A Home Without Equity Is Just a Rental With Debt

Despite the unsubstantiated ravings of the real estate bulls who have stepped up their vocalizations of late, the facts surrounding the future of real estate remain indisputable.  Debt levels remain too high, savings too low, home ownership at record high levels, global economy still surviving on government stimulus, fundamentals all well above long term means (with the exception of affordability which is at the upper range of its historic range, but only because of….) record low interest rates.  None of this is sustainable.

But let’s make sure we understand what that word means.  Sustainable prices would means that real estate can remain at these inflation-adjusted prices for the foreseeable future.  Robert Shiller, Prof at Yale and co-creator of the Case/Shiller Home Price Index, famously calculated that over long periods of time, real estate prices pace inflation, and more specifically inflation in incomes.  Nothing more, nothing less.  That’s not to say that there is not considerable variability around that mean, but when things deviate too far to one extreme, there is ALWAYS a reversion.  There will never be a paradigm shift so great that it changes the immutable fundamentals that are the price/income ratio, price/rent ratio, and affordability measures.  But that doesn’t mean that factors can’t be brought into play that can outright screw up the normal functioning of a market and keep them out of whack for extended periods of time.

I’m thinking in particular about government intervention to specifically target an expansion in the home owner population, as both Canada and the US experienced.  This manifests itself in a variety of ways: A change to taxation laws to favour home owners, the lowering of down payment requirements, the specific targeting of low income earners via affordable home ownership programs, the loosening of mortgage insurance requirements, the encouragement of lower standards in lending requirements, government insurance on mortgages to protect bank profits, etc.   In a report we will look at in a moment, the author used a number of these exact examples of government intervention in the housing market to accurately predict the housing boom, bubble, and bust in the US as early as 2001.

The point that I want you to take out of it is that it is one thing to recognize that a situation is unsustainable, it is another thing entirely to predict exactly when it will correct since there is a psychological element as well as government influences that exert unpredictable pressures on real estate valuations.

That being said, I’m quite confident that the time line I’ve proposed will hold.  I still believe that we will be down 5-10% year over year by the new year with another 10-20% haircut next year.  This will choke off consumer spending and credit expansion, likely leading to a renewed recession by Q3 2011.

With that in mind, consider the arguments forwarded by the bull crowd of late.  The vast majority of the arguments I keep hearing on various sites and forums are really not arguments at all; they are nothing more than taunts.  They usually go along the lines of, “you’ve been saying that for X number of years and real estate prices keep going up.”  So, you see, the ‘argument’ is essentially that real estate prices will continue to rise far beyond fundamentals simply because they have risen far beyond fundamentals.  You see the iron-clad logic, right?

Well, at least for now, they do have a point.  I first became convinced that real estate was overvalued in Canada in 2007.  I reached that conclusion by reading a number of fantastic books about mass psychology, changing societal trends over time, and the reversion to the mean principle, and fundamentals of real estate valuation.  I’d be happy to provide a recommended reading list to anyone interested.  Email me.

At that time, the notion of the Western world being in a credit bubble that was set to derail the broader economy was barely on the radar.  The idea that Canada had a real estate overvaluation issue didn’t even seem to be in the public consciousness.  I distinctly remember discussing my ‘radical’ ideas with family and friends back then.  They were virtually universally rejected.

Fast forward to 2008 and the great financial crisis.  We experienced the virtual death of our monetary and banking system at that time.  We now have a zombie banking system sustained almost entirely by radical stimulus measures and government guarantess, which continue to produce no economic benefit except to prevent the precipitous drop in stocks, real estate, and possibly bonds if governments removed that stimulus(QE2 and POMO are great examples of this).  After the credit crisis, you’ll recall that home prices experienced a double digit decline in Canada.  Vindication!  Well….not quite.

In a desperate attempt to stimulate credit and ward off a deflationary depression, the Bank of Canada crashed interest rates to historic lows.  The government, in a round-about, underhanded bailout, stepped in to purchase mortgages off our bank’s balance sheets, thereby ensuring a continued flow of credit.  At the same time, the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. The approval rate for these risky loans went from 33% in 2007 to 42% in 2008.  These steps worked so well that real estate popped right back up to its pre-recession highs by 2010.

