Sorry To NOT Burst Your Bubble

As an actuary, part of my training is to understand the proper use and limitations of statistics. Using broad statistics to describe complex issues can lead to misunderstanding at best and wrong solutions at worst.

This is exactly what has played out recently in Toronto with respect to real estate. Talk of how to address this problem has been all over the map. Our government has recently implemented measures to address what they see as the main problem – foreign buyers. There is some logic to this, because in a global context, Toronto is a world-class city with real estate prices that are still relatively cheap (think Hong Kong, New York, London, etc), However, data shows that only 4% – 5% of recent real estate deals in Toronto involved actual non-resident buyers. It’s quite likely that a significant proportion of deals involve foreign money being passed through local residents (spouses, relatives, business associates, etc), although there is no way to quantify this and no easy way for the provincial government to control it either (which may explain their focus on foreign buyers instead of foreign money).

To tackle any issue intelligently, one must first try to understand its root causes in detail, and more importantly, the magnitude of each cause. We put aside the presuppositions floating around in the media started with the most basic question – is this an actual bubble, or just a case of unaffordability & globalization? Is there a difference?

Our team decided to take a shot at mining real estate sales data and see if we could uncover anything resembling an answer. We started off confirming some of the general statistics published in the media lately. For example, the average value of residential real estate in Toronto has increased by 97% over the last 9 years (from 2008 to 2016). That’s almost double. It sounds impressive, but if you actually compare Toronto residential real estate to other investments, then 97% over 9 years works out to an annual “rate of return” of just under 8% per year. In happier times, a gross return of 8% per year would have been considered a reasonable stock market return. Mind you, economists and investment gurus will say that generally, real estate is less risky than stocks, which means real estate is “outperforming” expectations if it’s earning a rate of return similar to what would be expected of stocks.

However, note that 8% is the “gross” return – prior to taking into account expenses. It’s more costly to buy and sell real estate than a stock. In order to quantify this, we looked at expenses (maintenance & repairs, insurance, and property tax) which typically run about 1.5% per year (more for older homes), and transaction fees (land transfer tax, and realtor and legal fees), which can easily add up to 6% of the purchase price of a property – that is, roughly 0.7% per year over 9 years. This brought the annual “net rate of return” (after annual expenses and transaction fees) down to roughly 6% per year.

Not bad, but not as high as one would assume for an asset that virtually doubled in value over 9 years. Basically, residential real estate in Toronto has been performing relatively well as an investment, but it’s nothing to write home about. These annual rates of return actually tend to refute the “bubble” theory.

But what if we just happened to be looking at a “reasonable” time frame (the last 9 years). What if other time frames showed different results? For increased certainty, we ran the same type of analysis over other time periods ranging from 5 years to 20 years. Most of them revealed similar results, with the exception of the last 5 years, which showed average annual net returns of roughly 7% (instead of 6%) over the period.

However, this does not mean that there isn’t a problem in the real estate market in Toronto. First of all, 2017 has been very volatile so far (although we have yet to see how the recent regulatory changes will impact the market in the long run). More importantly, over the long run, average wages have not increased by anything close to 6%-7% per year, which means we definitely have an unaffordability issue.

We also tried to try to quantify the impact of changes in key factors during the last 9 years. We started with inflation and decreases in mortgage interest rates. Here’s a breakdown of how these two factors contributed to the average price increase:

Inflation was responsible for roughly 19% of the increase (out of a total of 100%).
Mortgage interest rates decreased by roughly 3% per year during the period. Mathematically, this means that for the same monthly mortgage payment(based on a 25 year amortization), a buyer can now afford a mortgage loan amount that is 60% higher than before!

So, between inflation and lower mortgage rates, we could now explain almost 80% of recent price increases. At this point we got lazy and decided that all “other” factors (including foreign money) were responsible for the remaining 20% of the increase.

But why would buyers be willing to agree to a 60% higher purchase price for the same property? One could argue that the majority of buyers look only at their initial monthly payment and tend to ignore the risk of rising interest rates. While this may not seem like rational behaviour for an investor, buying a home (especially for personal use) is often an emotionally charged decision.

