The Globe and Mail, Report on Business
Published March 17, 2012

By Tom Bradley

As an active manager of stocks and bonds, we’ve always considered our biggest competitor to be the market indexes. Over time, our clients expect us to beat them. These days, however, we’re facing another formidable foe. It’s called real estate. Investors (young and old) have a significant portion of their net worth invested in their homes, and we’re seeing more of them consider adding an income property to their portfolio.

I wanted to see what we’re up against, so I put residential real estate through my usual research process. Just as I do with stocks and bonds, I looked at houses and condos from the perspective of economic fundamentals, valuation and market sentiment.

Starting with the economics, it would appear the supply side of the equation looks manageable (except maybe condos in Toronto). Housing starts have exceeded household formation for a decade, but the inventory of unsold homes is not excessive. The demand side, however, is less encouraging.

What drives real estate over the long term is income growth (i.e. jobs). As Canada becomes less competitive in the global markets and our governments stop prescribing stimulus, employment trends aren't too exciting. In the meantime, our home ownership rate has gone from 62 per cent 15 years ago to 70 per cent today, slightly above the level attained in the U.S. in 2006.

Still on the demand side, the demographic charts show the segment of the population that’s the strongest net buyer of houses (those aged 25 to 34) is about to start declining, while the pool of potential sellers (over 65) is continuing to increase. The situation is the opposite to what prevailed in the 70’s and 80’s when the early boomers had a huge wave of buyers following behind them.

While supply and demand factors are important, what’s really driving real estate these days is financing. Sellers can charge fancy prices when buyers are plugging 2 to 3 per cent into their mortgage calculators. But here too, the trends are worrisome. Rates have little room to drop (despite Bank of Montreal’s efforts) and consumer debt levels are now equivalent to the U.S. at its worst (we seem intent on pursuing the American way).

Overall, the fundamental trends in favour of housing investment are getting tired, and in some cases reversing.

Moving on to valuation, it’s important to remember that cheap, abundant financing is transitory, while the price paid is forever. On that front, the affordability indexes show that most housing markets in Canada are near their long-term averages. Even with Vancouver included, the RBC Housing Affordability Measures show that on average 42 per cent of pre-tax household income is required to service mortgage payments and pay the taxes and utility bills on a 1,200-square-foot bungalow (two-storey houses are higher, condos lower). As high as that number sounds, it’s just slightly above the long-term average.

But – and there’s a big but – these calculations are based on current mortgage rates. When we return to a time when Bank of Montreal is advertising five-year mortgages at 4.99 per cent instead of 2.99 per cent, the measures will look ugly. In other words, valuations are okay in most markets at artificially low interest rates, but poor in all markets at higher rates.

An analysis wouldn’t be complete without a word on sentiment. In the capital markets, the mood of investors has a significant impact on prices. Real estate is no different. In this regard, I’ll say only that homeowners are definitely not prepared for prices to go down. Real estate has enjoyed a long upward cycle and with 12 good years comes a high degree of complacency.

When I pull together the economic fundamentals, valuation and sentiment, real estate, as an investment, doesn’t look very attractive. The distribution of potential outcomes looks asymmetrical to me – limited upside and plenty of possible downside. But what really screams out at me is how many important factors are at extremes … bad extremes. One or two off-trend numbers can be explained away, but too many are jumping off the charts – price increases, mortgage rates, loan growth, consumer debt and home ownership levels.

To invest in an asset class that is illiquid, has high holding and transaction costs and involves large amounts of leverage, I want a significant margin of safety. Right now, there are more warning signs than guardrails.