If you've been checking out the mainstream media lately, the softening Canadian real estate market has been making headlines. After years of crazy price increases some sanity appears to be finally creeping back in. Let's explore some concepts behind real estate and perhaps also explore where the market may be going.
First off, let's look at some historical data on real estate. According to Yale economist Robert Shiller, real estate prices historically just track inflation. Inflation is just the dilutive growth in the money supply from more money being created out of thin air. This creation of money is driven by borrowing. Borrowing, in my opinion, is primarily driven by population growth. So housing prices ultimately, over time, track growth in the population. This makes sense and should come as no shocking surprise to anybody. Here's Robert Shiller's chart on historical housing prices in the US, priced in constant dollars. Constant dollars already have the dilutive effect of inflation factored out of them. Given that real estate only tracks inflation, many people would say that buying a house is not really an investment, it should be seen as just an inflation hedge. I'd just like to point out that back in 2006, that graph shows a massive bubble in prices. Fast forward 2 years later and that bubble, driven by speculation and sales based on subprime mortgages, is finally bursting. How low will prices go? In my opinion, markets always over correct, be it to the upside or to the downside. The chart refers to the US housing market, but I'm told that Garth Turner's book "Greater Fool: The Troubled Future of Real Estate" has something similar which covers Canada. Essentially, if you're currently renting but are thinking of buying a home, you probably want to just continue to sit on the sidelines building your downpayment and watch prices come down to something sane.
So if buying a house is really nothing but stuffing an inflation hedged mattress with your money, why do it at all? Well, in general, you have to live somewhere and isn't it better to be stuffing your own mattress rather than a landlord's? Once your house has been completely paid for, that frees up a lot of monthy cash that you can use elsewhere, be it for retirement savings or just enjoying life. Also, the inflation gains on your money are tax free when you eventually sell, if the house is your primary residence. My advice, when shopping for a first house, is to buy primarily based on your needs, not your wants. Keep it affordable so you can pay it off faster! You can feed your "wants" and upgrade sometime in the future when you've already paid off your first home. Keep in mind that the bigger the mortgage, the longer it is going to take to pay it off and hence more interest money flows out of your pocket in the process.
Another point about real estate is that it costs a lot of money to simply possess. Municipal taxes can be as high as 1-2% of the value of your home. Also, homes "rot" if not maintained. Somewhere around $1000 per year or more should be set aside for maintenance fees not including landscaping costs. Condo fees can easily exceed $200 per month for a modest townhome, to over $400 in a highrise situation with elevators and a swimming pool to maintain. But to be fair, some utilities may be included in those fees. My point is, what other so-called "investment" has such a high cost of ownership? Sure, precious metals may have some safe keeping fees associated with them and some actively managed mutual funds have high MERs, but the "money pit" aspect of home ownership should be understood and not ignored.
A fully stuffed inflation hedged mattress can be a wonderful thing to have as lenders will fall all over themselves to loan you money using your home as collateral. If you invest that borrowed money (certain rules apply) the Canada Revenue Agency will let you write the interest off your regular income. If you're in a high marginal tax bracket, this can come close to cutting the cost of borrowing this money in half. Personally, I'm not a big fan of doing this, but some people do swear by it. As always, your mileage may vary. This may be a good future topic for other bloggers who have experience with some of these borrow-to-invest type of schemes.
Update: I just came across a fairly recent paper by Shiller exploring the speculative bubble aspect of the housing market.