Investing in residential real estate

Canada’s residential real estate market may be growing into a giant collapsible bubble. Portfolio manager and regular MoneyLetter columnist Keith Richards argues there are better ways to seek capital gains and investment income. Real Estate Investments Trusts (REITs) and stocks both offer opportunities for capital gains and income plus the huge additional benefit of almost-instant market place liquidity.

Hilliard MacBeth, director of wealth management at Richardson GMP, sees Canada’s residential real estate boom as a classic bubble. Historically, residential real estate (not to be confused with commercial real estate) has been seen as lifestyle purchasing. It’s a place where you live or vacation (your home, cottage, snowbird residence, etc.).

The more recent trend (by historical standards) of retail investors has been to invest in residential real estate for capital gain potential and income investing. MacBeth’s argument is that, like other bubbles, when retail investors (aka ‘dumb money’) move enthusiastically into a nontraditional asset class as an investment, the action signifies bubble conditions.

Household debt is bigger than the economy!

Statistics Canada reported in September that the ratio of household debt to income has reached 167.6 per cent—the highest it’s ever been—and the majority of that debt is mortgage debt. Canadians’ household debt is bigger than the country’s economy! To me, this is a statistic that may pose a problem for Canada’s real estate prices in the future. One can only borrow so much.

Housing starts in the big Vancouver and Ontario markets approached the same 2008 highs last year.  Since the introduction of the government tax on foreign property investors, Vancouver has slowed considerably (33 per cent – 59 per cent drop in sales from February to September of this year, yr/yr). But Ontario sales have continued to increase. National Bank economic research suggests Vancouver (and surrounding areas) should experience a 10-20 per cent decline in prices over 2017. They expect a smaller average decline in Toronto prices by about three per cent.

Comparing the risks of stocks and real estate

While it is arguable that the stock market is as overvalued as real estate, the stock market has a few advantages that I see when facing this dilemma. First, the cost of maintaining a stock portfolio—all things being equal—excludes those costs surrounding real estate investing. We do not pay property taxes and insurance, condo fees, maintenance or upkeep on our stocks. Another advantage of stocks is their immediate liquidity. If one notes a change in the trend in their stock portfolio, liquidation can usually occur in a matter of minutes—as can trimming one’s exposure.

There are no immediate markets in which you can liquidate a residential real estate investment (REITs aside).Your property may sit on the market with a ‘For Sale’ sign on the lawn (or listed with MLS) with no activity on it for months—and with a revolving “New Lower Price” sticker to keep pace with the falling market. This is unfavorable in a rapidly falling market, as I might imagine some Vancouver sellers are, or will soon be, noticing.

Hedging one’s risk within a residential real estate investment is nearly impossible. Stock risk can be offset by hedging with inverse ETFs or options. Those hedges can be removed on a moment’s notice with minimal cost and hassle. Diversification within residential real estate investing (other than REITs) is difficult. Conversely, diversifying through many stocks and commodity plays in different sectors and countries’ economies is pretty easy. Monitoring them for sell signals is simplified through technical analysis—such as those described in my book Sideways. Residential real estate is typically a very concentrated investment strategy with less quantitative sell signals.

For my money, I will always look for assurance that a bad investment can be easily disposed of—bubble or not. For that reason, it is my opinion that investing in residential real estate is perhaps less enticing than many retail investors believe.

Another national debt struggle ahead?

Debt isn’t limited to the retail consumer in Canada. Prime Minister Justin Trudeau, the guy who claimed that “the budget will balance itself”, may have some cold, hard reality hitting him in the face right now. A new analysis by TD Bank says the Trudeau government is on track to run $150 billion in budget deficits over the next five years. Before the election, even Trudeau’s opponents underestimated just how much the government would spend. Opponents suggested that the deficit would not be $10 billion as Trudeau claimed, but closer to $25 or $30 billion.

The TD report estimates that, given Ottawa’s current fiscal path, it will take more than a decade to bring the budget back into balance unless the government raises taxes or cuts spending. “I’m still promising to balance the budget, but do it in 2019” said Trudeau. Not according to the TD report. Reality may finally sink in when the bearish trend for our loonie, a decline in the long bond, an end to the real estate bubble and a struggling business environment all settle in.

The Canadian long bond is struggling at a key point of overhead resistance right now. The last time it reached similar heights back in 2015 our bond market fell. Remember, foreign investors price our bonds in part according to the credit rating scores, and that rating can be affected by rising debt.

A further decline in the loonie projected

So, too, will the loonie struggle if TD’s predictions are correct. In fact, since I first wrote the outline for this article in early October, Bank of Canada President Stephen Poloz announced concerns regarding the Canadian economy. Poloz’s comments caused a three per cent draw-down on our currency vs. the USD in October. I have some potential downside projections based on technical support after the recent failure of the loonie to hold its prior support level of $0.77USD. From a technical perspective, we could see the loonie hit $0.70 in the near term. A worse case scenario would be a return to the low $0.60s, but that would be an extreme case.

Oil plays a role in the loonie’s strength. Despite seasonal weakness for oil over the winter, I have a target of $62 or so on West Texas Intermediate oil over the coming year. However, any strength in oil should only delay—not eliminate—the likelihood of a longer-term decline for the loonie due to the above factors. For this reason, I continue to endorse holding significant USD in your portfolio, with a focus on liquidity and quality in your security selection.

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca. He may hold positions in the securities mentioned. Worldsource Securities Inc., sponsoring investment dealer of Keith Richards and member of the Canadian Investor Protection Fund and of the Investment Industry Regulatory Organization of Canada. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only and not necessarily those of Worldsource Securities Inc. It may also contain projections or other “forward-looking statements.” There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking st Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstances.

 

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