At the end of residency, I was ready to be a prodigious wealth accumulator by saving as much as possible in my early years. When thinking about asset accumulation, I had recently decided to have a 100% stock portfolio as mentioned in this post. As a form of diversification, I had been reading quite avidly about real estate investment properties as well during this time period. Almost every baby boomer I met would tell me that their stock portfolios gave mediocre results, but real estate had worked every time. I had read literature on long term investment returns for real estate averaging around 4-5%/year compared to stocks in the 6-8% range and had difficulty reconciling this discrepancy. After further investigation, I decided the answer comes from 3 main factors:
I believe the average Canadian homeowner acts more chill then the panicked, emotional stock investor I often show in my behavioral investing picture. The volatility profile of real estate tends to go through much longer periods of steady lower growth followed by protracted periods of flat to mildly declining markets. This leads to a smoother return profile than the lumpy returns of stocks. Naturally there will be locations that have long term higher demand such as major metropolitan cities that will vary in its volatility profile. There can still be periods of real estate speculation and excess that leads to more volatile losses such as in the US real estate bubble or what may occur in the Vancouver and Toronto markets within Canada.
Most Canadians hold all their real estate exposure within their primary residence. A smaller percentage will be lucky enough to have a 2nd vacation home or cottage. An even smaller percentage buy real estate as a separate investment class via acting as a landlord of an investment property. When the real estate has sentimental value, it isn’t truly viewed as a disposable asset in the same way a stock or bond is. Market panic leading huge swaths of Canadians to sell their primary residence will not occur, because most people don’t view it as an investment until they are retired and the property becomes too large or difficult to manage.
This view creates perfect investment behaviour. A long term investment orientation is assumed and the rational behaviour is encouraged by society. Can you imagine family and friends response if you decided to sell your house after property notice showed a decline in 5-10% value? It also takes significantly more effort to sell real estate as it proceeds over several months. This makes it an illiquid asset, which likely will lead to more rational analysis to buy and sell.
Stocks have a larger absolute percentage swing of gains and losses that lead to fervent buying and selling at the wrong times. They are also highly liquid, which means fear or excitement can quickly be turned into action. There is excellent evidence that stock market investors achieve lower returns than the quoted returns of their funds because of poor behavioral choices in buying and selling.
Ignoring Maintenance Costs
A stock portfolio is dramatically cheaper to liquidate than real estate. It may cost $50-$100 in commissions to sell a whole portfolio depending on how many individual holdings you have. This compares to a five digit sum for real estate sales via realtor/legal fees to dispose of real estate.
The transaction cost pales in comparison to the maintenance cost of home ownership over its lifespan. A professional real estate investor should allocate from cash flow 2%/year of the property’s total value to properly cover the depreciation cost of the physical property over time. This ensures the property doesn’t suddenly have to be sold if they are unable to finance a significant expense such as a roof or other major capital repairs.
Let’s imagine that as a homeowner, you spend 1%/year of property value on maintenance/capital improvement projects over the life of home ownership. On a $500,000 home that would be $5000/year of maintenance cost. This seems like a generous assumption since I have paid over $5000 in maintenance on my new home in less than 6 months!
Let’s assume the home is sold for $1.5 million in 20 years which is a 5.65%/yr (higher than the historical 4-5%/year quoted above) compound annual growth rate or CAGR for a $1 million capital gain. A million bucks would certainly make most Canadians feel like this home was their best investment ever!
Maintenance costs need to be factored in as additional “equity” that was required to achieve the final sale price however. If none of the repairs or capital improvements were done over the 20 years, it is likely the property would have a lower sale price.
$5000/yr x 20 years that was invested in stocks at 6-8%/year would have yielded $211K to $270K in total value. This assumption likely underestimates the future value of maintenance costs since the $5000/year cost would increase with inflation over 20 years.
In this example, ~20-27% of primary residence final value comes from extra maintenance cash flow over the life of the investment. If 25% is subtracted off the original gain, it would leave a $750K capital gain over the 20 yr life of the investment for a CAGR of 4.69%/year or a ~1% less CAGR overall.
If the actual historical CAGR for Canadian real estate of 4-5%/year is used, this would drop to 3-4%/year after the maintenance cost effect. That return is hard to get excited about!
So how does the primary residence feel like the best investment ever for Canadians?
Tax Free Capital Gains Status
Many people think this is the primary reason for the big riches enjoyed from home ownership. There are very few policies that allow professionals an unmitigated tax success, but a primary residence is the big one.
Every investment’s total return should be considered after fees and taxes to give its real return. Most non-registered capital gains tax will eat up ~25% of the capital gain. The primary residence sale ends up 100% in the homeowner’s pocket.
I tend to view this tax free benefit as offsetting the maintenance cost over the life of the asset as discussed above since it also hovers in the 25% cost range.
If it isn’t the tax free status, where is the big advantage?
Investor behaviour has a definite influence, but the dominant reason real estate is often the best investment a person makes in life is because of leverage. Leverage is simply borrowing to invest and has many different forms with real estate leverage being the most common form. It’s easier to explain the power of leverage via an example:
Let’s imagine a hypothetical home valued at $400,000 that is purchased with 20% down purchased by Brad. I will assume mortgage payments and housing maintenance costs paid during ownership is the same as if Brad decided to pay monthly rent. We will also ignore principal payments made on the mortgage just to keep the concept simple.
It leads to a $80K down payment and a $320K mortgage.
