These are great questions. I receive a couple emails each week from people looking for advice on this topic. Some are potential first time buyers, but many are existing home owners. My advice to those people may surprise my readers as I have yet to explicitly suggest that it is in someone’s best interest to sell their current home.
Should existing home owners consider selling?
It’s not an easy decision, and it is far from clear-cut. Even if we forecast a 20% drop in house prices in a certain location, does it automatically mean that all home owners would be wise to sell?
It’s a matter of weighing out the cold-hard math versus the intangible benefits of home ownership. It’s seldom a clear-cut decision. In any of my discussions with people on this topic, I always ask them to consider the following if they are a home owner contemplating selling:
- What is the outstanding mortgage versus their income? In general, a ‘safe’ mortgage value is no more than 3 times household income and preferably closer to 2 times income.
- How safe are their jobs? It’s easy to overestimate our job safety, so keep this in mind.
- Are they relying on the equity in their home to help fund their retirement? If so, it is much riskier to be holding a home as a retirement investment when valuations are at such precarious levels nationally. This is a major point. In previous posts I’ve explored the potential impact of demographics on house prices while trying to highlight the amount of near retirees who are planning on accessing home equity to fund their retirement. It is significant. If you are near retirement and are banking on that equity, your are taking a major gamble. In this case I would suggest that it far more beneficial to sell a year or two too early than a month too late.
- Do they have children? Would they have to uproot their children and possibly change schools? The disruptive nature of a move should be considered by any rational parent. It should not necessarily be the primary determinant, as overall financial stability is of far more importance, but I would caution against a serious disruption for children for the sake of saving a some home equity. This is particularly true of people who have substantial home equity, are living in a less bubbly area (as determined by price/rent multiples which we’ll look at), and who could withstand a 20% correction without being in a negative equity position. Things change when we’re dealing with more significant over valuations.
- How would a doubling or tripling of interest rates impact the ability to service debt?
- What would the house rent for? What would it likely sell for at current market prices? You can make a good approximation by looking at houses for rent on kijiji, mls, or by talking to a realtor. We have a tendency to overestimate both the value of our home and the rent it would fetch by approximately 10%. Adjust accordingly. The price to rent ratio of homes in a city are perhaps the biggest indicator of whether or not it is prudent to buy or rent. We’ll talk about that in a moment.
As you can see, it is not an easy decision to sell one’s current residence and consider renting in this current market. In many parts of Canada where the overvaluation may be slight to moderate, a good portion of the potential savings from selling a residence and trying to time re-entry into the market are eaten up by transaction fees and moving expenses.
In some of the bubblier areas (Vancouver and increasingly other areas of BC….and the Toronto condo market), selling and renting may make sense. In some cases, if you can tailor a deal with a real estate investor to rent back your current residence under a secure, long-term lease, you can possibly get the best of both worlds. This is particularly true of condos where up to 40% of condo purchases are by ‘investors’ (speculators would be a better term as most condos in the country’s largest centres are cash flow negative meaning the investor has to pony up money every month to make up the difference between carrying costs and their rental income. Some investment!).
Should potential new buyers sit on the sidelines in all markets?
When it comes to first time buyers, the decision is often much easier. However, it doesn’t automatically stand that all first time buyers should sit on the sidelines in the current market, though overwhelmingly it makes sense in most locations. Again there are many considerations that go into this decision:
- Job safety. Along with this I would also add that buyers should make sure that they are committed to an area for at least the next 5-10 years. If you know you’ll be moving to pursue other opportunities in a few years, it makes far more sense to rent rather than roll the dice in this market and have to pay transaction costs when you sell.
- Down payment. I would strongly suggest that potential home buyers save up the 20% down payment needed to avoid CMHC insurance fees. Those fees aren’t cheap (2-3% of loan value in general). While you can buy today with zero down if you take advantage of some of the cash-back offers from the banks, the reality is that your ability to manage your finances to a point that you can accumulate a down payment is an indicator of your overall financial health and responsibility. If you can’t save a substantial down payment, you’re not financially ready for home ownership. Period. I often hear people protest that it would take them years to save up a healthy down payment in the current market. Two thoughts on this:
- 1) Welcome to the reality that existed in Canada up until the late 90’s when down payments were lowered. We live in an instant gratification culture that is largely anomalous in the context of our own history. The reality is that these periods of significant change in consumer psychology tend not to represent a new and stable norm. One need only look at the rapid rise in debt relative to incomes to see that this is a trend that will not be sustained. Rather they tend to revert back to their long term (and more sensible) norms.
- 2) I am not entirely unsympathetic to this statement as it can also reveal the extent of overvaluation in some markets. In markets where it would take a typical wage earning household many years (or decades) to save up a healthy down payment, it should serve to highlight just how unsustainable the current market dynamics really are.
