dependent on one country as the buyer for its exports. In their case China consumes most of their commodity exports. In both countries future income will depend on commodity prices although the mix is different. In Canada crude oil and bitumen are most important; in Australia base metals such as iron ore and coal will provide income growth. In 2015 weakness in China’s economic growth, collapsing iron ore prices, and especially the important steel-making sector cast doubt on the short-term future of Australia’s commodity exports.
China’s housing bubble operates in a world of its own. According to a paper by Kaiji Chen and Yi Wen, of the Federal Reserve Bank of St. Louis, China’s average real house prices “have grown at an annual rate of 17 percent for the past decade, far exceeding the 10 percent average growth of real GDP … associated with … housing boom is the growing number of empty or ‘ghost’ apartments across major cities in China.”[12] That pace of growth implies that prices are doubling in less than five years. While many have written about China’s ghost cities and apartments referring to investors’ penchant for buying units and leaving them empty, the real estate boom in China defies all predictions of eventual collapse. As discussed in chapter 14, the inevitable slowdown or collapse of China’s housing construction industry will impact Australia and Canada through the drop in demand for the building materials that go into housing, especially copper, steel, nickel, coal, and iron ore.
There are a few house-price bubbles in the world, like Canada’s, that continue to grow more stretched and Canada ranks right up there with the best, probably tied with Australia in first or second place for the most advanced bubble. How did much of the planet come to a point where so many people became obsessed with home ownership and real estate speculation?
Chapter 4
The Investment Myth
“owner-occupied housing is looking like a bad long-term investment relative to the stock market: despite the occasional volatility of real estate, it has offered practically no capital gains for long-term investors”
— Robert Shiller, Irrational Exuberance[1]
Home ownership is unique in that it is often considered both a useful necessity and an investment. A home can be merely a place to live; it can be valued as an investment or it can be both. The investment value, if there is any, depends on the speculative component of ownership. The speculative component refers to potential for house prices to rise with time at a rate greater than inflation, generating a real profit for the owner if the property is sold.
The primary purpose of homeownership is the provision of shelter — a place to live — which is a good substitute for paying rent. Willem Buiter, in his National Bureau of Economics Research (NBER) paper “Housing Wealth Isn’t Wealth,” states that the true value of housing is the “present discounted value of its current and future rentals.”[2] In other words, the financial benefit of homeownership is the money saved by prepaying the cost of home rental for the remainder of one’s life.
The true economic value of home ownership consists of the sum of rent payments that are avoided plus (or minus) the gain (or loss) on the speculative component.
Buiter explains that those who are long housing, i.e., those who own more value in housing than the cost of renting, are temporarily better off during a bubble. But he argues that they have not created wealth by owning more real estate than they need. Those people are also the ones who are hurt by a bursting of the bubble, as they lose more than those who are short housing, i.e., those who either haven’t bought yet, are renting, or living in inexpensive housing.
Indeed, any young person who has not yet bought a house, or has bought a modest home but is occupying housing space that is smaller and/or less costly compared to their eventual permanent living space, would be made better off by a decline in house prices. The boomer couple — with an excess of housing assets because the nest is empty — will be worse off when the bubble bursts. This good news for millennials and Gen-Xers applies only to young people who haven’t already bought expensive housing and haven’t taken on more debt than they can handle.
The same holds true for the landlord. When the bubble bursts, the landlord will be worse off and the renter will be better off. Obviously, this increase in relative position for the renter holds true if the renter eventually buys a house because the purchase price will be more affordable. But a correction in house prices makes the renter better off even if they never buy a house as they gain in total wealth relative to the home owner by the amount of decline in the value of assets that is lost by the landlord/owner.
The rent substitute component of housing investment is always present and always has value. This amount is the monthly rent one would have to pay if one didn’t own a house. It can be calculated, with some accuracy, by looking at the cost of renting a home similar to the one that is purchased and comparing that to the total cost of home ownership. While the total rent cost is easy to calculate since a renter pays little beyond the monthly rent cheque, the total cost of home ownership is usually underestimated as prospective owners fail to include all the costs of owning a house. They do this because of inexperience, lack of information, or because they wish to bias the decision in favour of owning because of the intangible benefit to the status of owner versus renter. Shiller calls this “the psychic benefit one gets by owning and living in one’s own home,” and there is no way to measure the dollar value of that.
And, of course, if they are long housing in the context of Buiter’s definition, the true cost of owning a house would include the loss of wealth when the housing bubble bursts. Since it’s been so long that anyone has seen a decline in the speculative component of Canadian housing it would be rare for anyone to include this possible cost in calculating ownership costs. It could be stated in another way: when the housing bubble bursts, the speculative component is the amount of money that a prospective buyer would save by waiting until prices drop. Of course, nobody looks at housing that way. The more common point of view: Why rent when you can be an owner?
We’ve all heard, and perhaps some have repeated, the statement that goes something like, “Why pay rent to a landlord when I can build equity and make an investment through owning a home?” or “Paying rent is like throwing your money away.” I’ve heard it described this way: “Renting is like taking your money, dousing it with lighter fluid, and throwing a match to it.” It’s a universal myth that bears closer scrutiny. Is ownership of real estate a good “investment” today? Has it been in the past? Is it likely to be in the future? We can see from Shiller’s comment that some very smart people have concluded that real estate is not an investment. Let’s see what we can find. The first step to determining the investment value of housing is an accurate and all-inclusive calculation of the true cost of both options.
The Cost of Home Ownership
Usually the largest cost item is the interest on the mortgage loan that is required at the outset of becoming a homeowner. The CMHC website has tools that allow different assumptions on interest rates and mortgage amortization.
Assume a $400,000 mortgage, as this corresponds to the typical single-family home valued at $500,000 in major cities. In some cities like Calgary, Edmonton, Toronto, and Vancouver that amount buys only a very modest single family home.
Here are three interest rate scenarios. I chose these scenarios with rates higher than the 2014 rates to reflect possible interest rate fluctuations over the twenty-five-year term.
Scenario A
Interest rate at 4.80 percent
Total interest cost for twenty-five years = $284,326
Monthly payments are $2,281.09 including both interest and loan amortization.
Scenario