An overall home price increase of 25% from $400K to $500K over 5 years would a CAGR of ~4.6%/year. This is well below long term stock average returns in the 6-8%/year range. Yet it is imperative to recognize that Brad only used $80K of his own money to purchase the asset.
Therefore to sell his home after 5 years it would be:
$500K sale price – $320K mortgage – $80K cost basis = $100K profit
Turning $80K into $180K in 5 years is a phenomenal 17.6%/year CAGR investment return! Being able to borrow to invest has magnified the actual return significantly.
Leverage does come at a cost – the mortgage paid the bank a hefty amount of interest over the 5 year mortgage term. If we assumed a 4% interest rate, Brad would have paid around $37,000 in interest. Canadians have typically ignored the view that a mortgages have leverage cost, because the interest cost is viewed equivalently to the basic cost of shelter.
A roof over your head is a necessary expense and rent is seen as a permanent loss of shelter cost while home ownership is seen as providing savings over the long term. A debate should occur if the mortgage interest/property taxes/maintenance increases the homeowner’s monthly cost over expected monthly market rent for a similar property. For simplicity in this example, I will ignore this discussion which is better placed in a rent vs own post.
If Brad chose to keep the home and enjoy a 4.6%/year increase in home value over 25 years of slowly paying the home off, the final value of the home would be ~$1.23 million.
Doing the same math on his original $80K purchase price, the levered return would be 11.55%/year which is still quite impressive! This return rate is lower than the 17.6%/ year rate because the degree of leverage diminished over time as the house was being paid off. This is because the borrowed amount keeps reducing as more principal is paid.
Leverage can cut very deeply when done in the wrong environment or by stretching the borrow capacity to its furthest limits. Homeowners that stretch themselves too far and miss mortgage payments run the risk of the bank calling in the loan and forcing the sale of the home at prevailing market prices. This scenario will typically only happen in recessionary environments where unemployment rises and consumer confidence is low. Typically, the real estate market declines in such an environment, which leads to lower home foreclosure prices. People tend to walk away from houses with negative equity when asset prices start falling, which exacerbates the downward cycle and homeowners can suffer tremendous losses. This can lead to mass selling like in the recent American Housing Bubble.
In normal market conditions, a 10% housing decline in 1 year is totally reasonable. In Brad’s case, a 10% decline on his home of $400K is a $40K loss in value. On his originally $80K investment, this is a 50% market loss. A 20% housing decline can lead to a 100% loss of original capital!
A 50% stock market loss would be amongst the worst possible results and leads to market panic. Yet in the housing market, the leveraged 10% decline (resulting in a 50% nominal loss as shown above) would barely make people bat an eye. The requirement for housing and long term belief in Canadian real estate keeps Brad from doing anything emotional. He maintains an appropriate long term outlook of a patient investor, employs leverage and rides out any temporary blip to get the best investment return from his house compared to any other asset class!
Current Canadian Housing Market Conditions
Review of historical conventional wisdom suggested the average home purchase should not go higher then 3x the annual household gross income. This ratio would act as a “stress test” to ensure a homeowner had ample room for flexibility in earned income or unexpected expenses to still afford their mortgage. The magnitude of leverage is the highest when the homeowner is young and diminishes steadily over the life of a mortgage until it is paid off.
Current housing leverage has increased significantly from historic levels with recent low interest rates and strong demand from dramatic price increases that has been a sustained boom on a 20+ year trend. This Globe and Mail post from 2015 showed how levels had gone far higher then 3x household income. This has further increased to 10-25x household income in frothy markets like Vancouver or GTA. This is a whopping debt load and has led to Canadians being the most indebted relative to household income in quite some time.
Canadians have become so accustomed to a home purchase requiring a large mortgage that the magnitude of the leverage component is often ignored. Down payments in the 1970’s and 80’s were often in the 25-35% range because borrowing rates ranged between 8-12% interest with shorter amoritization periods. This compares to the last 20 years where optional down payments of 5% with 30+ year amoritization became common. New mortgage stress tests and increasing rates as detailed in this Globe and Mail post will likely act as drag on absolute leverage levels the banks can lend to the average borrower. Given that bank loan/ leverage size is the biggest contributor to how much home can be purchased, it is reasonable to assume that housing prices will decline or at minimum stagnate for a number of years to come.
Despite the title of the post, I personally delayed the purchase of our first real primary residence until almost 10 years after graduating residency. I viewed the short term risk/reward owning in Vancouver to be far greater then investing the difference I saved on renting. We also had analysis paralysis on if we would stay in Vancouver, the type of home and location etc. I likely would have purchased in many other Canadian cities, but the absolute level of debt that was required to own a basic home in Vancouver made me cringe. Our recent decision to buy here had multiple variables, but our financial position exceeding our financial goals was certainly a huge contributor.
In my opinion, it is indisputable that leverage is the key reason why a primary residence is the best investment most Canadians make. Having said that, risk associated with home ownership leverage is likely the highest it has been for many decades given the deviation from historic norms that has been developing.
Considering the above factors, a long term perspective on home ownership now will likely continue to be advantageous for most professionals with high income earning capacity. Leverage will be kind to those with steady cash flows and a long time horizon. It is especially kind in home ownership where people exhibit their best versions of behavioural investing.
You might be tempted to ask the question how leverage applied to a superior performing asset like the stock market will perform. This is a whole different kettle of fish which needs a separate topic.