When we write about investments, we’re usually referring to securities of some sort: Stocks, bonds, and the like. There’s a simple reason for this: As wealth advisors, we focus on liquid investments. So, when we construct portfolios for clients, most of them are situated in public markets, such as the TSX or S&P 500.
This month, however, we thought we’d talk about a significant asset that most clients hold outside their investment portfolios: real estate.
It’s not news that Canada has experienced a breathtaking surge in housing prices over the last two decades. Indeed, other than the occasional dip (such as around the global financial crisis in 2008), home values have marched upward.
The result? For one thing, the net worth of property-owning Canadians has surged. On the flip side, there are serious concerns that we are in the midst of a large housing bubble.
Our intent here is not to make a dramatic prediction. But we are comfortable with some observations rooted in both history and sound investing principles.
Rapid House Price Gains are Rarely Sustainable
In the past couple decades, the world has seen housing bubbles in the U.S., Spain, and Ireland. In each case, prices crashed from those lofty levels. (They have, to varying degrees, since recovered, most notably south of the border).
Canada’s house price growth is reasonably similar to the three bubbles that burst. This, in itself, is concerning. There’s a well-known adage that the most dangerous four words in markets are “This time is different”. Expecting the Canadian market to continue to defy gravity seems pretty unlikely, even if it’s impossible to predict when a downturn might occur.
Leverage is a Double-Edged Sword
For years now, Canadian households have taken on increasing levels of mortgage debt relative to their disposable income. So far, it’s been a winning move. People have bought primary residences and investment properties with a big assist from banks. And as their homes have risen in value, so too has their net worth.
This is the virtuous side of leverage. Yet there’s a vicious element at play when prices eventually fall. Households see their housing assets fall in value, but the mortgage they owe a lender stays the same. If prices fall sufficiently, an individual or family can be left with negative equity in their home.
Diversification is a Must
We have long preached the wisdom of diversification when it comes to an investment portfolio. But it’s important to be diversified across the entire spectrum of your assets. For example, imagine that, excluding your primary residence (which is not really a pure ‘investment’ because you live there), you own the following:
Stocks: $1 million
Bonds: $500,000
Condos: $5 million
On the one hand, the public element of this portfolio is well-balanced. (We’ll assume it’s spread across various sectors and geographies). On the other hand, there’s no escaping the fact that the vast majority of the total assets are in condos. So much for diversification!
There’s another consideration about real estate for Canadian investors. Namely, most individuals have significant indirect exposure to the housing market via our banks. Banks are responsible for the bulk of mortgages extended to Canadian borrowers, and just as they’ve done well as housing has soared, they could suffer loan losses if things go sour.
The lesson here is straightforward: As amazing as the Canadian housing market has done, it’s a tree that shouldn’t be expected to grow to the sky. Investors should consider their assets holistically, and ensure they are diversified while the good times are still rolling.
Another way of saying this? At this stage, betting the farm on home prices continuing their ascent is a risky move.
This material is provided for general information and is subject to change without notice. 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 make sure to see a professional advisor for individual financial advice based on your personal circumstances.
Assante Capital Management Ltd. is a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada.