What’s the Difference?

There was a Real Estate meltdown in the US recently, and many people in Canada expected the same thing to happen here.  There are a variety of reasons it did not, but they fall under two general categories; their system and their regulatory environments are both different from ours.

First and most important difference is the underlying philosophy; they encourage indebtedness and we have traditionally discouraged it.  They are generally more adventurous and we are more conservative.  They are allowed to deduct the interest on mortgages on their own homes from their taxable income, where we are not.  As a result, Canadians try hard to pay off their mortgages ASAP.  Until recently, the concept of borrowing against equity was very unpopular here.  Last stat I heard was that 54% of Canadian homes are free of mortgage.  In the US they keep their mortgages as high as possible, using whatever they can borrow to buy bling.  When they can’t pay for it any more, they walk away.  In Canada there are repurcussions if you give up your home, in the US less so.  This all encourages Canadians to work hard toward having a clear title, and the USans to work hard to keep their property fully mortgaged.  When things go sour, they suffer, we don’t.

Because all high ratio mortgages in Canada are insured against default by CMHC or one of several private insurers, all of which operate in the exact same way, the rules set by CMHC are critical to the process.  When there is a default here, the very first thing that happens is CMHC goes through the file with a fine toothed comb looking for errors made by the bank in the application process.  If the bank did not perform their due dilligence according to CMHC rules, the insurance is denied and the bank is on the hook for the house.  Bankers, being the risk averse types they are, do not want that to happen so they are very careful to do things correctly.  If anything, they are overzealous.  In the US there is a similar mechanism to check for errors by the banks, however I was astounded to learn about spring of 2011 that they had only recently begun to go through the files on the foreclosures.  That’s three years into the process and the regulators were just beginning their due dilligence.  That would never happen here.  Here, the majority of the foreclosures are held by the secondary lenders.  They are the ones used by people who the banks decline.  They accept a higher risk and charge higher interest rates, hoping to offset foreclosure losses through higher earnings.  It is to be expected that they will have foreclosures.  As the recession progressed and things got worse, more foreclosures have appeared with the major banks or CMHC listed as owner.  There is still not the flood as there is in the US, and they are selling, however they are keeping prices low.

Their banks were very active in the sub-prime mortgage market, and our banks were not.  This was mainly because the regulators in Canada are so slow to accept new ideas that they held the banks back for some time before allowing them to play.  As a result, the Canadian banks looked good by comparison, and bankers are strutting around like little bantam roosters, chests puffed out, saying ‘look what a good boy I am’ when in reality they would have had their heads deep in the trough, same as the yankees if they could have.  It’s no credit to either the regulators or the banks here that we didn’t fall into the same trap.  It is just a huge negative comentary on the super-incompetence of the US regulators.

Their government pushed the concept of everyone should own a home, and the administration did everything possible to bring this about.  They encouraged the banks to lend in undesirable areas and to unqualified buyers.  There were stories of regulators landing on the banks that didn’t cooperate, performing audits and other harassments until the banks toed the line and did as the government wanted, even though it was imprudent banking.  Inevitably, the house of cards collapsed. The result was the debacle in which they are still mired.   The reason it is taking so long to dig themselves out is that they have far too many houses in many areas.  The net result of all the stimulation brought about by easy credit was a massive overbuilding of housing.  There are too many houses and not enough people.  Until that oversupply is used up, their market won’t recover.

What can be done to ‘fix’ the problem?  In a word, nothing.  Government interference caused it, more interference will only make it worse.  If the regulators do their jobs properly, making the banks suffer for their stupidities and ensuring that the public is not victimized by the banks in the process, that will be the best that can be hoped for.  Every other approach leads to a worsening not a correction of the problems.  It is time for the government to step back, adopt a laissez-faire attitude and let things find their own way.  Left alone, the market will adjust to a new equilibrium.  Now, just leave it alone.

How Money is Made in Real Estate

Money is made in Real Estate by owning it.  When we buy a property, usually we put up a down payment and take out a mortgage to pay the balance.  We pay on the mortgage as long as we own the house and the mortgage is not paid off.  The mortgage balance is the amount we OWE, and the rest of the value of the property is our EQUITY, which is what we OWN.  At all times in this process, the value of the property is the total of those two numbers.

