Monday, March 27, 2006
Canada v. USA
Which is the better real estate investing environment? Read on ...
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First and foremost let me state here and now for the record, that Canada is flexing its military muscle once again. It seems that the nuclear sub – I forgot the name but there is no mistaking it … Canada has only one, bought second hand from Britain – that had to be de-commissioned because it was leaking underwater, is now going to be re-commissioned. Apparently the leak has been fixed. Alright, now that we can sit at the table on even footings, let me go straight to the point.
A caveat must be made here to the extent that the purpose of this Article is not to compare real estate markets but, rather, to compare economic environments. It is next to impossible to compare real estate markets since, as experienced investors no doubt already know, real estate markets are far too many and too varied to render any comparison at all meaningful.
A recent report prepared for and on behalf of none other than The Bank of Nova Scotia and released in February reveals, among other things, that the 2005 Household Debt to Income indicator measured as a percentage of disposable income is 13.8 percent in the United States (and rising), and 7.7 percent in Canada (and falling). The Household Debt to Income indicator, also known as ‘debt service ratio’ is very important, in that it measures the ratio of the mortgage payments to disposable income. Clearly the lower the indicator the lower the incidence of service debt on disposable income, and the higher the cash reserves. When the ratio gets too high, households become increasingly dependent on rising property values to service their debt.
The Household Debt to Income indicator, therefore, is nothing more than a measuring gauge of property owners’ wealth. The above figures just released merely reflect the fact that Canadian property owners keep the yield they receive from their real estate investments, contrary to their American counterparts. This is so because the financial leverage of each country is different. Financial leverage takes the form of borrowing money and reinvesting it with the hope to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. But conversely, the potential for loss is greater because if the investment becomes worthless, not only is that money lost but the loan still needs to be repaid.
Because real capital appreciation has been constantly more remarked in Canada than in the United States these past few years, it turns out that leverage is stronger in Canada than in the U.S., meaning the spread between real capital appreciation and cost of borrowing is higher in Canada. And this notwithstanding the fact that mortgage rates in Canada are typically nominally higher than in the States and that, in fact, wages in Canada are typically nominally lower.
Household Debt to Income influences another economic indicator important for real estate investing: the Household Debt to Equity Ratio, also known as ‘loan to value’. This is the ratio of the mortgage debt to the value of the underlying property and it increases when homeowners refinance and tap into their home equity through a second mortgage or home equity loan. According to the report of The Bank of Nova Scotia, the 2005 Household Debt to Equity Ratio is 73 percent for Canada (and rising) and 53 percent for the United States (and falling). It is easier to understand loan to value by looking at things in reverse. A 73 percent ratio simply means that the cost of borrowing is the difference between 100 percent of total value of the real asset minus the owner’s equity – in the case of Canada 100 – 73 = 27 percent. Hence, average cost of borrowing in Canada expressed as a percentage of disposable income was 27 percent in 2005 as opposed to a whopping 47 percent in the United States.
As stated before, this ratio increases when homeowners refinance and tap into their home equity through a second mortgage or home equity loan. Which, therefore, again goes a long way to point out what American property owners do with their equity – they spend it, in contrast with Canadian property owners who instead save it.
This brings into light the real essence of the difference between investing in an environment such as the American as opposed to the Canadian. The American economy is based on consumption and gives priority to consumerism, that is spending as opposed to saving. As such, Americans typically earn higher wages, at times make even a higher capital appreciation but ultimately end up spending more and saving less. Canada, on the other hand, gives precedent to saving, so that Canadians are cash and equity richer, even in the instances when they actually make less money. Which, at the end of the day, makes Canada a much more stable environment when it comes to investing. This goes further to explain why the American economy is far more susceptible to interest rates variations: with a domestic debt load nearly double, the economic ripples caused by shifts in cost of lending travel twice as far in the U.S. than in Canada.
A fact, this, that is reflected in the weakness of the Greenback vis-à-vis the Loonie. The Canadian Dollar has steadily gained value, according to the report, rising from a low of USD $0.62 in 2002 to USD $0.86 in 2005 and thus making the purchase of American real property assets more affordable for Canadians. Which is no good news to American mortgagors, since an increased international demand for the Greenback will cause a rise in domestic interest rates and, in turn, a higher Household Debt to Equity Ratio which will lead to an even higher Household Debt to Income indicator.
Luigi Frascati
Real Estate Chronicle
