A Fighting Chance Finance

Over the past 12 months, during the covid-19 pandemic, we have noticed an incredible run up in house prices in certain areas. Why did this happen? What can we expect moving forward? Nobody knows for sure, but here are my thoughts.

The Quarantine Effect

A few critical actions occurred in the past 12 months which have caused a seismic shift in the housing market. The first is buyer preferences. When the Covid-19 pandemic hit, local governments began implementing various forms of lock downs, which meant that the way we interact with residential real estate changed dramatically. Almost overnight, urban condominiums and apartments which were hugely popular before the pandemic for the lifestyle they offered lost their lustre. Why?

Imagine a single downtown urban dweller who lives in a 600 square foot one bedroom condo in a downtown core. Before the pandemic, their building offered an array of luxurious amenities like fitness, coworking, a pool and sauna and maybe a community congregation area for barbeques and social events. They live downtown because of the merits of an urban lifestyle as social, convenient and exciting. Now, offices are closed, many amenities are closed and the condo which used to be mostly used for eating and sleeping is now the sole 600 square foot space that urban dweller is allowed to occupy. I can understand the desire to leave cramped small spaces for the suburban lifestyle when folks are working from home and can’t enjoy all the benefits that downtown urban lifestyle offers.

As a result of the desire for more space, many suburban towns which pre-pandemic had low demand given distance from city centres have become real estate hotbeds given their offering of large single family homes on large lots.

Take Barrie Ontario as an example. Barrie is well over an hour drive from downtown Toronto. In Barrie, housing prices grew to an average $708,801 across the first quarter of 2021, which is a 35 per cent increase over housing prices noted in 2020. Excluding Barrie, the average price of a home throughout Simcoe County was $775,860 between January and March, a 46 per cent increase over last year.

The Interest Rate Effect

When the pandemic hit, the most powerful tool governments had to spur the economy and keep it from collapsing was interest rates. As interest rates fall, borrowing to invest becomes cheaper and there is less incentive for people to have money in bank accounts earning negative rates of return after inflation. On a recent visit to my bank, I noticed that the chequing account interest rates are down to 0.01% ANNUALLY. That means that if I put $10,000 in a chequing account, it earns $1 of interest per YEAR. As such, people and businesses now have an incentive to borrow and to invest.

Further, people are worried about inflationary impacts from the trillions of dollars of new money supply being printed. When people are worried about inflation, they try to use their dollars to buy assets like gold, real estate and stocks which give them a return to maintain their wealth. As we have seen, the stock market, the real estate market, the crypto market and even the precious metals markets have all sky rocketed due to these low interest rates and incredible new government induced liquidity.

As long as interest rates are low, people will buy real estate. The impact on monthly payments is too enticing to pass up. I’ll illustrate with some math.

Let’s take a typical $500,000 mortgage on a 25 year amortization as an example. A few years ago, the interest rate on a fixed rate mortgage might have been around 4%. The monthly payment would be about $2,600. Of that $2,600 first payment, $1,700 would go to interest and $900 would go to principal reduction. In the first year, assuming a 20% down payment, the mortgage payments would reduce the principal of the mortgage by nearly $12,000, which is a 9.5% increase in home equity. Even at a 4% rate, that’s a great equity building opportunity.

Enter 2021, and fixed rates have decreased to 1.75%. The payment is now $2,000 per month, and the first payment goes $1,300 to principal and $700 to interest. In year 1, principal repaid is $16,085, and represents a 13% increase in equity.

To put it a different way, if $2,600 is the monthly budget, that payment at a 1.75% interest rate now services a $631,000 mortgage, thereby increasing the buying power of this person by $131k.

What do I expect?

I am not a trained economist, and much of any prediction about future house prices, interest rates and inflation require an economist. I think that record low interest rates cannot last forever. They will probably stay low for another year or maybe two, but eventually when the economy returns to normal after Covid-19, and that huge money supply now in the system is put into use at restaurants, for travel and general economic velocity, the central banks of the world will need to raise interest rates to counter inflation. This is because higher interest rates will incentivize people to take money and save it to earn those rates, rather than spend it, thereby taking money supply out of the economy and helping to manage inflation. Higher interest rates will help to plateau the rise in house prices as very significant input.

However, there are other factors which go into house prices.

Immigration has been largely ceased during the pandemic as borders are closed. However, in Canada at least, immigration is needed to ensure Canada is not decreasing in population. Immigrants generally come to large city centers and increase demand for housing, causing prices to remain resilient.

Consumer demand, in my opinion, will move back to favoring urban centers once people are asked to return to the office (which I also think will happen) and remember why they lived downtown in the first place. Namely, they will realize their new suburban residence comes with a long painful commute, long distances from entertainment venues, great restaurants and the “buzz” of downtown. In fact, I predict that many suburban communities which have seen dramatic run up’s in prices will see dramatic collapses of prices as people want to leave and the demand for suburban lifestyle returns to pre-pandemic levels.. Time will tell.

In summary, I think house prices will level out over the coming years as higher interest rates take effect and demand for geographies rebalance. Only a crystal ball knows for sure!