If we keep the property for long enough, we arrive at a time where the value of the property and our equity in it are equal; we have paid off our mortgage.  This is when the real joy in Real Estate happens.  When we no longer pay a large mortgage payment each month we are less vulnerable to the economy and the curve balls which life throws at us.  The goal is to increase our equity position as quickly as possible.  Anything which interferes with this effort puts us behind.  Anything which increases our equity advances us in our efforts. 

There are three ways to increase your equity; Equity gain through mortgage paydown, improving the property to increase its value relative to other properties, and monetary inflation.  We only have control of the first two, inflation just happens.  As we pay on the mortgage, the balance owing is reduced and our equity is increased.  This is called equity gain on the mortgage.  This gain is very slow at first, because the interest is the larger portion of the payment and the equity portion is the lesser amount.  Equity gain speeds up and the interest component reduces over time, until the mortgage payment is mostly equity gain and very little interest.  If we increase the payments on the mortgage, every penny plus more goes into equity gain.  If we upgrade the property and we make it worth more, the increase in value is all equity.  If there is inflation, the dollar value of the property is increased while the mortgage remains the same.  All these increases in value increase our equity.  If we have deflation the reverse is true; the value of the property is decreased while the mortgage remains the same, and all the loss of value is from our equity position. 

During the Great Recession in the US, property values lowered dramatically and many mortgages are for more than the value of the property.  In many cases this was due to refinancing the property, borrowing against equity, to buy bling.  If these owners had pursued equity gain instead of bling, they would not now be ‘under water’ on their mortgages and there would not be a ‘housing crisis’.  For those conservative investors who own their property outright, the lowering  of values does not matter at all.  It matters a great deal to the underwater swimmers.  This is the perfect example of why it is important to gain equity as quickly as possible.

When you own property, the forces which act to increase your equity are slow, especially at first.  Depending on the market, it takes between one and five years to double your down payment through equity gain on the mortgage.  If during that time you decide to move, then the costs associated with the move will reduce your equity.  In some cases those costs might be so high that you end up with no equity at all.  If you move again and again, you have no chance to build equity.  If instead you  buy and hold, then over time equity will increase, and at a faster and faster rate.  When you buy a property you should always try to buy for the long term.  This will allow these forces to do their jobs.  If you don’t then there is no benefit to buying instead of renting, because you will be constantly paying top dollar for a place to live without any equity gain to offset the cost.

If you buy and hold, then you make all the money; if you buy and sell then the Realtors make all the money.  When choosing a Realtor, this should always be kept in mind; many Realtors engage in the practice of ‘churning’.  They encourage their clients to sell this house and buy that one.  When they do, the Realtor does very well.  Seek a Realtor who does not churn, and he will help you to prosper.  I encourage all my clients to buy for the long term and keep their properties.  Of course not all do, however several people are still in homes I helped them buy 20 to 25 years ago.  I consider them to be my successes; I helped them to buy a home that was so perfect for them that they felt no need to move in all that time.  Note that my successes have earned me the least money per client over time, however I feel that my mission is to do the best for my client so this is mission accomplished and gives me great satisfaction, even though it is not very profitable.

Everything I advocate will lead to benefits for you, not me.  I want to see all my clients prosper.  I hope that they will appreciate my approach, and that they will call me again when they have Real Estate needs, and recommend me to their friends.  If you appreciate this philosophy, call me to discuss your Real Estate needs and how you can prosper even in these challenging times.

The Five Year Plan

The joy in Real Estate comes when you own it outright.  That’s when it really pays off.  You probably will have had some shielding from higher rents in the meantime, so some benefits, but from now on you only pay taxes, insurance, maintenance and utilities.  Suddenly you are less vulnerable.  Now you can really sock away money for retirement.  Now you can enjoy life a little more.  The Five Year Plan is an approach designed to get you there quickly and relatively painlessly.

As you are seeking your first home, you must live frugally.  Eat at home, don’t go out for coffee or drinks, take your lunch to work, don’t buy anything you don’t really need etc.  Sock away money, as much as humanly possible.  You will find that the home purchasing process gobbles money.  You will need it all.  If you have it when you need it, everything is easier.  This also preps you for what is to come.

