Detached from reality

Let’s say you & your squeeze bought a detached in 905 two years ago when nobody could imagine empty commuter trains and people in masks. You paid $850,000. Now it’s worth $1,100,000.

You call the bank, get a HELOC for 65% of the value, and TNL@TB hands over $715,000 at prime. That’s 2.45%. You buy a condo down by the mall to lease ou.t Bingo. You’re a rentier. A person of properties. An investor. A god.

Sure, the rent barely covers the property taxes, condo fees, insurance and HELOC interest so the ROI is like a wimpy GIC. But, man, the $1,500 a month the line is costing you is 100% tax-deductible. Interest-only payments can be written off in their entirely. And the bank is asking for no principal repayment. Yahoo. It all came for free from the equity in your home. And you just know that condo unit will be worth a million in a few years. Suddenly that one genius real estate investment you made (the house) has turned into two of them.

What’s not to love about the system?

This is exactly what thousands of families are doing. New home equity line of credit (HELOC) loans surged wildly – 57% higher – in the last six months, compared to 2020. Almost all this money has been borrowed on variable rates and secured by a principal residence. The bulk of borrowers now make minimum payments and are not reducing the amount owing. And why would they? The cost is barely 2.5%. It’s deductible. And housing is rising by 20-30% a year. Free money, baby!

As we told you a couple of days ago, this accounts for 25% of all real estate deals now going to investors. No, not big companies hoovering up houses, but mom-and-pop-and-junior family units leveraging up the family digs to start a property empire.

Some people think this is not going to end well.

Says the credit outfit Equifax (which tracks this stuff): “The HELOC trend is worrisome as often the payments are tied to a variable interest rate. With many consumers now heavily leveraged and the potential for increases on variable rate mortgages and HELOCs, consumers may find themselves not in a position to pay back their debt obligations if interest rates rise. This can lead to higher insolvencies.”

As we told you yesterday, it worries the Bank of Canada, too. “A sudden influx of investors in the housing market likely contributed to the rapid price increases we saw earlier this year. That can expose the market to a higher chance of a correction… extrapolative expectations risk creating a disconnect between actual home prices and their more fundamental levels.” The odds of an earlier rate-tightening cycles are rising.

It worries the regulator, too. Peter Rutledge is head of OSFI (the federal bank cop) and says household finances are becoming more fragile. “The use of HELOCs and non-traditional housing backed products can lead to greater and more persistent outstanding principal balances, increasing risk of loss to lenders.” There’s speculation this will push the stress test even higher as everyone worries about excessive borrowing – especially in light of the federal Lib’s crazy plans (the FHSA, new buyer tax credits, enhanced shared-equity mortgage and the $1.25 million HMC limit).

Now this is worrying the mortgage dudes. Too.

Broker, web rate aggregator and media star Rob McLister is now talking of a “significant” correction in real estate values next year. Rates are going to jump, he says, while pointing to a National Bank report showing Canadian real estate assets are now five times national disposable income – the most extreme in the world. “When you get that all-important leg on the table — which is interest rates — being kicked out next year, couple that potentially with some more tightening by regulators and a higher potential mortgage qualifying rate, it raises a lot of questions about real estate next year,” he told BNN (which you should never watch).

So, the targets are clear. (1) The cost of money and mortgages will rise. (2) It’s likely we’ll see a tightening of the HELOC rules so people cannot turn houses into ATMs so easily. (3) The mortgage stress test may rise again. (4) We could see Ottawa disallow interest deductibility for real estate investment loans. NZ is doing exactly that.

Any one of these moves will be consequential. Prices are now detached from economic reality. Families are plunging headlong into leverage and debt, no longer fearing risk. As McLister says: “The point is, people are taking their newfound equity and redeploying it in the real estate market because that to them is one of the safest no-lose investments.”

Now, you can’t blame folks for doing this. It’s irresistible. Households are addicted to real estate, unable to break the habit and enabled by bankers, brokers and delusional, floundering policymakers. Risk has augmented dramatically. It threatens everything. Thus, regulators are accepting their responsibility to slap you down. Ouch.

About the picture: “Here’s our newest member of the family, ‘Scarlett’,” writes Jenn. “She is four months old and a Cavalier King Charles Spaniel. I met her breeder 3 years ago at a horse show and waited a long time for her. She joins my Golden x rescue and Hound x as part of the pack. We paid a pre-Covid price for her and I have been to the breeder’s house 3 times, met the puppy’s  father and mother and the rest of the puppies. Your blog has taught me more than any other source about personal finance and that’s saying a lot given that I have read well over 50 books on the subject over the years. Thanks for all that you do.”