- Interest rates and total debt levels. Many potential new home buyers have no idea how truly remarkable current interest rates are relative to the long term average. Double digit interest rates of two decades ago seem like distant relics that could not possibly reappear. Beware of this mentality. While I do think that interest rates will likely stay unusually low for some time, the overall direction of rates is undeniable. Calculate affordability based on an interest rate of at least double our current one.
- Consider lost opportunity costs of the down payment, taxes, insurance, miscellaneous maintenance, and transaction expenses when calculating whether or not it is better to rent or buy. Many people look only at the mortgage payment and equivalent rent. This is a mistake. For a more detailed breakdown of what should be considered in this calculation, have a look at this post.
Making the buy or rent decision considering the price/rent ratio
The house price to rent ratio is arguably the best tool for determining whether it makes sense for a potential first time buyer to take the plunge and whether it might make sense for an existing home owner to sell.
The ratio is usually expressed as the price of a house divided by the annual rent it would receive OR as the price of a house divided by its monthly rent.
For example, a house that would likely sell for 300,000 (look at MLS for comparables) and could be rented for $1500 a month (look at kijiji or talk to a realtor for rental data) would have a price/rent of 16.7 when annual rent is considered, or 200 when monthly rent is considered.
As a very general rule, the price/rent multiple on annualized rent has a long-term average of about 15.
To determine the price/rent ratio for your city, either do some snooping around on kijiji and MLS to figure out asking prices and rental rates. CMHC also calculates rental data for various cities, though most of their data is centred around the condo rental market.
It is worth noting that even in cities that are close to reasonably valued, great deals can still be found. I wrote about this in a previous post titled, “Vulching a rental home“. Despite the fact that the housing market is not atrociously overvalued in my area, I was still able to find a fantastic rental house with a price/rent ratio of nearly 30!!!!
A closer look at the house price-to-rent ratio
It’s first worth noting that the aggregate price/rent ratio in Canada is at an all-time high.
In fact, back in 2008, the OECD released house price and rental data for a number of countries. When compiled, it gave us the following graph. Note that Canada is the light blue line and at that time was second only to Spain in terms of our house prices versus the rent they would fetch.
None of this is particularly new. In fact, in a 2005 paper by the OECD, they recognized that massive, anomalous rise in price/rent ratio across Canada. With the exception of a brief dip in 2008-2009, we know that in the time since 2005, prices have far exceeded rental growth.
However, this is aggregate data that does not capture the variability between cities and even between market segments within the same city. Nevertheless, it suggests that the typical first time buyer in Canadian would be reasonably advised to rent. At the very least it suggests that some research within a market to ascertain the local price/rent ratio is certainly in order.
Accounting for the change in price/rent ratio over time
As with so many measures of fundamental value that are currently well outside their normal range, the change in the price/rent ratio is often glassed over or explained away with a ‘new paradigm’ mentality. That’s bunk!
In an interesting 2004 paper by the Federal Reserve Bank of San Francisco, they discussed the change in the price/rent ratio in the US. In particular they examined the factors that cause the change and what it means when it departs significantly from its long-term mean. This was the conclusion:
…Most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation.
How remarkably prescient that statement turned out to be. As we know, asset prices that deviate markedly from their long-term measures of fundamental value seldom (if ever) correct by going sideways. The animal spirits of shifting mass psychology virtually ensure that an asset is either widely loved or nearly universally despised. In the case of the US, here is their experience with their price/rent ratio:
Ultimately first time home buyers are faced with a decision of what to rent. They can either rent space or they can rent money. But overwhelmingly, they are still renters. The question then becomes which form of renting makes most financial sense.
By way of probabilities, it is overwhelmingly likely that the decision to rent a home in the current market will prove to be more financially beneficial for most first time buyers provided that they are disciplined enough to save the difference between the cost of renting and the cost of ownership. It is equally important that they then build investment portfolios that match their financial goals. For more on that, please see the three-part series on building an investment portfolio.
The house price to rent ratio provides one of the strongest signal of overvaluation in the Canadian housing market. While skewed higher by a handful of very bubbly cities and market segments, it nevertheless remains elevated in most parts of the country. This is far more likely a reflection of changing attitudes towards renting than it is a new and stable paradigm. As such, it bears careful consideration when taking the initial plunge.
For existing home owners concerned about the possibility of vanishing equity, the decision to sell is complicated by significant transaction costs, equity levels, and the extent to which each owner is reliant on home equity for retirement. Furthermore, there are substantial intangible benefits associated with ownership, particularly when school aged children are involved. Decisions must be made by each family, and to this extent my ability to provide guidance on this topic is highly limited. Nevertheless, I’m happy to give my opinion for what it’s worth.