Relying on rising home prices could be a fool's strategy: Don Pittis

If you are certain house prices will keep rising, paying more than you can afford seems completely justified. But the strategy changes when house prices turn flat.

The 'greater fool' justification for paying more than you can afford is waning

Buyers may find it rational to purchase homes they cannot easily afford if they expect prices will continue to rise rapidly. (David Donnelly/CBC)

New data from the Canadian Real Estate Association indicates the rules have suddenly changed for people trying to buy into Canada's pricey real estate market.

The latest CREA figures are not in themselves worrying, showing prices are roughly flat. 

Of course, an average figure disguises wide differences in areas such as Toronto, where prices continue to soar, and Newfoundland and Labrador, where they have plunged by 10 per cent.

But if averages mean anything, Canada as a whole has reached a turning point where, on average, one of the strongest justifications for paying more than you can really afford for a home has disappeared.

The fundamental reasons for a slowdown in real estate are various.

A change in rules for foreign buyers has hit the Vancouver area. The crash in oil prices from the 2014 peak near $100 U.S. a barrel has hit oil-producing areas. For more sophisticated buyers, fear that North American interest rates will rise may be having an effect.

But the effect of flat property prices on potential buyers has much more to do with psychology than traditional market fundamentals. That does not weaken its effect.

Timing can be everything

The justification for overpaying for property or any other speculative asset is sometime called the "greater fool" theory.

Former federal minister and business journalist Garth Turner wrote a book on the Canadian property market called Greater Fool: The Troubled Future of Real Estate. 

Former federal minister and financial journalist Garth Turner warned about the strategy of paying too much for a home while assuming the price will rise. (Key Porter Books)

Of course, if you had bought a house using the greater fool strategy in 2008, in most parts of Canada you would have done very well indeed. There have been few better investments.

But when markets are changing direction, timing is everything.

The essence of the greater fool effect is that buyers may actually know they are being fools by buying overpriced assets. They walk in with their eyes wide open.

"It is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price," explains the website Investopedia.

Average house prices in Toronto rose by more than 20 per cent last year. (Adrian Cheung/CBC)

In the stock market, where prices can continue to go up due to popular euphoria long after a decline has been signalled, the greater fool strategy depends on being sure you are not the greatest fool. You must sell just before the market madness ends.

Getting in deep

The danger in the Canadian property market is subtly different, because prices have been rising so quickly — and until recently so reliably — and because the prices are so high. The most important consideration may be that many Canadian buyers have been knowingly getting themselves in too deep.

"Perhaps most important, speculative fervour thrives on expectations of rapidly rising prices — rising rapidly enough that buyers find it rational to make bets they could not normally afford," said The Economist magazine.

That quote was in an article about the market in collectible sports cards, but the phenomenon applies just as well to houses.

Bidding more than you could afford on a gorgeous Vancouver house seemed less risky when prices were rising more than 20 per cent in a single year. Average prices dropped by 19 per cent in January compared with a year ago. (Simon Charland/CBC)

Getting in over your head may not be a worry when house prices rise 24 per cent in a year, as they were at the beginning of last year in Vancouver.

But when house prices are no longer shooting up, Canadian buyers must begin to think seriously about whether they are still willing to go out on a limb with their finances when they can expect no bailout from a soaring property market.

And that can have its own impact on prices.

Other things being equal, without the reassurance that real estate will keep rising, the most cautious buyers at any level will scale down their aspirations. They may be less likely to throw themselves into bidding wars.

In many parts of the country, that has not happened yet. Bidding wars continue to hit the news. Just last week in Brampton, a city outside Toronto, a house attracted 500 viewings and 82 offers, selling for hundreds of thousands over asking.

Lenders are usually careful to investigate the paying power of buyers, though maxing out the bank's mortgage limit often squeezes out other spending, leaving buyers "house poor" and with little in the way of emergency savings. 

The federal government has adjusted mortgage requirements to make sure new homeowners have a buffer if interest rates rise. 

It may be that the current slowdown in the rise of house prices is merely a blip, a plateau before another climb.

People have to live somewhere. Perhaps the demand for new housing in areas of the country where the economy and population are growing will force desperate house hunters to continue paying more than they would like simply because there is no alternative. 

But when average house prices begin to go flat, it is reasonable that some buyers will exhibit greater caution. When markets are turning, no one wants to be the person who pays the highest price. Nobody wants to be the greatest fool.

Follow Don on Twitter @don_pittis

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About the Author

Don Pittis

Business columnist

Don Pittis was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London. He is currently senior producer at CBC's business unit.


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