The doomsday scenario: Why you’re more tied to real estate than you think and what you can do about
Canadian Real Estate prices only have three main directions they can go: Up, flat or down.
Now that we have gotten that out of the way, this article is about what happens if they go down. It is not a prediction, but just trying to paint a picture of just what might be in store for Canadians — and outlining things you can do today to protect yourself.
For the sake of excitement, let’s say that there is a solid decline of 25 per cent from today’s prices. It can certainly happen.
From 1989 to 1996 Toronto average home prices dropped 36 per cent. In 1980, Vancouver average home prices dropped over 40 per cent within one year. But is the worst of your trouble simply the drop in value of your house? Unfortunately, that is only the biggest of a long list of worries if we face a major house price decline. These would likely include:
Your investment portfolio would be hit hard if you own Canadian Bank Stocks, Canadian REITs, Canadian Mortgage and Mortgage Insurer stocks. Also look to declines in any retailer or manufacturer of appliances or building materials with significant exposure to the Canadian market.
Your taxes will go up. This will happen because the gravy boat of real estate related revenues will need to be replaced. This is particularly true of your Municipal Government.
You might see a tax hit due to our collective ownership of the Canadian Mortgage and Housing Corporation (CMHC). The very large government owned mortgage insurer provides mortgage guarantees (among other services) on many of the most vulnerable loans. These are often for home owners who may have only 10 per cent down on a house. In the event of a 25 per cent price decline, these people would now owe 15 per cent more on their mortgage than the value of their house. I can tell you that many of the recent changes to Mortgage rules in Canada are tied very closely to the Governments’ great fear of what will happen to CMHC if there is a house price meltdown. In total, current Mortgage Insurance in force stands at $523 billion!!
If you are a real estate builder or developer, real estate agent, mortgage broker, real estate lawyer, provider of title insurance or any other job that is directly related to Canadian real estate, clearly there will be a direct employment impact to you. But what about others? How many cars, cottages, boats, vacations, high end watches, nice restaurant meals, and the list could go on, have been bought by those who are directly employed by the real estate industry? Assume that every one of those industries will suffer a hit as spending falls.
What about all of the Canadians who are real estate rich? In Canada today there is a little under $2 trillion of household credit, of which over $1.4 trillion is directly related to borrowing against real estate. Imagine all of the spending that Canadians do that is in part funded by either the actual dollars borrowed against their house or the added confidence that their ever growing house value provides. On both fronts many Canadians will pull back on their overall spending because of a 25 per cent decline in house values. This will hit the Canadian economy across the board.
Selling your house at that point may not save you. It can help, but what might take a week to do in a hot market could take you a year to do when you are desperate, unless you want to take an even bigger loss on your house.
To summarize this doomsday scenario, your house value will drop and selling will be tough, your taxes will go up, your investment portfolio will suffer, the economy will drop and possibly you will lose your job. You must be thrilled that you ever read this article.
Is there anything you can do to avoid getting hit on all fronts? I believe there are four things that you can do today to minimize the pain from a very bad Canadian real estate market:
If more than 60 per cent of your total net worth or equity exposure is in Canadian real estate, you might want to consider selling or downsizing to lower that exposure. For example, if you have non-real estate assets worth $400,000 and a $1 million house and a $400,000 mortgage, I would suggest you have $1 million of net worth, and your equity exposure to real estate is actually 100 per cent. This person would have to sell their home, and buy something worth $600,000 or less to get to a 60 per cent real estate exposure.
How directly is your employment tied to the Canadian real estate market? The harder your job would be hit from a decline in real estate values, the more important that 60 per cent number becomes for you in point No. 1. In fact, you may want to use a 50 per cent number.
You likely have complete freedom in how your RRSPs and other funds are invested. Take a hard look at your exposure to Canadian real estate in your investment portfolio. If you are overly exposed in item number one or two above, then it is even more important to have meaningful investment exposure outside of Canada or at least outside of Canadian Financials, mortgage funds and REITs. We see too many people that believe that these sectors are bullet proof, but unfortunately they are layering on added risk to their large personal Canadian real estate exposure.
The final item is to review your debt exposure. When times are tough, cash is king and debt can be a tremendous weight. It is at those times when you need it most that your income and investments can suffer. If your debt minus your non-registered investment assets is more than double your annual household income, then you should take a hard look at how you will be able to manage a recession.
Nobody really knows which way the Canadian real estate market is headed from here. What we do know is that for much of the country, the past 20 years have been quite kind to real estate. We also know that real estate has cycles just like every other investment, and it has been quite a while since we have seen a sizable decline. It is definitely coming. It is only a question of when. Don’t act like you are immune.
Ted Rechtshaffen is President and Wealth Advisor at TriDelta Financial, a boutique wealth management firm focusing on investment counselling and estate planning. email@example.com