Coreen T Sol
May 17, 2023Financial literacy
Real Estate/Real Bias
Last week, I met a mortgage broker at a social event. He was a big fan of real estate—perhaps an occupational hazard. To drum up a casual conversation, I mentioned that the Teranet-National Bank™ year-over-year Composite Home Price Index fell 8.5%, more than the previous record set during the 2008 financial crisis.
His response was complete disbelief, and he immediately argued about why real estate doesn't ever drop.
Behaviour is often predictable and consistent under certain circumstances. Yet, it is still startling how many people believe that real estate values only rise. Part of that reasoning is that if you live in your house, you won't sell it if the market values drop; therefore, we often reason, your investment never falls because you didn't price it during the downturn.
Many of those same individuals grumble—or even worse, sell—when their stock or bond portfolio drops during a temporary economic downturn.
There is good evidence that investors can tolerate investment volatility when they stop checking the market values. It stands to reason. Reviewing your investment accounts—especially when markets become jittery—induces fear, leading to excess trading and holding cash for too long.
Both of which lead to underperformance.
There are a couple of other behavioural reasons investors are falsely lured into believing that real estate is the best-performing asset class. First on the list is that the numbers are big! For example, my friend bought a home in the Okanagan in 2006 for $850,000 and sold it in 2021 for $1.6M! That seems to be a considerable gain, but it's only a measly 4.52%.
You may feel the urge to point out that they only had a small amount invested since most people have a mortgage. Borrowing to invest amplifies the return on the amount of money you have at work. Having a mortgage means you have much less money at stake.
But when mortgage interest rates are higher than the growth of the asset, that argument fizzles out. And don't forget that investors can also borrow to invest in other asset classes for the same enhanced effect of leverage.
With real estate, there are two unique advantage that don’t exist with other asset classes, however. Tax advantage is one. In Canada, a primary residence grows tax-free; in certain circumstances, mortgage interest may be tax deductible. The second is that you can live in your home, while you can’t live in a stock portfolio.
Despite these advantages, don’t be overcome with bias. Once you realize the effects of large numbers, leverage and avoiding regular valuations, you can apply this view to all asset classes.
The moral of the story?
Even conservative investors can tolerate a well-constructed investment in volatile asset classes when they limit the frequency of valuing those assets. If you can sleep on the train knowing that the engineer will get you to the station, you probably won’t notice the bumpy ride.
This passage should not be construed as advice since it cannot consider your circumstances. Please contact our office for investment advice tailored to you and your family. We are accepting new private wealth clients with over $3 million in total family assets.