Is homeowner equity a predictor of future price movements?

There’s been quite a buzz about Vancouver detached homes hitting a new all-time high.  I will address that data in my monthly tour of board stats just as soon as the data packages are released at the other big boards, which should be on Friday.

In the meantime, let’s consider an article from the Globe and Mail (kind thanks to my number 1 fan Mango for the link):

Why a rate hike won’t be a blow to most

“And given that some 30 per cent of Canadians rent, about 58 per cent of households pay no mortgage interest. Coupled with that is the fact that the net equity of owners in their homes is “very high,” more than 60 per cent, compared to 39 per cent in the United States.”

And it includes this lovely graph showing equity levels in Canada and the US, as well as the percentage of households who own their home.

58% of Canadians pay no mortgage interest

Let me remind my readers that real estate prices are set at the margins.  In other words, in a stable demand environment, real estate prices fall simply if a small number of home owners run into trouble and are forced to sell.  If you doubt this, consider the sub prime fiasco in the US which blew sky high in 2005-2006.  Although in the year prior to the bust, subprime mortgages were roughly 20% of all new mortgage originations, as a total percentage of all US households they were still quite small.  And yet the market tipped and began its descent as these homeowners at the margins first ran into problems.  Keep that in mind as you read the rest of this post.

Let’s start by deconstructing the first fallacy:  Many Canadians do not pay mortgage interest, therefore a rise in interest rates is not a major concern.  Consider the fact that 58% of Canadians pay no interest, as noted in the article.  First off, 55% of Americans pay no interest on their mortgages, and it’s even higher than that given the massive amount of delinquent and foreclosed homeowners who still have a mortgage but who aren’t paying. 

The math is simple.  Home ownership rate in America has fallen to 66% from its high of 70% meaning that there are 34% of households who now rent.  Of the 66% that are home owners, 31% own their home outright (roughly 21% of the total population).  Sprinkle in the millions of delinquent mortgages and we find that Americans likely have a greater percentage of homeowners who pay no interest than we do.  Given this fact, we might expect the US Fed to take a muted tone on prospects of rising interest rates.

Nothing could be further from the truth.  In fact, the Fed in the US is so terrified of higher interest rates that they have engaged in two rounds of quantitative easing in an attempt to lower them.  Why would they do that?  Their consumers are less indebted that we are and they have a comparable portion of homeowners paying no interest.  They should be able to shrug it off as the article suggests.  They can’t do that because it is precisely the marginal home owners who would be affected the most.   

Let’s discuss some Canadian-specific data.  CAAMP data  suggests that 11% of households would run into financial trouble if mortgage rates rose only 1.5%.  That’s not an insignificant number.  It is plenty to squeeze the market at the margins and ensure that distressed properties would hit the market at a time of falling demand.

The bottom line is that the fact that 58% of Canadians pay no mortgage interest means very little to the direction of real estate prices as it is the most vulnerable borrowers (evidently over 10% of households meet this criteria) who set the price trend if they are forced to sell due to financial reasons.

Home owner equity as a predictor of price movements

That brings us to home owner equity.  The average American homeowner currently has 39% equity in their home while the average Canadian home owner has 63%.  No comparison.  

It’s been suggested by the mainstream media and commenters on this blog that our relatively high percentage of homeowner equity should act as a cushion during a potential correction, limiting downside pressure.

Before we discuss the dynamics that make this assertion false, let’s have a gander at how our American friends looked just prior to their bust (thanks to RP1  for this graph)

If you deduced that the average US homeowner had 60% equity in their home just prior to their real estate bust, pat yourself on the back.  As I have said many times, home owner equity always looks good at the tail end of a real estate bull run, but it has absolutely zero predictive value.  If home owner equity was distributed evenly, it absolutely would have the effect of supporting home prices.  But equity is not distributed evenly, and therein lies the rub.

To understand why, it’s important to know just how a major real estate bust unfolds.  All major real estate busts have two things in common, neither of which is high interest rates.  Both Japan and the US imploded even with record low interest rates.  Rather, all real estate busts begin when a group of borrowers run into trouble and are forced to sell their homes under distress.  At the same time, the illusion of perpetually rising real estate values which is central to any real estate bubble, for whatever reason finally lifts.

