eggs in one basket.

Renting is significantly cheaper so saving and investing the difference over the next few years would make a huge difference to your long term finances.  It is more important than ever to avoid falling into the common thinking that real estate is the only financial plan you need as most Canadians will not have employer pension plans and are not saving nearly enough.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

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