I was unable to find the time to write up a post yesterday, despite some interesting data points worth discussing. Luckily, others in the blogosphere were on the ball, so I’m not going to discuss topics that have been well covered elsewhere.
The big interesting piece of information was related to the financial state of our swollen boomer population. As you’ll recall, I wrote a primer on this, speculating that we may see significant selling pressure from the boomer group over the next few years as they look to free up equity. As it turns out, new data seems to support my thesis.
Rather than analyzing the data, I’ll instead point you to several excellent blog posts by other authors:
Of interest to me yesterday was the fact that Stats Canada released some new data regarding incomes and household wealth here in Canada. Of course, the data is always slightly dated, but it nevertheless helps us paint a picture of the differences between Canada and the US.
Many people will point to the fact that our lending institutions are more conservative than those in the US and therefore this will save us from a possible real estate bubble. Granted we never saw the levels of excess in irresponsible lending seen in the US, but we nevertheless saw some pretty shady practices, some of which are still ongoing.
The bottom line is that we have our own problems to deal with. It’s pretty silly to look south of the border at perhaps the greatest speculative bubble and subsequent wealth destruction in human history and then say, ‘at least we’re not them, so that means we’ve got no problems of our own!’.
So with that, let’s take a critical look at incomes in Canada and the US and see just how we stack up with regards to the most important driver of real estate values.
Before we do that though, let’s note that the current average price of a home in Canada is $331,000 while the average in the US at last check was $171,000, meaning the average house in Canada is nearly double the price of the average price in the US.
What can possibly account for such a massive difference between our relatively similar countries? Prior to examining incomes, we should n fairness discuss some significant legislative differences between our two nations, some of which seem to favour each.
Capital gains tax: In Canada, capital gains in real estate are not taxable. In the US, there is a $250,000 capital gains exemption, meaning that you are only taxed on cap gains above this threshold. With average prices where they are, this essentially means that the vast majority of home sellers in the US pay no capital gains tax. Bottom line: this difference in tax law slightly favours Canadian real estate but in reality is virtually negligible.
Interest deductibility: In most cases, all mortgage interest on primary residences in the US can be deducted from federal taxes. This is absolutely not the case here in Canada, though interest paid on investment properties is tax deductible. Bottom line: this difference in deductibility of interest favours US real estate in a major way.
Mortgage terms and interest rates: In Canada, the vast majority of mortgages have 5 year terms, meaning you have to refinance every 5 years. This exposes home owners to possibly adverse interest rate shocks if they have to refinance at a higher interest rate. There is a strong argument that Canada has its own ‘teaser rate’ mortgage issue similar to the one that helped spawn the real estate meltdown in the US. All fixed-rate mortgages originated at the record-low interest rates of the past 18 months must be refinanced within the next few years. If interest rates have risen substantially at that point, homeowners will see a rising percentage of their pay go to service their mortgage. A standard rule of thumb is that each percentage point increase amounts to an additional 9% added to the payment.
Now contrast all this that with the situation in the US, where the majority of mortgages are for 30 year terms, meaning that the interest rate never changes over the duration of the mortgage. Imagine the security! And the current interest rate on 30 year mortgages in the US? As low as 3.4% currently! Compare that with Canada, where the closest product we have is a 25 year term at RBC, where you would pay %8.25 to eliminate interest rate risk. Bottom line: Mortgage rates and terms heavily favour the US market.
Immigration: The CIA Factbook lists net migration rate in Canada at 5.63 per 1000, placing it in 15th place among all countries. The US net migration rate is at 4.32 migrants per 1000, placing it 22nd. While the Canadian total is higher, let’s not gloss over the fact that the US, by world standards, is still an extremely accommodating country when it comes to immigration. For those thinking that somehow immigration is the holy grail of perpetually rising real estate above income growth and inflation have to grapple with the reality that our immigration story in Canada is not markedly different than that in the US. Bottom line: Immigration rate favours Canadian real estate.
With those factors outlined for your consideration, lets now look at a few fundamental drivers.
Let’s start with incomes. The price to income ratio is perhaps the best predictor of the sustainability of real estate prices at a certain level. High price to income ratios relative to long term norms can exist in periods of declining interest rates, but set the stage for corrections when interest rates do rise. I don’t see rapid rises in interest rates for several years, but the point still remains: They can’t get any lower! When they rise is a bit of a moot point.
Let’s remember just where our price/income ratio sits here in Canada.
We are currently over one standard deviation above long-term norms. That alone should tell you a great deal about the precarious valuation levels we’ve placed on real estate.
But how does our income actually compare to the per-capita income in the US, where it costs half as much to buy the average house?
Wow. Yes we are different! Shocking that the per capita income is slightly higher in the US, while real estate prices are almost half of what they are here, while certain aspects of their mortgage and tax system heavily favour home ownership there. With all indications that the US market has yet to touch a bottom and may well have further to fall, it begs the question of what really sets us apart as such a bastion of exceptionally high prices.
As an aside, it’s also worth noting the percentage of home owners in the US versus in Canada. It’s pretty obvious that there is a concrete upper boundary to the level of home ownership in a society. In the US, ownership rates peaked in 2004 at 69% and now sits at approximately 67%. In Canada, our home ownership rate has surpassed the US peak and how sits at approximately 70%. It should indeed be interesting to see how much higher this rate can go, given that the vast majority of Canadians believe that real estate is the best path to financial security and have positioned themselves accordingly.
As I’ve said all along, credit bubbles have a tendency of pulling demand forward. They may alter fundamentals over the short term, but markets have a strange way of making their way back to their long-term means. It’s what economists and analysts refer to as ‘reversion to the mean’. We’re different alright. In the US, their reversion is well underway. For us, it’s still in our future, and the economic fallout of this reversion will be felt by all.
Don’t be swayed by the delusional masses or the madness of the crowds. Look with a critical eye at what really drives long term appreciation and what hinders it, then decide for yourself what the future likely holds.