Robert Champion is vice-president of client services for Toronto-based Sprung Investment Management.
A recent Globe and Mail series explored the risks associated with rising household debt in Canada. One risk associated with our addiction to cheap money is its effect on home prices.
Low interest rates have encouraged home buyers to take on larger mortgages. That has led to a dramatic rise in home prices over the past 20 years. The wealth effect caused by rising home prices has also encouraged homeowners to take on additional debt through home-equity lines of credit.
There has been much debate as to whether house prices in Canada, particularly in Toronto and Vancouver, are overvalued – and if so, by how much. Many wonder whether this purported bubble is likely to burst in the near future. The reality is that there is no way to know whether a bubble in house prices, or the prices of any asset class, exists until it actually bursts.
Given that uncertainty, what do we know about house prices? Looking at Toronto house prices from 1970 to 2014, it's easy to see (from the grey line in the chart) that the long-term trend for house prices has indeed been up.
A second observation we can make is that for extended periods of time, house prices rise significantly above the long-term trend. These periods of above-trend prices are followed by extended periods of below-trend prices.
Why does this happen? Anyone who has a memory of current events will likely recall that during the mid-1970s, the oil crisis wreaked economic havoc, while the selloff at the end of the 1980s was caused by the U.S. Federal Reserve Board ratcheting up interest rates to slay inflation.
But there is a more general reason that the prices of houses and other assets tend rise and fall over time. It's called reversion to the mean (often mistakenly called "regression" to the mean).
Reversion to the mean says that extreme values are more likely to be followed by less extreme values. Think of it this way: Performance that is well above average usually doesn't stay there forever; it typically comes back to earth. Performance that is well below average often gets better. If you're a golfer, you have likely experienced this phenomenon.
How can we use this information to guide decisions about housing?
Most people who are considering buying a house look at the rising prices, and assume that they will continue to rise. They believe that they must buy now before they rise even higher. In reality, periods of rapid house price appreciation are eventually followed by extended periods of declining prices (see the red line in the chart).
Prospective buyers may be better off to rent now and wait for lower prices. The Economist recently reported that Canadian house prices are 89 per cent overvalued compared with rents. That means it is significantly cheaper to rent than own. Potential home buyers should likely consider the option of continuing to rent and save a larger portion of their income.
For many older Canadians, their home is their single largest asset. As we age, many of us sell our homes and use the proceeds to help fund our retirement. Knowing that we will need to sell our homes at some future date, we look at the rising house prices and assume that they will continue to rise. We believe that we will benefit from deferring the decision to sell. That could be a huge mistake: If you choose not to sell your house in the near term and prices decline, a health or financial crisis could force you to sell at a much lower price.
For older homeowners, here is the key takeaway: The historical data show that when house prices decline, it takes 10 years or more for them to recover. Younger homeowners have time on their side; they can afford to wait for prices to recover. Older homeowners may not have that luxury.
Buying and selling a home are the biggest financial decisions most of us are likely to make in our lifetimes. Our behavioural biases mean that we tend to make decisions based on recent data that fit our view of events, rather than incorporating long-term historical data. We base our decisions on the fact that house prices have risen significantly in recent years and ignore that fact that they declined by 30 per cent in the 1990s. It's different this time, right?