The small amount of distressed home owners find themselves having to sell at a time of stagnant or falling demand, thereby putting price pressure on the overall market.  The houses sold under distress become the new comparables to which others are compared.  As house prices begin to fall, buyers ironically become scarce.  Remember that one of Bob Farrell’s rules of investing is that people buy most at the top and least at the bottom in any financial market.  Where lower prices are seen as a good thing for consumer items, they are viewed inversely when it comes to investments, strangely enough. 

As prices fall, more home owners find themselves in negative equity positions.  With the illusion of perpetually rising real estate values now gone, they consider defaulting.  Negative equity, not affordability, is the number one predictor of mortgage default, even in recourse jurisdictions. 

As more and more distressed homes enter the market, either in the form of those trying to lock in potential gains (speculators) or by way of default and foreclosure, prices fall further.  Even more home owners find themselves in negative equity positions.  Rinse, repeat.

Indeed the average home owner equity position masks the fact that many home buyers in the past few years have little to no equity once transaction costs are taken into account.  It’s these home owners who would be the first domino to fall in the event of a real estate bust.  While our percentage of homeowner equity has remained stable, this in itself suggests a worrisome trend given that the rapid rise in home prices should be translating into a corresponding rise in equity position.  That it’s not is a reflection of either dwindling down payments, equity withdrawals, or both.  

Ultimately we need to look no further than the US experience to see that homeowner equity has zero predictive value when it comes to forecasting real estate price movements.



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19 Responses to Is homeowner equity a predictor of future price movements?

  1. Tom says:

    Comparisons to the U.S. are ridiculous at this time. There would of been a far greater reduction in Home ownership if the Federal Government had not implemented Chapter 13. Many people are restructuring there situations through Chapter 13 in the U.S.
    You get to keep your home and they blow the 2nd mortgage away. I suspect Canada will implement this Bankruptcy law at some point. Here is the link.

    Individual Debt Adjustment

    The chapter of the Bankruptcy Code providing for adjustment of debts of an individual with regular income. (Chapter 13 allows a debtor to keep property and pay debts over time, usually three to five years.)

  2. pascal says:

    BUYERS BE AWARE… don t tell you did it know!
    This site is GOOD! Thanks very much.

  3. Mango says:

    1. You graph shows a decline of home equity during the boom year, so on the margin loans that we crap, had low equity and failed? Yes, expected. But you know what, at the same time those margin loans were dragging up prices and then dragged them down (your margin argument) – What is your normalized expectation from real estate and how has that diverged? That is what fits the margin argument. It has to go both ways if you claim the margin price setter.

    2. Mr Shakedown, 5/35 to 5/30 is $400 on a 1 million bucks. This is not gonna be Detroit.

    3. What is your estiamte that a real estate investor should earn from rental income? Since you don’t live in Toronto or Vancouver and have not transacted in real estate or seem to get the real estate math, what is your personal experience that you are sharing with people?

    • SuperPL says:

      If you purchased a property in the last 3 years than you are cash flow negative each month. Doesn’t matter what you purchased.

      eg. Mississauga 1+Den condo, 250-270k, 350-450 maint. fee, 2000-2300 tax/year

      Total, based on 3.5% interest fee, 35year, 5% down (for now) = 1525.99 to 1753.60 per month. These units rent from 1300 on the low end to 1450 on the high end.

      Please explain to me your RE math and which grade it came from because for they didn’t cover this type of negative return investing in econ101.

      • Mango says:

        Because you clown, you are including p+i in your mtg payment. You have to include just i

        using your mid points

        i borrow 300k at 3.5% = 10.5k a year, taxes + fees, say 4k =14.5k
        Rent income = $16,500 = 1375$ a month

        I put 15k down and make the diff – 2k, that is 13% return on my cash

        That is using your 3.5%, you can go to and get 2.25% and make even more.

        You need to go back to school.

      • UnagiDon says:

        Don’t forget the cost of maintaining the condo: leaky sinks, leaky toilets, repainting, etc.

      • UnagiDon says:

        Oh I see, your 350-450 was strata + maintenance.

    • SuperPL says:

      First of all, Negative cash flows meant that the money going out is larger than the money coming in, and its not necessarily a loss. So maybe you should go back to school and brush up on that math a little.

      Second, you have to be a fool not to include p as part of your expenditure; you have to budget for it and pay it every month. Sure its a “forced saving”, but its still something you need to account for and you have no access to these funds. Only way to access them is to either sell and pay commission, or borrow it back through HELOC and pay interest on your “savings”.

