Former U.S. Federal Reserve Chairman, Alan Greenspan, was interviewed recently on the subject of economic bubbles which many economists have been suggesting we are heading towards. In fact, some proclaim we are in one already.
Living in a Bubble: Time to sell and run for cover
Greenspan said: “When bubbles emerge, they take on a life on their own. It is very difficult to stop them, short of a debilitating crunch in the marketplace.” He should know what he is talking about as he was right there, heading the Feds during the 1989/90 housing crash. About a year before that debilitating crash, he was continuously warning that the real estate bubble was about to burst, but not many heeded his warnings. There is a lot of evidence to support his new reference to the present bubble in the U.S., and for that matter, Canada as well. In fact, we may be worse off than our American neighbours. More about it later.
The U.S. is presently living in the third biggest stock bubble in its history. Their stocks are about 80% overvalued on certain key long-term measures, according to research by financial consultant, Andrew Smithers, the Chairman of Smithers & Co., and one of the few to warn of the bubble of the late 1990s at the time. History shows that the bubbles form from time to time, and affect some, or in certain instances, all segments of the economy. A major high-tech bubble occurred in the 1990s, as many Canadians may remember, but back then many investors re-invested their money in the real estate sector which started to improve by 1997, following its disastrous collapse of 1989/90. To what degree will the bursting of the next economic bubble affect investors and the ordinary folk on the street is anybody’s guess, but the consequences of it may be severe. When the bubble bursts, the exit strategy is most probably not going to be reinvesting in real estate.
The question is not whether another crash is around the corner but when it will happen. It may happen in 6 months or 2 years from now. An interesting article appeared in The Globe and Mail on April 20, 2014, “RBC economist predicts home price declines in 2016, as rates rise,” which is in concert with the U.S. Federal Reserve Bank’s announcement that their quantitative easing, which kept the American economy breathing on artificial lungs for quite some time now, may come to an end by the end of this year. This means no more printing bonds to keep the economy going, plus much worse – introducing higher interest rates to combat the possible inflation. This will automatically affect the Canadian economy as well.
Should the U.S. raise its interest rates after the end of the quantitative easing as many economists predict, Canada will have no choice but to follow suit. Increase of interest rates is almost always associated with inflation. Inflation is one of the most feared economic conditions which drives consumer confidence down and historically speaking, brings housing appreciation down to zero.
Some argue that Canada and the U.S. are, economically speaking, different countries with Canada having an edge over their southerly neighbours reflected in more vibrant markets. Most of the real estate industry stakeholders still adamantly maintain that due to high demand, there will be no real estate bubble bursting in Canada any time soon. They base their argument on Canada outperforming the rest of the world, ever since the global meltdown of 2008. However, the recent article that appeared in the Globe and Mail on August 11, 2014 by Jim Stanford, demystifies that myth. I may add to that another myth that needs to be demystified – believing the bail-outs extended to our banks by our governments during the 2008 crisis did not happen and that we’re not intrinsically connected with the U.S. economically, in spite of the fact that the average Canadian is aware that they are our major trading partner. Stanford states that Canada’s boastful claims are increasingly far fetched and riding on federal conservative claims for this country’s supposedly superior performance, whereas in fact, we now lag many other countries, and our relative underperformance is getting worse.
Speaking of real estate, the average income of Canadian household’s is a major obstacle when it comes to purchasing it. The erosion of affordability is at an all-time high, due to artificially inflated real estate prices.
Notwithstanding what you may read and/or hear in certain selective media, real estate, and particularly its condominium section, is being pushed on buyers by means never seen before. No down payment schemes that offer $10,000 cash back which can be seen all over Metro Toronto ads for condos, indicate that developers are struggling to sell their over-inflated inventory to anybody that knocks on their door. This in spite of official government policies pointing to such practices as being unfair, if not worse. Our chief central banker Mr. Stephen Poloz seems to be unable to enforce his own warnings. After the passing of Jim Flaherty, our former Minister of Finance, there seems to be no one in Ottawa willing to enforce the rule against the kick-backs from developers, who resort to unfair sale tactics, for the sake of moving the real estate sector forward. That should change and fast. It seems no one is paying attention to the dismal jobs reports in this country. Huge numbers of the millennial generation burdened by heavy student debts, cannot even afford to rent, let alone buy their homes.
According to at least two chief economists of our major banks, they don’t know the demographic ratio of real estate buyers, i.e. are they mostly foreigners or domestic investors? This may not even matter to the average Canadian as the affordability factor is at an all-time low. Some bankers estimate that up to 48% or more of the average household income presently goes towards paying taxes, and maintaining mortgage payments and maintenance fees, in the case of condos. You seriously compromise your quality of life by paying so much for the roof over your head by not having enough cash left for other basic necessities of life. When interest rates shoot up, you may not be able to afford your financial obligations, thus risking your property.
A disturbing reality may present itself, which I quote in my book, The Condo Bible, Everything you must know before and after buying a Condo, (available at your public library): “The ever-increasing number of real estate purchases by newly wealthy emerging foreign investors may bring temporary relief to the economy on a whole but could cause irreversible damage to Canadian citizens who may not be able to equally compete with these investors in the future. Simply put, the bidding on real estate products by such wealthy buyers will drive prices out of reach of what most buyers can afford.”
By monitoring the exceptionally over-inflated real estate values with the average household income of Canadians, one comes to a sad realization that even if the interest rates were to remain at historical lows, Canadians simply can’t afford to pay huge payments on the correspondingly over-inflated mortgages. Paying for a shoe-box size condo of 400 sq/ft up to $800 or $1,000 per sq/ft in downtown Toronto or Vancouver, does not make any sense at all. The public should know that prudent developers spend no more than $350 per foot to build the condo unit and that often includes the so called “soft costs.” The condo hype riding on the “pride of ownership” was well designed, resulting in ever increasing prices, all for the benefit of developers and municipalities which charge separate realty taxes on those units. In other words, a typical cash grab scenario at work.
In my estimate, the overall real estate in Canada is overvalued by at least 35% and as far as condos go, up to 50% in some selective urban areas, such as Vancouver and Toronto. If real estate was to crash simultaneously with the stock market, the future would not bode well for the Canadian economy. Such a possibility may become a very painful reality to existing home and especially condo owners as well as seniors whose livelihood depends on dividends from invested stocks. On the other side of the coin, the crashing of real estate would spell some relief by providing plenty of inventory to choose from at reduced prices so one could expect cheaper homes and condos as well as rental accommodation for everybody.
Recent reports from Canadian stakeholders in the real estate industry suggest that a considerable amount of purchased real estate is being rented out as it is bought by investors that don’t live in their invested properties! This is eerily reminiscent of the period of time before the 1989/90 real estate crash where investors/speculators were trading amongst themselves not realizing that there was no end-buyer for their condo units. When they sobered up, panic ensued as they fled the market, causing the commencement of the real estate price collapse.
In order to avoid such an unpleasant scenario which is in the offing, it may now be wise to sell your investment in real estate and stocks and hold on to your cash. In times of uncertainty, “Cash is King.” You can buy stocks and real estate cheaper once the bubble bursts and the devaluation takes place. It may be exceptionally wise to sell your overpriced condominiums and stay away from them altogether, as they are extremely volatile in any economic slowdowns. Most condominium complexes are comprised by unit owners of various financial strengths. Remember: the weak financial unit owners will be the first ones to go when the market tanks, causing vacancies in the complexes and putting a strain on the remaining unit holders by way of high maintenance fees and special assessments.