They say it’s no secret that owning real estate is an excellent way to grow your personal wealth over time. As the maxim goes, ideally one buys a dwelling and aggressively pays down any debt leveraged against the home, while the property appreciates in value.
Certainly over the past 25 years (my career is now in its 28 year), anyone who has played the long game of real estate with an eye to the future has been, thus far, rewarded financially. For all of the factors that have fueled the Toronto real estate market, it’s ultimately been the subliminal societal pressure for Canadians to achieve homeownership at any cost – which I explore in my post Why Does Homeownership Remain A Priority For Canadians, Despite The High Costs?. The efforts of all layers of government have supported a subscription to relying on an asset-based economy that has ensured financial rewards through the purchase and sale of real estate. However, by my assessment, a significant reason property owners are netting solid returns today is that property buyers are routinely maxing themselves out with significant debt as part of the privilege of homeownership, subscribing to the belief that values will continue to routinely increase.
Obviously, there are vulnerabilities inherent with this movement, as well as implications for society as a whole, even beyond the financial health of individual households. I talk about how homeowners are adapting their purchasing behaviour, as well as other more market influences, in my most recent edition of Urbaneer’s Real Estate Forecasts – it’s a great supplemental read!
Courtesy Of CanadaMortgagesInc
The Shift Towards An Asset-Based Economy
An asset-based economy functions in a capitalist society, where equity-based assets like real estate or stock market equities – rather than goods and services – promote economic growth. It’s the appreciation of these assets that grow wealth and increase net worth while creating economic momentum for the national and/or local economies.
The benefit of an asset-based economy is that it can be used as a temporary measure to stimulate economic growth. The problem with an asset-based model is that it hinges heavily on low interest rates in order to permit borrowing and purchasing, which will theoretically help to increase the asset prices. Critics of the model contend that inevitably, the market of the asset will weaken over time, creating losses.
The other major drawback of an asset-based economy is that this model is often are attributed to boom and bust scenarios (i.e. economic bubbles). When these bubbles burst, they very often trigger recessions. An asset bubble forms when demand is heavy and propels value, but when the underlying economic fundamentals are not strong enough to sustain it. All of this happened in the wake of the sub-prime crisis in the U.S.A. a decade ago.
In Toronto, today, household debt-to-income ratio tops 200 per cent. Even a slight increase in interest rates or dip in housing prices can send shock waves of financial ruin. Although rates remain low, increases will inevitably emerge over time. Click here to read my post How To Adapt To Canada’s Rising Interest Rates.
This article – “Canada Has Taken A Perilous Road To An Asset-Based Economy” – very succinctly discusses some of the inherent danger of an asset-based economy, which is most certainly what Canada (and particularly cities like Toronto and Vancouver) have become. An asset-based economy, “is underpinned by continuous asset price inflation alongside the suppression of income inflation, meaning a rising debt-to-income ratio is built-in,” according to the article. It also discusses some of the dangers of putting all of our collective eggs in one basket. Furthermore, as this article suggests, given the proliferation of the asset-based economy in housing in Canada, the Government must protect this market. This means that spending and support in other areas, like addressing climate change, or developing the economies of technology and innovation may have to fall back in priority, if it means protecting a large portion of Canadians losing wealth en masse.
High Debt = New Normal
Given the price of admission to buy shelter is expensive, it’s becoming more and more common for people to leverage themselves to with mortgage and consumer debt, living well beyond what is reasonable (and/or financially safe), justifying the short term debt by the belief that the asset value of their homes will grow substantially. I address navigating this reality in my post Should I Max Out My House Hunting Budget With CMHC Mortgage Loan Insurance?
Programs like CMHC Mortgage Loan Insurance, a government program that encourages borrowing, supports the underlying principle of an asset-based economy. Promoting debt ultimately helps to boost the value of real estate by allowing people to borrow more and pay higher prices, but it has translated into an entire generation of homebuyers who are laden with debt. It’s not just huge mortgages either. Although the rate of consumer credit borrowing has slowed, people have accumulated enormous consumer debt loads over the past several years – in many cases to make ends meet as the cost of living is so high.
When people have access to borrowing large sums of money, one of the byproducts is that people can become desensitized to the danger over being overleveraged. This article from Globe and Mail columnist, Rob Carrick “Sorry, Owning A House Doesn’t Earn You An A+ Grade In Personal Finance” characterizes our attitude towards borrowing in the current environment. While the rate of accumulation of consumer debt (i.e. non-housing debt) has slowed , we as a country and a culture seem to put housing debt in another category, at least mentally (a means to an end). Carrick says, “Housing is where we draw the line on getting more sensible about spending.” He discusses affordability in the context of real-life, not qualifying on paper. Housing affordability, as he points out, isn’t just about making mortgage payments. It’s being able to cover maintenance, commuting and family care costs all while being able to put some cash aside for short and long term goals (emergency saving and retirement).