      Your math doesn’t add up…again

      2100 property tax + (~400 maint. fee x 12) does not equal “say 4k” but closer to 6900$

      Now I am not saying that RE is bad, far from, but I will assume you did not own any in the late 80’s and have not seen how quickly your “forced savings” evaporate with declining home prices.

      But whatever floats your boat Krusty.

      • Mango says:

        “First of all, Negative cash flows meant that the money going out is larger than the money coming in, and its not necessarily a loss”

        Correct, people are making economic gains – and if you ever get close to owning real estate, which you won’t because you can’t do simple math, you will see banks give interest only loans. Try one!

        I used your numbers, I am sure they are far from reality. Your claims are that all real estate investors in the last 3 years are all negative cash flow, not a loss – YOU WOULD HAVE been so lucky to purchase 3 years anywhere in our home and native land. You would have made a killing. You lost out and are bitter and making up numbers. Too bad for you

        Another way, do you think prices will drop to where they were 3 years ago? Never.

        “Now I am not saying that RE is bad, far from, but I will assume you did not own any in the late 80′s and have not seen how quickly your “forced savings” evaporate with declining home prices.”

        I actually thought you could redeem yourself. My husband use to make the same arguments, but you know what. Again, if I owned in the late 80’s, I would be up even more. You clown, someone who owned in the late 80’s would be up huge. Prices are not going back to those levels…

        Evaporate???? if you held out, rented, negative cash, whatever you present, you made out large on your capital gains….tax free i might add

      • SuperPL says:

        For your information I own RE, a few properties actually. Purchased after the 89 downturn and did infact make a “killing”. Still doesn’t change the fact that over the last few years RE has been over valued and will, most likely, correct. Will it be this year, maybe, maybe not. I dont really care since I diversified a few years ago (2007 to be exact). Unlike you, I am not emotionally attached to my investments.

        So if you have something meaningful to add to these discussion, and not call people clowns or this blog “crap” than please do. Please tell us why exactly your home will never go down in price.


      • Mango says:

        wow, look at you…you timed RE market perfect and made a “killing”

  4. Best Place on Meth says:

    Yes, homeowner equity looks real pretty when real estate has inflated but turns real ugly when the market deflates.

    With regards to rising interest rates, even if they don’t have a huge impact on existing home owners they will certainly affect potential first time buyers – that all important first rung on the property ladder.

  5. mac says:

    Best Meth,

    It’s not going to turn the tide and you know it. You’re witnessing a spring market like every spring market over the past 10 years. This time with the top tier being sold out from underneath locals. We’ve been too wrong for too long to trot out the same old desperate hopes.

    There are so many whys why these too clever by half prognostications haven’t come to pass: inflation, globalization, inter-generational money, drugs, commodities, oil, modest recovery from recession, increasing land values, endless low interest rates forced on Canadians because of the US Feds’ policy, plus this blog’s poster John, who literally graphed that Canada may not be in a bubble at all. Only Vancouver and Calgary deviated from the mean in terms of price. Take your pick from the list above for the reasons why.

    • Best Place on Meth says:

      We are nowhere near spring yet, it’s still 7 weeks away.

      What we are witnessing is the beginning of a very volatile winter market like we’ve never seen before thanks to the new rules coming March 18th.

      Spring starts 3 days after those rules take effect and it may be the quietest spring ever.

      • Mango says:

        New rules, are you on smoking Meth??

        The new rule adds 400$ a month on a 1M dollar purchase – that is going to scare people??

        People are paying 600k over the offer???? You think 400$ a month is an issue.

  6. Anonymous says:

    Mango says:
    February 2, 2011 at 10:04 pm

    Evaporate???? if you held out, rented, negative cash, whatever you present, you made out large on your capital gains….tax free i might add

    Tax free is principle residence only. Rev Canada is enjoying all the people who think they are getting away with this. Land registry and Rev Can systems have been linked since 1990. Bells and whistles go off all the time my friend who works there says. Sometimes they leave these for a few years. Then surprise people who think they can scam. They love the put it in a relatives name. They just follow the proceeds.

    • SuperPL says:

      Funny you should mention this since an “investor” just got fined over 84K for tax evasion.

      Yes, gains made on your principle residence are tax free EXCEPT; when you sell higher you typically buy higher (this tends to be proportional), and you’re gains are all in paper – meaning you dont have a single dime to spend more unless you borrow it back from HELOC. Actual gains are made when selling high and buying low, or going back to rent.

  7. Pingback: Bank of America Merill Lynch weighs in on Canadian real estate | Financial Insights

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