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Larry Berman: A sobering look at investing in real estate

ANALYSIS: The goal of today’s post and of the Berman’s Call housing panel debate in Vancouver, Calgary, and Toronto is to attempt to enlighten and perhaps shed a point of view on the housing sector in Canada as an investment. Please, please, please don’t go out and sell your house--we all need a place to live. But if you are speculating or investing in real estate it might be helpful to join the discussion @LarryBermanETF and #bermaneducation.

My guest today is Rob Carrick of the Globe and Mail who will be participating in our Real Estate Panel at our Toronto Berman’s Call tour event on November 29. Rob has been a personal finance columnist with the G&M since 1998 and is a great advocate for Canadians.

If your house traded on a stock exchange and you could buy it today, would you? Would you sell it? If we look at investing in housing from the perspective of a portfolio manager, you might get a sobering surprise. Or maybe not, depending on the blogs you frequent. One study we saw which looked at the cost of owning in the hot markets of Vancouver and Toronto suggests we may be in irrational exuberance territory. For some curious reason, people are far more emotional about real estate as an asset class than they are about the stock market. Suggest the market is a little expensive, and people quietly contemplate selling equities. Suggest real estate is overvalued, and burning torches and pitchforks come out. Before you tweet me to express similar emotions, please know that I know there have been people saying it’s a bubble for years, and well, prices have gone nowhere but up. Behavioural finance biases remind us that people have trouble seeing beyond their biases, and most don’t know what they don’t know. I’m not trying to forecast housing prices. Other than owning my own home, I have never invested/speculated in real estate, because it generally implies a huge amount of leverage and for the most part I’m a very conservative investor. I’ve used margin for investing years ago when I was first learning to trade with margin accounts, options, and futures. I learned many lessons over the years, one being that leverage that kills you, which is one reason why I don’t use or recommend leveraged ETFs.

Annual ownership cost as a percentage of household income could be looked at a few different ways. One interesting twist would be to look at it like an MER and another would be like a price to earnings ratio (P/E).

On the MER front, the annual costs include mortgage, utilities, maintenance, and property taxes. There are others, but these are the biggies. Actually, few consider the maintenance cost like gardening, snow removal, general paint and upkeep to be a cost, but it can be material. The graphic in the video attached to this blog shows the cost like an MER (as a percentage of household income) in Vancouver and Toronto. These data were provided by the excellent research of Ben Rabidoux of North Cove Advisors. In Vancouver, the MER is closing in on 100% of median income, which does not leave much room for food and other costs of living.

Price of the median house versus the median earnings of families would be a like a P/E and when we look at it from this perspective, house prices in these cities have never been more expensive. According to The Canadian Real Estate Board the median detached home in Toronto is $685K and the median family income is about $80K by recent estimates. So the P/E of the average house in Toronto is about 8.5x. In Vancouver it’s already north of 11x. For a little perspective, New York sits at around 6.1x. When interest rates were last somewhat normal in 2000, the price of the average house in the GTA was about $250K with the average household income of $46K for a P/E of about 5.1x. Have declining interest rates made the cost of houses irrationally exuberant?

Interestingly enough, we are seeing a similar dynamic for high dividend paying stocks these days where the historic P/E for high yielding stocks is at a discount to the market P/E and currently, because of the preference for dividends and low interest rates, there is a significant premium. So are investors irrationally exuberant about dividend stocks and housing because of low interest rates?

The reality of the New Normal economy is that these are unintended consequences of government policies to stimulate the economy and there is no doubt in my mind that we are in a bubble and it’s extremely overvalued. Having said that, Alan Greenspan gave his famous irrational exuberance speech in Dec 1996 and was 3.5 years early as things got vastly MORE exuberant before crashing in 2000. No one can forecast anything consistently and you should never bet the farm in a bubble environment. My best advice is to understand, as best as you can, what is happening and why and look to mitigate and diversify if you have a disproportional amount of your wealth in housing (not your prime residence unless you are significantly leveraged).

One thing I have learned over my near 30 years investing that is a virtual certainty is expected return going forward is low or negative when assets are overvalued. The breakeven analysis or ROI based on my back of the envelope calculations is about 50% down for a house these days to rent out and carry it at a neutral cash flow when taking in to account the annual MER. So unless you have 50% down, you are looking at a cash flow negative investment – and this does not consider the positive cash flow you could get with the same investment in another asset class (opportunity cost of capital). Those commercials you hear about positive cash flow and high ROI with little money down are fantasies that will likely end badly for you.

What are the risks for a bubble scenario? Jobs, interest rates, and immigration. On the interest rate side, the global economy is so levered up on a personal and government basis that rates are likely to stay low for decades, so that probably won’t be the prick that breaks the bubble. Job loss might be, as we are seeing in Alberta and Saskatchewan with the stress building in the energy sector - that is not likely to spread to Vancouver and Toronto although that is open for debate too. Canada is likely to stay with a robust immigration policy for decades to come, so it is possible housing plateaus for a few decades and the bubble can deflate sideways unless one of these three things breaks. There are always risks to any analysis, but I would say that real estate speculation risk is high for the foreseeable future.

For the young folks out there speculating on condos consider this: The first home (condo) that I bought with my wife in 1990 traded at $225k to the previous owner in 1989 at the peak of the last bubble and interest rates were 9.75% for my first mortgage. We paid $168k in 1990 (one year later) and sold it in 1994 when I went to work in the US for $135k and after all legal fees and commissions were paid my wife and I got $107 back wiping out all our equity and principle payments of almost 5 years. But we needed a place to live and while we were not happy, we were fine with it. But if we had other properties we were renting out, we could have been wiped out and deep in the hole.

If you want to learn more about how you can navigate through the New Normal come out to my current speaking tour: AN INVESTOR’S GUIDE TO THRIVING How to Navigate in a High-Debt, Low Growth, Bubble-Prone world where we will look at way to navigate current markets, the impact of interest rates, energy, the dollar, politics, and for the first time the series will feature a debate panel discussing real estate investing in Canada (in Vancouver, Calgary and Toronto). Our panelists consist of some of the very top experts and authors on the subject of Canadians real estate and includes our guest this week, Rob Carrick, David Madani of Capital Economics, Ben Rabidoux – an expert on the Canadian private lending (aka subprime) market, Benjamin Tal, and Craig Alexander (panelists vary by city, except in Toronto where all will be present)

Larry Berman is the host of Berman’s Call on BNN and the CEO of ETF Capital Management

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