It isn't new that the pundits have been forewarning of an imminent real estate crash – some for well over a decade – but it begs the question: “What if it did?”. After writing about how 'A Swansea Toronto House Received 33 Offers' garnered a sum 54% over its asking price – a sum significantly higher than what I, a seasoned realtor with 26 years of experience, anticipated, I thought perhaps a post offering caution and preparedness might be appropriate.
Yup, in the City of Toronto where prices seem to keep setting records and then breaking them, affordability is a growing issue that has both financial and social consequences. With the lack of available stock and no shortage of buyers, the traditional shape of the property ladder (buy a starter house and move up in succession, until you are ready to downsize again) has been set on its ear. This is due, in part, to the fact that Buyers are often maxing out their budgets now (Dear urbaneer: Should I Max Out My House Hunting Budget), just to get into the market, with an eye to staying put and renovating, rather than climbing the ladder in the traditional sense. I touched on the impact of afforadibility, most recently in my Real Estate Forecasts Parts One and Two, but another subplot to this story is the amount of debt homeowners must inevitably be taking on when they max out their purchase, either to finance those renovations or, in some cases, cover living expenses.
Low interest rates have been seen as a bit of an ally for homebuyers furiously competing to secure a property. There is a quiet gratitude for cheap money that gives the additional boost they need in a bidding war to to secure a property after a likely lengthy, emotionally draining search (I wrote about this recently in Dear urbaneer: Help! Buying A Home Is Emotionally Exhausting!).
No question, when your goal is to buy property and the competition is fierce, you do what you have to do. What the issue may be here though is that the focus is consistently on that accomplishment of buying that dwelling. There is less emphasis on the debt that you are taking on in order to do so. More specifically, there is little attention paid to servicing that debt, in the context of living your life in the years after the housing purchase closes. And we’re not talking about becoming house poor, although that's part of it. This is more about considering the likelihood (and amount) of extra debt that you’re likely to acquire in the years to come because you’re a homeowner.
The Emotional Driver
Fear is an emotion that unquestionably has the ability to topple all sense of reason. In a real estate market like the present one in Toronto, fear of getting shut out of the market all together is weighing heavily on homebuyers, who are “forced” to take out as much debt as they are allowed. On the one hand, it lets the homebuyer reach their goal (i.e. purchase a home). But on the other hand, this kind of frantic behaviour is actually playing a role in increasing prices, which creates more pressure on the market, in an ironic twist. Additionally, what is waiting for these maxed out homeowners after the purchase closes are huge mortgage payments that constrict their quality of life. Some will inevitably fall behind on payments (statistics are showing that some already are); Some might even be forced to take out second jobs, just to service that housing debt – and the other debt that will follow – either to maintain their home, or to pay for their living expenses, which on the surface sounds straight up crazy. However, for a frantic Buyer under pressure, this sounds like a reasonable solution, and there are implications on the society as a whole, financially and socially. A recent article in The Huffington Post called “Are Our Emotions Running The Real Estate Market?” touches on the impact of this current phenomeneon.
Big Debt Has Big Cost
There has been no end of headlines around concerns of rapidly rising house prices in Toronto and eroding affordability. Similarly, there have been as many headlines around record-breaking levels of household debt, most of which (and there is no surprise here when you put the two together) is being propelled by a surge in mortgage debt, made possible by low interest rates – and put into action by rising prices. Most recently, average household debt load stands at about 165 percent. That means for every dollar we make, we owe $1.65. Yikes!
Homeownership is a curious lynchpin in this debt dynamic. On the one hand it provides wealth and social stability. On the other, it’s a catalyst for debt. And in the City of Toronto, where the age of housing stock, along with rising prices require homeowners to take on homes that require work – (ergo debt).
One doesn’t have to look too far into the rear view mirror to see what happens when a good chunk of the population is over-leveraged with debt in real estate. That’s exactly how the house of cards tumbled during the U.S. subprime housing crisis. In the approaching decade that has followed that collapse, the Canadian government and various financial bodies have intervened to try to exert some control over mortgage debt in this country. First a couple of years ago, CMHC tightened lending policies, which didn’t have much material impact necessarily on the market, but did likely succeed in keeping some home buyers on the fringe, that may have been dangerously close to the debt edge to begin with. They also scaled back their involvement with home equity lines of credit.
A couple of years later, the market keeps chuggin’ and resetting the bar for itself cyclically.
Big Brother Helps A Bit
Earlier this year there were additional measures taken by CMHC, increasing down payments for certain price points (between $500,000 and $100,000,000), which was in part intended to quell the super hot market like that in Toronto, while reducing the vulnerability of highly leveraged home buyers. (Here is some of our press from the Reuters newswire on that subject.)
Most recently, the Office of the Superintendent of Financial Institutions (OFSI) has put the onus on lenders to play the heavy with their lending criteria, being more strict about things like borrower income, stress testing potential mortgage rate increase and credit history. However, as is pointed out in this very salient Globe and Mail article called, “New Bank Rules Won’t Cure Greatest Housing Threat.”, these measures are all very well and good during the process qualifying for and taking out that debt by taking a very accurate picture of your financials during the application process. What these measures all fail to consider is what life is like for these mortgage holders after the loan is granted. And what they suggest too in this article is that restrictions around lending don’t do enough to try to play out potential debt scenarios as a homeowner, undergoing major renovations or even a series of repairs.
That window of time before you buy your home for the first time, you are usually a financial superstar. You’re probably flush with cash that you’ve accumulated for your down payment. Your debts may be limited to some student loans and other smaller consumer debts. You may or may not have children yet, which will increase your spending considerably.
A More Accurate Stress Test
Just this week, The Globe and Mail story Canadian Borrowers Could Face Payment Shock If Interest Rates Rise identified that “more than 700,000 Canadian borrowers could be facing payment shock on their debt obligations if interest rates rise by a quarter point, and that rises to as many as one million people should rates go up by 1 per cent, according to study by credit monitoring firm TransUnion.”
If this is a potential reality for you, it's critical to explore all the variables in a 'mortgage stress test', where you play out your worst to best scenarios as they may happen in real life. For example, are you assuming your finances will stay the same? Most homeowners discover the very act of purchasing property changes their circumstance. Further debt accumulation is the by-product of being heavily laden with mortgage debt, simply because lenders often offer you more debt to take on, and in other instances increased debt is a by-product of having to borrow to make necessary repairs. In short, that huge mortgage you are taking out really is just the price of admission in a lot of cases.
The answer to protecting your own household against the vulnerabilities of household debt? Play out your own scenarios. When you are setting your budget, take into account your current house buying objectives as well as medium and longer term goals. How will your available cash flow as a homeowner figure into that? Will you be able to continue to save outside of real estate? How does your renovation list balance out against needs and wants – and then further- how does it balance against your cash flow and/or credit?
At urbaneer, my team and I always, always contend that smart buys are cautious, well-thought out and heavily researched. That’s because owning a home is an activity that unfolds over years, with potential implications (good and bad) over that time period. It’s part of our job (supported with our experience and access to real-time, thorough data) to help you make a purchase that fits you best. Today and tomorrow. We’re here to help!
Steven Fudge and his Urbaneer Team
Bosley Real Estate Ltd., Brokerage • (416) 322-8000
http://www.urbaneer.com • info@urbaneer.com
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