As of September 30, 2016, the price for a single family house has risen 22 percent, from September 30, 2015. This could be discouraging for anyone not in the real estate market or for younger people looking to save for a down payment to buy a house. With prices at historic highs, the temptation may be to rush into real estate before it goes higher. Similar to the stock market, when you buy is extremely important. Buying your principal residence is different which we will explain below.
The housing market is typically one area where using leverage (borrowed money) to purchase an asset has been good. Let’s walk through an example of leverage to purchase a single family home in Victoria. According the Victoria Real Estate Board (VREB) the benchmark median value (September 2016) for a single family home in Victoria is $745,700. Unfortunately, the exemption rules with respect to first time home buyers and property transfer tax are archaic and unrealistic in larger centres – property transfer tax of $12,914 would apply. We think it would be beneficial if the province would adjust the qualifying value for exemption or at least allow some form of proration for affordable housing. In Ontario, the Finance Minister has announced that they will refund up to $4,000 from the land-transfer tax for first-time home buyers.
In addition to the purchase price, I estimate the following additional costs at a minimum: legal fees $750, house inspection $500, and house insurance $800. At a minimum, the immediate cash out-lay to purchase the home is $760,664. To avoid CMHC insurance, a purchaser must put a down payment of 20 per cent, or in this case $152,132.80. The remaining $608,531.20 must be financed or in other words, “leveraged”.
As noted at the very beginning, prices for Real Estate jumped 22 per cent in one year. It is, therefore, not unreasonable to stress test what would happen if real estate declined 10 per cent in one year. If a 10 percent correction in real estate prices occurred, then this single family home example would decline $74,570. Based on the down payment of $152,132.80, this would represent a loss on capital saved of 49 per cent. Illustrating leverage to a younger person is essential in order to understand the associated risks.
In our first column we talked about the tax benefits of owning a principal residence – essentially no tax on capital gains. Canada Revenue Agency has a term called “personal-use property” which applies to a principal residence. Any loss on the disposition/sell of a property which is used as a primary residence is deemed to be nil by virtue of sub-paragraph 40(2)(g)(iii) of the Income Tax Act.
If an investor entered the stock market with a non-registered account at a market high point before it pulled back, then, at least with the stock market, people are able to claim a capital loss and use it indefinitely.
Assuming a 25 year amortization and monthly payments, let’s do another form of stress test to see how a change in interest rates would impact payments on the $608,531.20 mortgage. Assuming a mortgage at 3.2 per cent, the monthly payments would be $2,949.43. If rates rise slightly to 3.7 per cent, the monthly payments would rise to $3,112.12. In the near term it looks like rates will stay low, but a realistic view of the 25 year amortization should reflect rates rising off historic lows. The best scenario would have the first time home buyer paying down as much of the principal before rates potentially rise to reduce the impact.
When interest rates go up, home prices tend to go down simultaneously. This would only compound the effect of the loss on capital saved in the short-term.
Taking a long-term vision and being sure that you can weather the stress tests above in the short-term are key factors prior to rushing in to buy a home. Similar to the stock market, we feel confident in the long-term that valuations will be higher than today.
Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138. greenardgroup.com
This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.