Risks In Real Estate

frustrated-couple

Recently there have been a lot of news articles talking about real estate deals gone bad. First there were the Mattamy homes in Whitby that dropped almost $100,000 in price this year. Buyers from last year had remorse and begged to get their home prices readjusted but to no avail.

Then came another Mattamy story out in Oakville where buyers who bought at the peak are now having difficulties closing on their new homes. These buyers are now complaining that they are in dire financial trouble and need the government to assist them to bail them out. This has led to a very public outcry and a social media push to get the general public on their side.

Then you have the condo buyers out in Vaughan, where over 1100 condo units were cancelled due to the lack of financing available to the builder. It seems the banks are no longer willing to take on big project risks anymore.

Finally we have stories of buyers losing hundreds of thousands of dollars because of deals gone bad. It’s starting to look like the “safest investment” doesn’t hold true anymore.

These stories lie on opposite ends of the spectrum. On one end, falling detached house prices have buyers calling foul because appraisals from banks state that their home is no longer as valuable as when they had purchased them. Now mortgages are in jeopardy.

On the other side, buyers of condos are angry because prices have continued to rise and they are no longer being built. This means some buyers are now priced out of the market and those looking for a quick flip are no longer able to make a quick profit.

It seems no matter which way prices are going, up or down, home buyers are not happy.

The Risk Is Real

To many, real estate represents the safest investment. It’s hard to argue against that fact since many of our parents have seen the price of their homes rise substantially. Similarly, over the last 20 years, real estate in Canada hasn’t really fallen. Compare that to the stock market where stocks fell over 50%. This never happened in real estate.

The shock that many real estate buyers and investors are experiencing now is a cycle that has probably never happened in their lifetime. Rising interest rates and lack of affordability has put a big damper on real estate sales. Prices that were never supposed to drop have fallen by double digit percentages in the surrounding Toronto areas. This is not good news.

Now buyers are sitting on the sidelines because they don’t want to fall into the same fate as buyers from last year, where they were caught buying a house they couldn’t afford. Those buyers have lost money by losing deposits and losing lawsuits for walking away from signed deals. Even condo buyers need to be wary of defaults by builders and the lost interest from deposits that were paid for units that never got built.

All this negative news has led to a decline in real estate activity. Sales of homes are down 22.7% in March across all of Canada. Much of the fall has been concentrated in Vancouver and Toronto markets because these are the two least affordable markets in Canada.

mortgage-stress-test_infographic

Courtesy Global News

It might seem ridiculous, but those qualifying income levels are well beyond the average income for a family in Toronto and Vancouver. Bring on the fact that those average prices can’t even get you a detached home and you can see why the market is on ice right now.

Real Math

What many people don’t understand when real estate falls in value is the risk of being underwater on their mortgage. Some may argue that falling prices don’t mean much because they are still hovering around 2016 levels, which is still more than twice the value from 10 years ago. This is true, however, there is always a small segment of buyers who purchased recently in the last year that will be hurting the most.

Being underwater on the mortgage means that the house is worth less than the outstanding mortgage. This hurts buyers of real estate because it means that selling the house would still result in a large short fall that the home owners would need to cover. It might seem like this wouldn’t matter if the house is kept till it’s paid off, but this rarely happens. For whatever reasons, people on average only stay in their homes for 6-7 years before moving. We’re nomads no matter how you think of it.

Now the scarier thing. When prices are up 100% that’s great. It means you would have doubled your purchase price. When prices fall though, they don’t have to fall by the same amount for you to come back to the original price. Something that goes up 100%, only needs to fall 50% to get back to the original price. It’s not 100%. Yes, the math isn’t the same. Just think about it a little.

In the case of areas in the 905 near Toronto, some areas like Markham and Newmarket have experienced prices drops of greater than 20% year over year. That’s the equivalent of losing 25% of gains which is quite significant.

Psychology

The greatest risk to the real estate industry isn’t rising interest rates or the falling prices, but our own mental perception of the marketplace. If people start getting scared and run for the exits because of a slight price correction, then we may get some panicked selling and a housing crash. This seems unlikely at the current moment because enthusiasm for real estate ownership is still at an all time high. One only has to look at a recent convention in Toronto pumping real estate and Bitcoin to see that there are still many people that are “motivated” to stay in the game.

Nothing in the market is stronger than emotions. So long as people continue to want to own real estate, the market should remain stable. That’s why it’s not a time to panic, but more a time to reflect about what real estate and home ownership means to you.

As prices continue to fall, don’t ask yourself whether you are afraid of losing money buying or owning real estate. Ask yourself whether that is the lifestyle choice you want to commit to. Owning a home isn’t about making money, it’s about whether you want that to be your defining legacy. Once you feel committed to owning a home, that’s when it’s necessary to review your finances and make sure it’s affordable to you. Everyone is different, but it’s important that you understand the risks before jumping in.

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