Opportunity cost is an important concept in the world of finance. Institutional investors that played a key role in the housing market growth in the U.S. and Canada understand the significance of “forgone benefit”.
This class invests in different assets to derive maximum returns. In order to safeguard a risky investment, like in the hyper-volatile cryptocurrency space, these investors will park some money in safe havens and stable assets with balanced returns, such as S&P 500 index funds.
Retail investors that have accumulated record mortgage debt tend to overlook the concept of opportunity cost.
Investing is both a science and an art. A prudent investment strategy involves a good understanding of available options. An individual with disposable income can invest in a variety of options. Certificates of Deposit are traditional options that promise fixed returns. Then there are stocks and market-related instruments, which do not provide fixed returns but have become a mainstream option today.
Real estate assets are placed within the “traditional option” category. In the long term, the returns on these assets are positive with few exceptions.
The Canadian housing market is not exactly identical to markets of other developed nations. According to Statistics Canada, 63 per cent of Canadian families owned homes in 2016. In 1999, home ownership was at 60 per cent. This means the country has many more potential buyers to keep up the momentum in the real estate market. Moreover, Canada has a liberal immigration policy, and new Canadians or foreign students will help sustain momentum in home purchases as well as rentals.
House prices versus S&P 500 index
The MLS Home Price Index (HPI) provides a quick look into how prices have unfolded in Canada since 2005. The Aggregate Composite HPI was 242,700 in January 2005 (base year). The index rose to 200 in the second half of 2016 when the Aggregate Composite HPI nearly doubled.
Numbers suggest it took almost 11 years for home price levels to double.
The S&P 500 index has given a compound average yearly growth of nearly 11 per cent over the past 30 years. The return was as high as nearly 32 per cent in 2019, and the index also delivered negative annual returns on a few occasions.
The HPI soared to 300 in April 2021, thanks to the buyer frenzy in the housing market. It means home price levels went up by three times in almost 16 years. By this count, it can be complex to arrive at the opportunity cost of investing in real estate assets.
What accompanies a rising housing market is mortgage debt. Canadians now owe nearly $2 trillion in mortgage debt. Debt increased by $18 billion in April, the biggest-ever growth on record. Data by Statistics Canada suggests that Canadians have been paying down their credit card debt in record figures. While credit card balances had been constantly rising since 2000, debt dropped 18 per cent in the one year ending January 2021.
Despite the economic downturn brought on by the pandemic, Canadians have paid down non-mortgage debt at a record pace. A buildup of high mortgage debt remains an outlier, and a likely cause of concern but only in the event of a slower-than-expected economic revival.
Are housing markets cooling?
Data compiled by CREA suggests a persistent slowdown in the market. The average price peaked in March 2021, and subsequent months have seen a decline in both prices as well as the number of units sold. The declining trend in July was the same in most provinces. This is despite the Bank of Canada maintaining record-low policy rates that have brought mortgage rates to below one per cent.
In other countries, housing markets are exhibiting similar signs of cooling. In the U.S., the median home price was US$359,900 in July. The year-on-year growth was 17.8 per cent, but it was down from a growth of over 20 per cent recorded over the past year. The inventory of houses increased in the U.S. in July. In Australia, the Australian Bureau of Statistics data reveals a drop in demand for new home loans.
The cooling of housing markets, in Canada and elsewhere, has yet to turn into a large decline in housing activity. The slowdown over the past few months has not been anything near the “crash” or “bubble burst” that some analysts were predicting. As stated earlier, a large number of Canadian families are yet to own a home and the influx of immigrants, both residents and students, is likely to keep up the momentum in the near-to-medium term.
Opportunity cost unlikely to hurt investors
The opportunity cost – the value lost when money is not parked in an alternative option – of investing in the housing market of Canada is not likely to hurt investors.
For now, all factors that fueled growth are intact. The federal government has extended supports ranging from an emergency wage subsidy to rental assistance until October. Regardless of any change in the House of Commons after this election, the new government will be skewed toward providing all necessary support to the economy. The Bank of Canada has retained near-zero policy rates and any near-term withdrawal of liquidity is unlikely.