Buying & Selling Homes

Chapter 1
Canada’s Housing Bubble Defies Gravity

The market for real estate, particularly individual homes, would seem likely to display speculative booms from time to time, since the psychological salience of the price of the places we see every day and the homes we live in must be very high, and because homes are such a popular topic of conversation.
— Robert Shiller, Irrational Exuberance, 2000

One of the earliest uses in recorded history of the word bubble in relation to financial speculation was in reference to the South Sea Bubble — the South Sea Company was a joint-stock company founded in England in 1711. It issued shares to the public in 1719 and in less than a year increased its stock market value ten-fold. A short time later, its stock price had dropped back to close to the original listing price, a crash that reduced the value of the company by 90 percent. Fortunes were made and lost. Despite the huge devaluation in the share price of the company, it continued to exist; indeed, it eventually took over responsibility for the debt of the Government of the United Kingdom.

The Bubble Company, as it was known, copied the Banque Royale, a company that was formed in France in 1716, which was also organized as a joint-stock company and used to finance government debt. Both of these companies were created for the purpose of converting government debt into shares of stock in a listed company. This idea of paying off government debt with shares sounds crazy today, but, at that time, it fired the public imagination and many ordinary people got caught up — speculators would eventually lose their life savings. These two companies and other similar copycat companies became known as the bubble companies. The concept became so popular that the U.K. parliament passed the Bubble Act in 1720 to control them.

Another, more famous, instance of financial insanity and speculative fever was a period known as the tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn’t referred to as a bubble, perhaps because of the difficulty for the human tongue in saying “tulip bulb bubble.” Some people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person’s life savings for one rare bulb. The fad spread to England and many other countries. Even today, in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago.

The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash, along with widespread public involvement and fascination.

Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn’t do any better in providing explanations, since bubbles don’t readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. Even Canadian-born economist John Kenneth Galbraith — who discussed many of the most extreme bubbles in A Short History of Financial Euphoria, and provided analysis that does a much better job of explaining economic cycles than do most of his peers and successors — fails to come up with a suitable definition of the bubble phenomenon. Galbraith merely states that they are recurring episodes of collective financial insanity, fuelled by greed, and that they are inevitable.

Given the difficulty of experts who have studied bubbles in detail in coming up with a coherent explanation regarding the origin of bubbles, their nature, or patterns, it’s not surprising that it’s next to impossible for the average person to detect when they are in the grips of a manic episode of excessive speculation. The only defence is to develop a healthy degree of skepticism, an attitude that comes naturally to few people.

One such person is Jeremy Grantham, the founder of the large investment firm GMO, who manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him in New York City after he presented at a conference in 2003. He opened his remarks by stating, “I’ve never been wrong.” The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause, he continued, “I’ve been early,” and the room erupted into laughter.

Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim, the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for the bubble participants who ignore the warnings. Inevitably, the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction. As Grantham says in an April 2014 GMO quarterly letter, “the pain will be psychological and will come from looking like an old fuddy-duddy.” However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price. Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right. When the financial crisis hit in 2006, it began with housing, and the next year spread to the financial industry, eventually resulting in the collapse of Bear Stearns, and, in 2008, Lehman Brothers.

Grantham described his research into bubbles. His research showed that “all [ twenty-eight] major bubbles … eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed.” The definition used for a bubble was any event that was two standard deviations from the mean. Standard deviation is a statistical tool that tells how unusual an event is. Bubbles of that size, according to Grantham, are expected to occur at a frequency of once every forty-four years. The U.S. housing bubble exceeded 3.5 standard deviations from the mean, an event that would be expected to happen very rarely, only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003, and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the United States and the world for decades.

Back in the late 1990s, I went on a personal quest for a tropical paradise. For one thing, I wanted to get away from the cold winters of Canada’s Alberta foothills, but I was too restless and too young to just head south and flop on a beach. First I tried the Caribbean, but it was overcrowded and overpriced. I was born too late to get started there. The best spots in the Caribbean were developed twenty or more years before I set out on my search.
The prime parts of Mexico were also overdeveloped. A forest of high-rises filled with tourists on package tours was not my idea of paradise. I prefer boutique hotels to mega-resorts. So I started looking in Central America. Costa Rica attracted me. What’s not to like? It’s peaceful and prosperous with everything from mountains to beaches and a democratic government to boot. I bought some land and embarked on a small venture.
Working in western Canada, based in the free-market province of Alberta, I was spoiled, plain and simple. Titles pass easily through the system, as they do in the United States. Throughout much of the English-speaking world, the land survey regime is open, accurate, and, above all, easy to understand if you move from one place to another.

