Wednesday, July 13, 2005


The Wealth Effect and Real Estate: the Pro's and Con's

Consumerism these days in both the United States and Canada is at its peak in light of the buoyant real estate market. Consumerism is a side-effect of capitalism - the good capitalism as Adam Smith might call it. Consumerism is that particular economic niche where you find wealthy consumers snapping up goods. Consumerism is good for the economy, as it promotes trade and the exchange of money. It is also bad, as it fuels inflation. And consumerism in 2005 is definitely spurred by ever increasing real estate values.
When people feel rich, they spend - a psychological effect known in Economics as "the wealth effect" . It doesn't matter whether their wealth is actual or merely on paper, whether the money they spend is their own or borrowed on the equity of their real estate. We saw this phenomenon at work during the stock run-up of the 90's, except that it is even more potent with housing. Over the past three years the wealth effect in Canada from rising home values has accounted for a third of all growth in consumer spending according to the Joint Center for Housing Studies at McGill University. Consumer spending, in fact, has been single-handedly responsible for keeping us out of a recession for two years. When house values increase - especially as dramatically as in recent months - people feel freer to spend from the wealth they have, or the wealth they perceive they have. They may decide to buy a bigger car, to eat out more often, to indulge in electronics or fashionable items, all of which is in most cases financed by their equity. And, strangely enough, people spend their hypothetical riches faster when their houses go up in value than when their stocks do, because they believe that housing gains are more stable.
But are housing gains really more stable? This is the $56 billion question of the first boom in the 21st century. Are today's real estate revelers partying like they did in 1999 - just before the stock market bubble burst? To some economists the housing market - especially in hot coastal areas like the Lower Mainland and Greater Victoria - is a bubble just as ripe for popping. The main reason, they say, is that there is no reason for it. Prices in certain areas have more than doubled these past three years and there is no fundamental to account for it. Not even the 2010 Winter Olympics which, they say, are still five years away. Instead many "bubbleologists" believe that what's driving the market is low interest rates, herd psychology, speculation and most of all the expectation of unending price increases. Meanwhile promiscuous lenders keep on throwing money at buyers. The lending business has become so cut-throat that practically anyone can walk into a bank and get a loan with zero percent down at three or four times their income.
Real Estate Boards across the country, however, thoroughly disagree with the doomsayers. Most predict another record year for real estate in 2005 with a median 9% jump in prices nationwide. Most Boards argue that there are substantial differences between real estate and the stock market. Real estate, they claim, is in fact based on tight housing, especially in places such as Vancouver and Toronto where it is expensive to build and where available land is in chronic short supply. Add such population factors as immigration, foreign buyers (snapping up properties cheap because of a relatively weak dollar) and baby boomers' demand for second homes and voila', there you have your sound real estate market.
Fact of the matter is that there are indeed troubling aspects to the real estate boom. If one wants to compare stocks to real estate, it is evident that at the peak of the stock market 1% of the investors controlled 33.5% of stock wealth. But in today's real estate boom, the top 1% of home equity holders nationwide have only 13% of all housing wealth. In other words, a broad drop in housing values - should it ever happen - would affect a far larger cross section of Canadians than did the stock market bust of 2000. To render this situation even more volatile, home buyers have turned to some risky strategies to afford their purchases, with the more or less tacit complicity of the Federal Government. Nothing down, interest-only loans and "negative amortization" (in which you wind up paying so little each month that your principal amount grows larger although, hopefully, your house value rises faster) mortgages are on the rise. Such loans can pay off if you sell within a few years at a profit. But if interest rates rise borrowers may become overwhelmed by steadily rising payments. The consequences of such an apocalypse would be felt throughout the economy. If enough homeowners become swamped by their debts and have to sell - or are being foreclosed upon - prices would drop creating a "reverse wealth effect" and bringing the entire economy to a grinding halt.
In any event, whether the real estate market rises, plummets or flattens, whether it happens in one year or five, it will not undo the changes that the boom has wrought in the relationship between the homeowner and the home. This particularly applies to the notion that the house is no longer just a home. By tapping into their wealth through refinancing and home-equity loans, many homeowners have ensured that the idea of the house as piggybank will stay with us for a great many years to come - the wealth effect.
Luigi Frascati

As Featured On Ezine Articles Platinum Author

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