While one could argue that an entire generation (i.e. the Baby Boomers) have amassed tremendous wealth simply by buying at the right time as the market grew by leaps and bounds, such that their need to focus on saving money outside of their real estate acquisition maybe wasn’t necessary, one of the basic building blocks of investing is to diversify to reduce vulnerability. By spreading your capital across different investment vehicles in the market (i.e. cash or cash-equivalent, stocks/bonds and real estate) it allows you to benefit from multiple exposures to different markets while limiting the impact of financial vulnerabilities should one type of market suffer. However, in the case of real estate, especially when all – or a substantial portion – of your assets are tied up in it, you can be prone to a lot of vulnerability because it isn’t easily liquid. In an asset-based economy, if your biggest asset is highly leveraged with mortgage debt, and it isn’t easy to sell, your Return On Investment could quickly erode.
Homeownership and Savings
As this article “Less Savings, More Debt: Inside A Multi-Decade Shift In Canadians’ Finances” discusses, there has been a definite shift amongst Canadians away from saving in recent years. It’s not totally surprising as the low-interest rate environment (which, of course, is one of the proponents of an asset-based economy) provides incentives to borrowers, not savers.
According to a Stats Can study referenced in this article, the household savings rate (which is the amount of disposable income left over after household spending obligations are met) has dipped to the lowest level in 60 years at 1.7 per cent. To put this plainly, only six years ago in 2013, average annual savings was $3500. Five years later in 2015, average annual saving was only $852. This steep decline, while staggering in amount, isn’t entirely unexpected when you consider the combination of high cost of living, high housing prices and incomes that don’t keep up. There just isn’t enough money coming in to cover it all. Money that might at one point in time have gone towards savings is now going toward debt repayment.
It’s interesting to note as well that this trend is fairly unique to Canada. In other countries, like the U.S. for instance, consumers have increased their savings, despite low interest rates. Perhaps having lived through the bursting of an asset bubble- the breakdown of the real estate market in the subprime mortgage crisis a decade ago has prompted a shift in attitude towards spending vs. saving. As assets evaporated, millions learned the dangers of non-diversification and high debt in the most devastating of ways.
Even though prices have moderated somewhat in Toronto over the last few years (though by all accounts it appears we’re going to see Toronto real estate skyrocket this Spring due to a lack of supply), housing and other living costs still take a substantial bite out of household income. And the struggle is real. This article, “More Than A Third Of Canadians Have No Retirement Savings, Half Live Paycheque To Paycheque, Poll Finds” looks at the negative impacts on the cumulative effects of gathering debt over time. The findings? An increasing number (57%) are carrying credit card debt. Nearly half of the respondents are carrying $20k or more in non-mortgage debt and nearly 70% believe that their savings won’t last through retirement (39% don’t have any retirement savings at all!) And perhaps most telling? A quarter of respondents feel that their debt is “overwhelming”.
You’ve heard of “good debt” and “bad debt”? Good debt is debt taken out that will help you to increase your net worth (in theory a mortgage). However, when the level of “good debt” is so substantial that you are turning to “bad debt” to make ends meet, you’re going to be spinning your wheels and not growing your wealth. The moment debt becomes a means to cover the cost of living, you’ve succumbed to the counterintuitive justification of taking out debt to amass wealth. Certainly yes, years from now your real estate investment could be much higher in value, but tapping into that wealth at that point in time assumes that you can weather the present-day storm of high debt, high cost of living and financial vulnerability.
Be informed. Want to see how you fare financially? Here’s a calculator from The Globe and Mail called “Do You Know Your Debt-To-Income Ratio?”
What does all of this mean? As always, I take a prudent, well-researched approach to guiding my clients with their real estate objectives, which includes addressing their short, medium and long term goals. This often means their exercising great patience and foresight in the pursuit of acquiring a property that will meet their wishes, wants and needs, or making some intelligent compromises that will help them achieve their end goal sooner. In the fast-paced world that is Toronto real estate, there is no one-fits-all solution, which is why it’s important you choose a realtor who has experience, knowledge, and a sterling reputation.
May I, and my team, be of assistance to you, or someone you love?
Here are some of my past posts on Canadian Housing, some of which are embedded in links throughout the post:
Urbaneer’s Toronto Real Estate Forecast 2019: Part One and Part Two
Toronto Real Estate, Yellowbelt Zoning & The Missing Middle: Part One – and – Part Two
Gentrification, Densification, And The History Of Toronto Real Estate
The Four Values Of Real Estate For Bidding Wars And Bully Offers In Any Market Climate
How Toronto Real Estate Near Queen Street – East & West – Is Climbing In Value
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Steven Fudge, Sales Representative
& The Innovative Urbaneer Team
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