Once you have your home and have moved in, continue to live as frugally as possible.  There are tremendous resources on the internet on how to live like a king on a pauper’s salary by doing things for yourselves.  Do everything you can to save money.  Look for ways to earn extra money to add to the savings.  Sock away every cent you can, and keep on paying the mortgage.  In six months, look at what you have saved, and put most of it on the mortgage.  Keep a little as a slush fund and continue to save.  At the end of the year, put almost every penny you can onto the mortgage.  Add a little to the slush fund, but keep it small.   If you come into money from any source; income tax refund, gift etc, put all that into the savings account and then onto the mortgage.  Most mortgage companies allow 10-20% annual prepayment without penalty.  They don’t like to take extra payments too often because of accounting difficulties.  I suggest paying extra twice each year, however if it suits you and your bank is agreeable, you might pay more often.  Don’t allow the savings account to get too large or you might be tempted to use it for another purpose.  Once it is paid on the mortgage, it is no longer available to tempt you.

All of the extra money you pay comes off the principal amount, and reduces the interest component of the ensuing payments.  During the first few years of a mortgage, the payment goes mostly to interest, little to principal.  In the first year of a $300,000, 25 year mortgage you will make $17,000 in payments while only paying off about $8,000. (Based on 2012 rates of 2.99%)  If you can pay off an extra $8000, you save a year of payments, saving you about $9,000 in interest.  If you can pay an extra $16,000 you save two years etc.  The idea is to beat down your mortgage as quickly as possible.

If you have good jobs and are dilligent, you can do it.  You can pay your home off in 5 years.  I know people who have.  If you can pay the house off, you will be $1400 or more ahead of your peer group every month, over $17000 per year in after tax dollars just from not paying mortgage payments.  You also won’t be paying extra on the mortgage so you will have that money too.

Even if you are only somewhat successful, at least you are ahead of the pack.  If  all you do is make your payments for 5 years, you will approach your mortgage renewal with a balance of $256,000.  Your renewal options will be limited, you must renew for 20 years at current rates and keep on making the same payment.  If you have substantially reduced the total, you can reschedule the mortgage to allow for new circumstances.  That way if you decide to start a family, take a new job or whatever, you can simply lower the payments.  If you move into a higher income bracket you might increase the payments.  You might keep them the same to continue to pay the principal off more quickly.  If you then continue to pay extra, the remainder will be gone relatively quickly.

Whether you pay the mortgage off entirely or just reduce it substantially in the first five years, you will be less vulnerable.  Interest rates on mortgage renewal date won’t matter as much.  Whatever curve balls life throws your way, you will be in a better position to deal with them.

One final benefit to the process is that you will develop a strong discipline with money which will be valuable for the rest of your life.

Why We Buy

Most people don’t analyse their Real Estate buying decision on the basis of numbers.  For most people, the only Real Estate they ever buy is the family home, and they buy on the basis of emotional appeal and practicality; do they like it, does it suit their needs, and is it within their budget?  Is the price asked appropriate for the value perceived at this time in this market?

There are, however some over-riding concepts which guide them to choose ownership over tenancy:

First and foremost is establishing a home for their family.  They want to build strong family ties and see the home as a vital part of that picture.  We especially see this in young women bearing their first child, where the ‘nesting instinct’ is in high gear.

They seek control.  As a renter, you have less control over a variety of factors than do owners.  Renters are not in charge of maintenance or upgrades so they may be forced to live in less than ideal conditions.  Their rent can be increased any time or they can be evicted if the owner decides to sell or move his relative in.  The landlord can enter the property with notice at any time, and the renter is not permitted to prevent that.  They perceive renting as less stable in the long term than ownership because the needs of the owners could over-ride their needs as renters.

They seek a step up in the social heirarchy.  Owners are viewed as having higher status than renters for a variety of reasons;  It is a public declaration of financial maturity and purposefulness, because owners tend to be long term thinkers, renters short term.  Owners are seen as having a stake in society, and therefore will contribute to it.  Renters are seen as somewhat transitory and less stable, more likely to be takers than givers.  Because this is a step forward in the social sense it is approved of by others, notably those in business and banking, who view owners in a somewhat more benevolent light than renters.

They seek a hedge against inflation.  They don’t know the exact numbers, but they understand the concept that their payments will stay relatively stable over time if they buy vs. paying rent which will inevitably rise with inflation over time.  They also understand the concept of rising values, so they want to buy now before prices go up even more, and hope that after they buy prices will continue to rise.

They have a long term goal of paying the house off and having no payment at all.   When your mortgage is paid off you are ahead of renters by the amount of rent they pay each month minus your cost of operating your house (taxes, maintenance etc).  In today’s dollars you will be ahead $1000 or more each month if you own an average house.  That money can be used for a variety of purposes; to increase your standard of living, to play or travel, to save for retirement, to do good works etc.