So you see, I was completely right in my assertions, yet dead wrong in that I had no idea to what extent the government would go to protect house prices and keep credit expanding.  I’ve since come to understand the great impact that real estate valuations have on the broader economy.  It’s the goose that layed the golden egg of our pseudo economic growth since the early 2000s.  I realize now just how devastating it will be when that goose finally buys the farm.  The government clearly knows this and thus will do everything in its power to keep it on life support.

So, what does the future hold?  Again let me restate that real estate valuations are completely unsustainable.  Unsustainable prices, by definition, cannot be sustained, for all the reasons repeated on this blog.  I may be completely wrong about the timing (I doubt it), but understand this:  I am NOT wrong on the fact that real estate will return to its long-term levels of fundamental value.  When you are dealing with an asset that is bought with considerable leverage, being on the wrong side of that inevitable correction will mean that you will see your wealth melt away faster than a snowball in July.

So if you are considering making the largest purchase of your life and are looking at 30 years of significant debt, please weigh out the arguments that I present with the arguments presented by those who believe that real estate will continue to increase unabated. I wouldn’t want a 30 year debt millstone hung around my head because I took the plunge on the advice that, “real estate hasn’t fallen yet, therefore it won’t fall”.  I’d want to take a more critical look at what actually creates sustainable price increase in real estate.

Now for anyone who would like to debate that, please explain what will drive the continued expansion in real estate valuations from already lofty levels.  I don’t expect any responses outside of the usual empty arguments of ‘rich Asians’, ‘tons of immigrants’, etc, none of which are worth posting.

Let’s talk about that report I referenced at the beginning of this post.  It was a housing report by Graham Fisher & Company, an independent research firm which provides consulting services to institutional investors:

Housing In the New Millennium: A Home Without Equity Is Just a Rental With Debt

This report is so prescient that it is scary!  It is a must-read.  I may dedicate a separate post just to highlighting the massive amount of insightful analysis contained in this report.  As you read it, consider two things:

1)  The parallels with Canada.  Trust me, they’ll fly off the page at you.

2)  The fact that this report was four years before the crash actually came!  All gains generated in the following four years have long since been erased as the US market still seeks a bottom.

Was the author wrong?  What taunts by the intelligent housing bulls must the author have endured?  Interesting thought! That’s the problem with people who ignore market fundamentals.  As Helen Keller famously said, “The only thing worse than being blind is having sight but no vision”.  Ah yes, sight, but no insight!  A massive problem plaguing our society.  Behold!

Time reveals all ignorance.  Be patient!


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8 Responses to A Home Without Equity Is Just a Rental With Debt

  1. Pingback: Tweets that mention A Home Without Equity Is Just a Rental With Debt | Financial Insights -- Topsy.com

  2. Petrovich says:

    Hey Ben,
    I’d be interested to look over that list of psychology books you’ve mentioned. Any chance you could post that as well?


  3. MikeT says:

    Hi Ben,
    I will second the first poster. Can you share the list on the site?
    Reading your blog daily and loving it!

  4. Pingback: A Home Without Equity Is Just a Rental With Debt | Financial Insights | Home Equity Guard - Risk Management Solutions for American Homeowners

  5. Pingback: More thoughts on CAAMP report; RRSP use among younger generation at record lows; | Financial Insights

  6. Jeff Neasmith says:

    Reading List For Buyer Psychology

    You referred to some books you read on this subject. Can you send me a list of them?

    “Well, at least for now, they do have a point. I first became convinced that real estate was overvalued in Canada in 2007. I reached that conclusion by reading a number of fantastic books about mass psychology, changing societal trends over time, and the reversion to the mean principle, and fundamentals of real estate valuation. I’d be happy to provide a recommended reading list to anyone interested. Email me.”



  7. Pingback: Another look at mass psychology, asset bubbles, and the Canadian real estate market | Financial Insights

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