Performance figures for each account are calculated using time weighted rate of returns on a daily basis. The Composite returns are calculated based on the asset-weighted monthly composite constituents based on beginning of month asset mix and include the reinvestment of all earnings as of the payment date. Composite returns are as follows:

The Tipping Point

By John Nicola, CLU, CHFC, CFP

IN THIS ISSUE: Has the Housing Bubble finally burst? For the past six years or so, real estate prices have soared with virtually no end in sight – but recent drops in the US housing market might have tipped the scales. How will this affect Canada and, specifically, BC? How does this affect mortgages payments and interest rates? Will there even be a Canadian correction? In this article, John Nicola explores the influence and impact of downturns in the US housing market.

when Malcom Gladwell wrote his best selling book, “The Tipping Point” (Back Bay Books, 2002), he used many metaphors to describe that one additional event that can often trigger momentous and sometimes cataclysmic events (such as the one extra Timbit that prevents your jeans from zipping up).

Over the past few years, we have been writing and speaking about our concerns regarding the potential for another asset bubble in housing that could match or even exceed the manic dotcom 90’s (Castles in the Sky, June 2003 and Lord of the Manor, September 2004).

One of the problems of being a fundamental value investor is that expensive markets can remain that way much longer than logic would ever suggest, and often assets we think are pricey continue to march onwards and upwards with classical irrational exuberance. Since we first expressed our housing concerns in 2003, many of the more attractive markets have risen by 30-40%. If one had the foresight then to buy a Vancouver Condo with 10% down and completion in 2006, the returns earned would have made the NASDAQ pre-2000 look like a lame duck. No question timing helps.

The problem for some investors is when they confuse being lucky with a new paradigm that says housing will rise forever at a rate that is 200-400% the rate of growth of the economy and individuals’ incomes. Logic dictates that is impossible for any length of time and, in fact, the longer it persists, the more likely a reversion to the mean can occur and prices will correct.

Recently, there has been a lot of news about the end of the US housing bubble. There are many articles on this (see references on the next page), but one of the most quoted is a blog written by NYU economics Professor Nouriel Roubini (

Here are some of the highlights:

  • Toll Brothers (the largest builders of McMansions in the US) says this is worst slump they have seen in their 40 year existence. They recently gave up options on 35,000 lots worth over $1.6 billion, because of the drop in demand.
  • Angelo Mozilo (CEO of Coutrywide – the US’s largest independent mortgage lender) says he has never seen a “soft landing” in 53 years. Expect conditions to get much worse.
  • Both new home and existing home sales have dropped considerably in July of 2006 and have left unsold inventory at multi-year highs
  • One year ago, median house prices in the US increased by 15%. As of June 2006, that had dropped to 0.9%. Since WWII, median house prices have never dropped in a 12 month period of time. Depending on what occurs over the last 6 months of 2006, we could see the first drop in median housing prices in the US in 60 years.
  • 30% of all new employment created in the US in the last three years was directly and indirectly related to housing.
  • Up until interest rates leveled off recently, Americans have been using their homes like ATM’s, refinancing them to free up cash for spending. In 2005, that amount was estimated to be $700 billion, or about 7% of national income. These Mortgage Equity Withdrawals (MEW’s) have declined significantly, and with it so will consumer spending, which is the main driver of the US Economy.
  • In 2007, $1 trillion of Adjustable Rate Mortgages (ARM’s) roll over ($1.7 trillion is the estimate for 2008). In the spring of 2004, when mortgage rates bottomed, ARM’s were 3.6% and now as of September 2006 they average 6.6%. That 3% difference will take tens of billions of dollars of annual income from consumers’ pockets and most of the effect of this has yet to be realized.

 So is the potential bursting of the US Housing bubble a precursor to the next recession? Will it have any affect on Canada and in particular BC? How will our portfolios react to a drop in housing prices if that is what occurs?

As a contrarian, perhaps the best news is that when I Google “Housing Bubble”, I get somewhere in the vicinity of 11,700,000 hits. Reading them all takes up a decent part of my Sunday afternoon. If so many people are writing or speaking about a crash in housing, then almost assuredly it will not happen. In the convoluted thinking of contrarians this should be so… shouldn’t it?

Not this time, most likely. The rapid run up in housing prices, which has been a global phenomenon for the last ten years or so, has already ended in a number of jurisdictions such as Australia and England. But as the table below from The Economist shows, many countries are still realizing double digit increases in housing prices. Interestingly, however, neither Canada nor the US is the frothiest of markets, so perhaps any future corrections will be milder here.

But why should there be any correction at all? Why couldn’t house prices just level off or rise at a slower pace? Anything is possible, but let’s examine some fundamentals.

Robert Schiller is a well-known Harvard economics professor who accurately predicted the fall of the Dotcom Era (and equities in general) with his book, “Irrational Exuberance” (Broadway, 2001). He wrote a follow up to that book last year called “Irrational Exuberance – Second Edition” (Princeton University Press, 2005) in which he took issue with the US housing market. One of his more interesting research results is a graph (see next page) that shows how for over 100 years until the mid-1990’s, US housing prices adjusted for both quality and inflation, sold in a very tight range, and overall had not increased in that century. Since then, inflation and quality adjusted prices have increased by about 75% in the US.