They see home ownership as a component of a comfortable retirement.  If you are a renter when you retire, a large portion of your pension income will go to just pay for a place to live.  Even if your pension is generous, if you don’t have other investments or savings the housing component will take a large bite out of your standard of living.  If you own your own home outright and it’s in good shape your pension goes a lot farther.   When you are older and the house no longer suits your needs, you can sell it and take that large sum of money and use it to suplement your pension and pay rent.

These are powerful motivators to buy.  Homeownership proportions vary within a narrow range; between 60-70% of Canadians are owners at any given time.  This is a very high percentage when you consider the number of youth and aging who are renters because they have few choices, youth because they are not yet ready to own and the aging because they are unable to properly care for a home.  Even among the aging, many own condominiums because the desire to own and control their own place is so strong.  When I talk to older people many can’t even think about renting even though, looked at objectively, it might be their best choice.  These powerful motivators also cause people to view the investment in a home differently than other investments.  This is one of the reasons Canadian default rates are so low, and why we did not suffer the same harm to our housing market as the US did in the great recession.  Canadians don’t put home at risk.

The Three Legged Stool

Just as a three legged stool is the most stable platform, so Real Estate is the most stable form of investing, because it has three sources of returns.  The sum of all of these returns outperforms all other investments over time.  The three sources are 1. Equity Gain, 2. Cash flow, 3. Inflation.

Equity gain is the paydown part of the mortgage payment.  Each payment is blended; part is interest, part is principal.  The principal part is equity gain.  As time passes, the part of each payment going to principal increases, and interest decreases.  Eventually we have the mortgage paid off.

Cash flow is that part of the income of a property that exceeds the costs to own it, which the owner gets to keep.  Even when we talk about our own home, there is cash flow potential;  Payments on the mortgage are stable over time, while rents rise.  When the rents rise they exceed our payments.  The difference is a form of cash flow, because if we hadn’t bought the house we would be paying more, so the difference is cash in our pocket.  If the property is an investment, the cash flow is return on this investment, and it should be viewed as such with our own home too.

Inflation is a persistent devaluing of money.  When we buy we pay for the property with today’s money, and pay it off with devalued dollars in the future.  When we sell the property, we receive more of the devalued dollars in exchange.  This is why Real Estate is called a ’Hedge Against Inflation’.  This is only partially true, for though we might receive three times as many dollars for the property, the dollars we receive in 25 years might be worth only 1/4 of their value today, thus we are receiving less buying power in the end.  The difference between the buying power of the purchase today and the sale of tomorrow equals the depreciation of the property over the 25 year period.  Even though Real Estate does not totally protect us against inflation, it protects us more than any other investment.

The other component of Real Estate investing which is important is leverage.  Leverage is the principle of buying something with a down payment and financing.  Real Estate requires the smallest down payment of any investment, requiring as little as 5% down.  When we analyse our return on investment, we compare with the down payment.  Because the DP is so low, our return is magnified.  Example:  5% down, 95% mortgage paid off over 25 years.  Total return is 1900%  (95/5 X100).  1900%/25 years gives a simple rate of return per year of 76%.  Even if we use compound interest rate calculations, we return far more on our own homes than any other investment.

Other investments such as stocks etc. also allow leverage, (usually 50% down payment), however the difference is that the balance of the price is paid by the owner of the stocks, whereas Real Estate is paid off by tenants.  This can be a tricky concept when applied to our own homes.  If you view yourself as a tenant, renting your house from you, the landlord, you can visualize it better.  The tenant you pays ’rent’ and the landlord you pays the mortgage.  The tenant you is paying off the mortgage, just as you would if you were renting from someone else.  Seeing as you must pay to live indoors anyway, you just pay your own mortgage instead of someone else’s.  The landlord you is the investor; he doesn’t pay the mortgage, you the renter do, just as regular tenants do.

