The disconnected

Yesterday John and his new bride were vexing over advice from their accountant. (Note: never take investment or marital guidance from an accountant.)

J bought a bung east of the 416, converted it to a duplex and moved into the basement. That was two years ago. Then Covid. Then nesting. Then WFH. Then the massive shelter inflation. The value of the property swelled. Actually it doubled. Then he got hitched and, wired with dopamine and swimming in endorphins, the kids (31) bought a honking big new-build in the hood.

The bean-counter says keep the bung for future gains and a retirement income stream. Bad advice, of course. Once they move into new digs, rental property gains will be taxable. The income stream will equal just a GIC-type return on equity. Tenants are a total PITA. And the two have no other liquid assets. No TFSAs. No savings or financial securities. No pensions, either. So having 100% exposure to one asset class, while carrying leverage on two properties at rates destined to rise is, well, dodgy thinking. But so Canadian.

Find a greater fool I said. Harvest that windfall taxless gain. Pay down the debt on the new place. Set up a diversified portfolio for the future – which will include kids. And protect yourself against the inevitable, which will include (a) interest rate escalation and (b) real estate risk.

I think the kiddos listened to the right guy. We’ll see.

Of course, most people don’t. They suffer recency bias – believing real estate gains that took place in a pandemic will go on forever – as well as FOMO. When assets go up, folks are desperate to jump on. Greed is a powerful motivator. But fear is even greater. And a new report suggests in a couple of years we’ll be feeling a lot of that.

Let’s start off with these two charts, courtesy of Macquarie Group’s David Doyle, who is a very smart cookie. Check this out. He suggests we’re pooched…

Source: Macquarie; National Post

What do these graphs tell us about Canadians and the money we hand over for houses? “Prices are totally disconnected from the fundamentals,” says Doyle. Therefore it’s neither logic nor economic basics driving real estate to the highest relative level in the industrialized world. Nah, it’s emotion. And bad advice. Clearly it’s dangerous to allow housing to represent such a big chunk of the economy. And it cannot last.

Doyle, and virtually every other economist (plus the odd blogger) believe people who bought houses during the pandemic will be facing an interest shock at renewal. Mortgages taken at 2% will double, or more. Not only will payments increase, but the amount of principal paid off monthly will crash. Debts are elongated as rates augment. You pay more and pay off less. And along the way if house prices flatline or fall – even slightly – household balance sheets takes a hit.

These days inflation is rising. Bond yields are going up. Mortgage costs have swollen three times in a month. The Bank of Canada has announced the abrupt end of its bond-buying program. And CB benchmark rates will start to climb in the spring. Tightening cycles are never short, and no reason to expect different this time. By 2024, says Doyle, things could get really uncomfortable for the leveraged among us. “By 2023, things start to get iffy,” he states. “I’m more concerned after 2024, at that point the Bank of Canada will be hiking rates and housing will be impacted.”

Meanwhile, Covid will be over. The vax rate in Canada will be 90% and the pill will be here. All those reasons why a global pandemic caused panic nesting will be gone. While some people will stay with remote employment, WFH will be over for millions of others. Those office towers are not staying empty. Human nature hasn’t changed, although technology has. People congregate to accomplish things for a reason. They shall do so again. The consequences for families who moved to the hinterland are obvious.

Most critically, we’ve rendered real estate unaffordable. The average detached house in the 905 belt around Toronto, for example, is over $1.4 million, up just under 30% y/y. Incomes have advanced 2%. Inflation is 4.4%. Folks have less money, not more. This explains $400 billion in new mortgage debt over the past year – all of which will renew at far higher levels. As a society, we’re drawing wealth from the future to finance things we cannot afford today. But that future will come.

As Doyle says, the amount being invested into residential real estate exceeds total business investment. We’re putting more into where we live than what we make. How does that possibly end well?

Time to bail, John.

About the picture: “Standing on guard for thee! I thought this would make a good picture,” writes Brian the lawyer from Toronto. “Not sure she makes the cut. Her name is Korra.  Your blog is great.” (The flags are installed on the lawn of Manulife’s head office in Toronto, in honour of 118,000 Canadian soldiers who did not return from battle. Each flag represents 10 soldiers.)