Why would this do so? We could look at many factors, but the two largest factors in my opinion are:

  • The continual lowering of interest rates
  • Strong global economic performance

With the normal exceptions of economic slowdowns and recessions, which are part of the business cycle, there is no reason to assume that global incomes and wealth will not continue to increase (although the rate of that growth will likely slow down – something we will review in a future newsletter). The impact of interest rates, however, is another matter.

Common sense tells us that if interest rates drop, the cost of financing a mortgage will also drop and make it cheaper for us to buy a home. As the illustration below shows, a 6% drop in mortgage rates between 1992 and 2005 has allowed the average homeowner to borrow 70% more debt for the same cost. Therefore, lower interest rates make financing a house cheaper – correct? The answer, unfortunately, is in no way clear. In fact, it is quite easy to make an argument that higher interest rates make total financing costs much less expensive when one factors in the long-term effects of inflation. How can we spout this heresy? Consider the following example and results:

Over the long-term, mortgage rates work out to about 3-4% over the inflation rate. That means when mortgage rates are at 5.5% as they are now, we would expect inflation of around 2% (and we are quite close to that number). Similarly, if mortgage rates were 10% for an extended period of time, we could expect inflation to be around 6-7% annually.

Most mortgages are funded over 25 years and issued based on the income of the borrower. So let’s connect the dots and see what the real impact of higher interest rates is.


  • $500,000 mortgage amount amortized over 25 years
  • The borrower’s after-tax income is $150,000 and increases each year with inflation
  • Scenario 1 is a 5% mortgage rate with 2% inflation. At 5%, the mortgage payment is about $35,000 per year (or 23.4% of the borrower’s current income).
  • Scenario 2 is 10% mortgage rates with 7% inflation. At 10%, the mortgage payment is around $54,000 per year (or 36% of the borrower’s current income).

Which person will pay the lowest total mortgage payments as a percentage of their total spendable income? Better yet – is this a trick question?

As the illustration below shows, there is no trick but perhaps an illusion. The 10% mortgage will cost an additional $487,000 more over 25 years, but the 10% mortgage exists in a 7% inflation environment and, as such, the borrower will earn almost twice as much after-tax income over 25 years. So as a percentage of their income (i.e.: how much of my cash flow will it cost me to pay off this mortgage?), the 10% mortgage requires 14.4% vs. 18.3% for the 5% mortgage. Inflation is a borrower’s best friend (and, by corollary, a lender’s worst enemy).

In this case, in the 25th year, the 10% borrower is now earning $760,000/yr and the mortgage payment is only 7.2% of his income, while the 5% borrower’s income has only risen to $241,000 and her mortgage payment is still 14.5% of her income.

(A note here: this example works, because we are taking longer to pay off the debt and, as such, inflation is reducing the value of what is left owing over time. If the borrowers were to pay off the mortgage sooner, then inflation would have a lesser effect. The two scenarios have virtually the same result over ten years, so if the mortgage is paid off over ten years or less, then those lower rates will make the overall cost of the debt cheaper.)

By the way, when we look at an analysis such as this, we are not pining away for more inflation and higher interest rates (along with wide lapels and platform shoes). We are simply observing that the statement – lower mortgage rates make real estate less expensive – does not always hold up when all factors are considered. Paying more for a condo or house simply because the first mortgage payment is lower than it might have been a few years ago is, in most cases, not justified.

Before we reach some conclusions and observations, we should consider our local markets. The points below show an interesting story related to Vancouver housing prices.

  • Over the last 25 years, housing prices in Vancouver have risen about 7% annually which, coincidentally, is about the same as the annual increase in average incomes.
  • Over the last 5 years, the annual price increase has been 12.3% per year and more than 20% over the latest 12 month period of time (far more than the increase in incomes).
  • In the last 25 years there have been two occasions when Vancouver house prices dropped on average by more than 10%, and these periods of time lasted for 5-6 years from peak to recovery (1981-1987 and 1995-2001).
  • According the MLS Housing index, prices have increased by 85% in the Lower Mainland between 2001 and 2006. However, condo prices are up even more at 115% for the same period of time. (This seems to me to make condos the housing asset with the greatest risk and the greatest potential leverage.)


So will we see the same type of rapid housing slowdown that is being realized in many of the most attractive US cities such as San Diego, Miami, Phoenix, Las Vegas, and Boston?

We have several factors that support a better result for many areas of BC. Quality of lifestyle, immigration, and economic growth are just some of them. Still, just as a rising tide lifts all boats, it will eventually recede. A major US housing correction will have a significant affect on consumer spending and likely cause a recession in the US. We will never be immune from that. Mortgage rates are rising slowly and no longer make MEW’s easy or practical.

Prior housing corrections in BC have tended to be slow and controlled. Nevertheless, they also seem to last a long time. We always want to think that this time it is different (Olympics, commodity prices, beautiful city, etc…), but that is why cycles occur. Housing prices will increase over time as a function of inflation and rising incomes, but history suggests that they will not rise much faster than that for a prolonged period of time. We are 6 years into this housing boom – likely closer to the end than the beginning.

For most of our clients the value of their home may be an interesting bit of information, but it has little effect on their retirement income or level of financial independence.

Downsizing never seems to occur financially (the new home or condo maybe smaller –perhaps even better and newer – but it is rarely cheaper). On the other hand, a flat or slowly declining market would be good news for many younger citizens and also for those who wish to move up in size or quality.

Let’s just hope that any corrections we see here or in the US are measured and not precipitous – in other words, let’s hope this “Tipping Point” comes with a gradual slope.