Until You Move Indoors

Why has the value of Real Estate gone up so dramatically in the past half century?  The system of lending on Real Estate changed dramatically, and the last 50 years is how long it has taken to play out.  At any time, the financing environment determines the price vector.  If money to buy houses is cheap and easy to get, prices rise; if not, they don’t.  Prior to the passing of the National Housing Act (NHA) and the establishment of Canada Mortgage and Housing Corporation (CMHC) to oversee its implementation in the early 1950′s, most homes were sold on a ‘handshake’ basis, with the owner ‘carrying the paper’.  The buyer was usually known to the seller, they had a social relationship, and the value of the property was essentially established in a ‘non-arm’s-length’ fashion.  Values were stable and there was no benefit to improving the property because the value would not have been enhanced.  Banks were prohibited by the Bank Act from doing much lending on residential Real Estate.  They lent to apartment owners based on the rental income of the property, much as they lent on farms, factories and businesses but houses were out of bounds.  Populations had been stable for a long time so the supply-demand situation was in balance and apartment building values were stable.  The system of Realtors as we know it today did not exist.  There were some commercial type Realtors, however the only type of residential property they sold was apartments, because banks could finance them and the Realtor could be paid.  There was no money to pay a Realtor for selling a house so the did not sell them.

This situation changed dramatically following the end of hostilities in 1945.  Returning servicemen wanted to make up for lost time, get married and start a family.  To do that they needed a home.  There was an extreme shortage of housing in the entire country and much of what did exist was poorly built.  The NHA established the first set of national building standards.  At first, CMHC lent money directly to the buyers.  They only lent on new houses built to NHA standards.  Builders quickly adopted the new standards, and huge areas of cities grew up virtually overnight.  I grew up in such an area in Medicine Hat called Crescent Heights, and the concept of mortgages to buy a home was so new in 1958 that people called it Mortgage Heights.  CMHC then packaged those loans together and sold them to insurance companies.  Later, the banks entered the mortgage market and now CMHC acts mainly as an insurer of the banks against default, which allows the banks to lend high ratio mortgages.  The banks are now the dominant force in Canadian mortgage lending, and each bank is trying hard to lend as many mortgages as possible.

How has this led to much higher values?  The political pressure of the returning soldiers caused changes to the way housing is financed.  Many people bought new houses using mortgages.  The mortgages were sold to insurance companies.  When the insurance industry was unable to expand their purchases enough to supply the marketplace, the banks were permitted to step in and directly lend to the buyer, carrying CMHC insurance if they lent over 75% of value.  The banks initially wrote their own mortgages and retained them, then they started collateralizing them and selling them off to investors, many of them foreigners.  Because these were CMHC insured mortgages, if there was a default CMHC dealt with it and the investor was covered, so investors loved these mortgage backed securities.  The banks also moved into mortgaging existing housing, though CMHC restricted them to only housing which substantially met NHA standards.  As time went by, pressure from the Realtors, bankers and the public caused those requirements to be eased somewhat.  As a result, buying an existing home is as easy as buying a new one, and existing housing is being upgraded because its relative value can be increased.  As the system got rolling in the mid 1950′s so did the residential Real Estate brokerage business.  Little local Real Estate companies grew into large national franchises, and the entire industry flourished.  As it flourished, Realtors and mortgage brokers found new and innovative ways to finance homes.  This has allowed buyers to continue to pay higher prices, so house prices have risen.  Additionally, new houses are perceived as ‘better’ because they suit our present lifestyle better, so older housing is being either upgraded to compete, or else replaced.  This has led to an increase in the overall quality, and therefore intrinsic value, of all housing, albeit at prices unheard of just a few years ago.  The system will always push prices towards affordability limits.  When those limits rise, prices rise also.  Today’s low interest rates have raised the affordability limit so prices are rising.  When rates rise, prices will not rise and might even decline.  Other factors might become more important and the effects of all these changes are difficult to foresee.

Today, the forces having the most impact on the system include the aging of the ‘Boomers’, the aging housing stock and the low interest rate environment.  How will these forces shape the future of Real Estate?  Stay tuned.

It’s a Free Country

Another factor influencing values is the rental market.  Many renters wish to buy homes.  The difference between the cost of buying and the cost of renting is a major factor in their decision.  If the difference is small, they move easily into ownership.  When the difference increases the tendency is to keep on renting, hoping that prices will moderate and trying to save more down payment in the meantime.

Real Estate is a local market because it cannot be moved to where demand is greater.  The local economy is the most important factor affecting values.  When a city is in decline, people move away.  This leads to vacancies, lower rents, fewer sales and lower house values.  When a city is in a boom, people are moving in, there are few vacancies, rents rise and more renters buy, driving prices higher.  When a city is stable so is the population and rents and prices stabilize.  When people are making buying decisions, they try to see into the future to determine whether now is a good time to make a move.  There is a tendency to believe that the current trend will continue.  This leads to more radical swings in the market where values are too high at the end of a boom and too low at the end of a bust.  There are opportunities for the astute investor at both ends of the swing.