Still, we felt like there may be something more to it. For example, the last 3-4 years have seen much less movement in mortgage rates and still high price increases. At this point we developed a theory – what if average statistics were not really based on the same homes? How many renovations, flips and complete rebuilds has Toronto had in the last several years, and how was this activity impacting real estate values over the last 3-4 years? This was NOT an easy question to answer.

The first logical step was to try to identify properties that had been subject to significant “value added” activity (such as major renovations, or complete rebuilds) in the last 3-4 years. Obviously, this type of extensive activity would be less frequent and more difficult to identify in condos, so we decided to stick to houses for the purpose of this exercise.

We downloaded almost 16,000 transactions from the MLS system (where realtors list houses for sale) that happened during the period of 2013 – 2017. We focused on detached and semi-detached houses in the “central” Toronto MLS districts (C01 – C15). We put all 16,000 transactions into an excel spreadsheet. Of these, we were able to identify roughly 1,000 that had been bought and sold again during that same period (specifically between August 2013 and March 2017). This now became our data set.Here are some key metrics from our analysis of that data (note that this is only for the detached and semi-detached segments of the market – it does not include condos or townhouses):

• Of the 1,000 “re-sold” houses, only 26 of them were sold for less than they were purchased (these were probably foreclosures, distressed sales, or has issues / damages that were discovered after the first purchase).
• On average, the “holding” period for these houses was 1.4 years, with a weighted-average price increase of 53% during that period (or 36% per year).
• Smaller & cheaper houses increased in value faster than bigger more expensive houses.
• After adjusting for transaction fees, net average returns were still 30% peryear.

But how much of this was caused by “value added” activity? Well, it turned out there was way more than we expected. We determined that at least HALF of the houses in the 1,000 house data set had been significantly renovated or completely rebuilt. We removed these houses from the data so we could analyze only the “apples to apples” houses (that is, houses that were bought and then sold again without significant renovations). Below are some key metrics for the “apples to apples” houses:

• The average “holding” period was a bit shorter at 1.2 years (which makes sense, since they did not need extra time to have significant work done).
• These houses showed average net returns of only 9.5% per year (compared to 30% per year for the entire group!).

This implied to us that many people were not buying the same house that was bought by the current owners. They were buying a house that had hundreds of thousands (and in some cases, millions) of dollars invested in it.

This has been an eye-opening exercise for us and our analysis has resulted in the following three conclusions:

1. Prices have been materially impacted by lower interest rates. What can we do about this? Not much, it turns out (at least not right away) – interest rates are a tricky beast because they impact all aspects of our economy, and the federal government is very hesitant to increase them at any speed faster than a snail’s pace.
2. The impact of “value-added” activity, which has been sorely left out of any mainstream media analysis, is a significant contributor to price increases and general unaffordability. What can we do about this? Well, I suppose the city could implement a moratorium on major residential renovations (or maybe a higher tax on “flipped” house sales). This would increase the supply of smaller, older (cheaper) houses.
3. Foreign buyer taxes may cause a temporary decrease in home prices (as we have seen in other cities), but the data does not point to foreign buyers as a major factor in these recent price hikes. Unfortunately, these are the issues our government has decided to focus on (perhaps because they are easier to deal with), while ignoring the real issues.

In the long-term, I believe housing prices will be tempered by other more general technological and societal advances. For example, working remotely continues to grow in popularity with forward-thinking companies. Advances in transportation technology will reduce traffic and increase efficiency (think inter-connected driver-less Ubers all moving in perfect sync). Eventually, many of the jobs that require a physical presence will not. Furthermore, developments in energy technology will allow people to live efficiently and comfortably “off the grid”. Canada has plenty of space and over time society’s focus will shift from where we live to how we live.

John Melinte is an Associate of the Society of Actuaries and a partner at Sky View Suites – a leading corporate housing firm in Toronto.