I considered Costa Rica. It is a wonderful country; however, I discovered, after spending time in the capital, San José, and travelling throughout the country, that it was already developed and prices were too high to get in on the ground floor. It seemed that the elevator had left the lobby long ago. Another problem is the country’s legal and land-transfer systems. Frankly, it is a nightmare. For someone used to British common law and the transparency at work in countries such as Canada, the United States, and the United Kingdom, Costa Rica and other Central American countries, as well as Mexico, are very frustrating places to invest. The laws are based on the old Spanish civil code. Everything is in Spanish. It means lost time, money, and endless frustration.
You might think that because of all this I would have run. However, I was young and impatient to prove my investment savvy. So, I bought some property. It didn’t take me long to realize that I had made a mistake. I took a hard look at the place and decided, after I owned property there for a short while, that the country was not for me. I quickly soured on Costa Rica as a place to live and make money.
While I waited to sell my property, I looked at the map, and saw Belize, formerly known as British Honduras. It wasn’t a random flip through the atlas; a friend of mine tipped me off to the place.

***

My first trip to Belize convinced me it was the spot: an undeveloped, affordable paradise with everything going for it.
I quickly found that there were big differences between Spanish-speaking Costa Rica and English- speaking Belize, not the least of which was language. The common language and culture may explain the friendliness toward Americans and other English speakers in Belize — something that is noticeably different from the kind of grouchiness that exists in many parts of Spanish-speaking Latin America and even in some of the other English-speaking countries in the Caribbean.
From my experience — and I am a man of colour — they embrace all newcomers in Belize. In the town of San Pedro on the island of Ambergris Caye, where I spend a lot of my time when I’m in Belize, visitors are treated as if they are locals, which to my mind is the highest compliment. There are three main streets in the town, with the beach at one end, and the ferry terminal at the other. Simple. And that’s how life is there, too. It is difficult to describe just how friendly the place really is without seeing it with your own eyes.
Not only is there respect for people of all types, there is also respect for private property here — something that is very much part of the British heritage of Belize. This means that the state doesn’t act in an arbitrary way, enacting laws that penalize foreign property owners, as often happens in neighbouring Mexico. This respect for property means the law makes it extremely difficult for people to seize property under so-called squatters’ rights. That sets it apart from most Latin American countries.

I’ve been fortunate enough to give hundreds of talks about personal finance, mortgages, and real estate investing across Canada, from teaching MBA students at two of Canada’s top MBA programs to speaking to large groups of “everyday people” at major convention centres. I’ve learned many lessons from these talks, and I believe any speaker will tell you the same thing: as much as we try to add value to our audience members’ lives, we probably receive more from them.
Of all the lessons I’ve learned, I believe the core lesson is about the general psychology of money. It comes down to this: In spite of our best efforts, we fail to think mathematically about money. Instead of calculating income, expenses, taxes, and ROIs, we act emotionally and instinctually. We allow the momentum of past generations to decide our financial future.
I’ve often started talks with a simple question that demonstrates the time value of money. You can play along at home by asking yourself this:
Would you rather have $1 million today or a penny that doubles every day for a month?
Keep in mind that attending a live event is akin to entering into a social contract. You often know that the speaker will try to disorient you, challenge you, and alter your perspective. With this social contract in place, you’d think audience members would expect a challenge question and that the correct answer would be obvious. When a speaker asks such a question, the counterintuitive choice must be the correct one.
But even knowing that I’m asking a challenge question, the audience’s response is typically heavily weighted to the answer that will give them far less money. When I ask them to raise their hands if they would take the $1 million, a large majority puts up their hands. When I ask who would take the penny that doubles every day for a month, the number of hands that go up is a small minority.
I need to stress again that the audience will do this in spite of the fact that it must be obvious I’m presenting a challenge question. It’s a tangible example of how we struggle to think mathematically when it comes to money.
Now, $1 million sounds like so much money compared to a little old penny, but due to the power of compounding interest, that little old penny is worth $5,368,709.12 by day thirty. If you want to consider a thirty-one-day month, it would be worth $10,737,418.24. In both cases, that little old penny has been transformed into a magic seed, and, not unlike a seed, we don’t see its possibilities until it has grown.
The typical audience response is instructive, as this is exactly what happens in the daily financial life of most individuals. Due to a failure to think mathematically, or a misunderstanding of compound interest and the time value of money, we make impulsive decisions that are bad for our finances. If we can’t visualize compound interest and the time value of money even when the example is extreme (doubling daily), what chance do we have with the pedestrian conditions of real-world finance, where a strong return might be only 7 percent over an entire year?
Once you add in market fluctuations that result in paper losses some years and poor decision-making that leads investors to pull out of the markets, you end up with the shaky and often difficult-to-understand reality that most investors face. Because we fail to understand the opportunity cost and time value of money, we continue to make short-term financial decisions. We are willing to give up $10 million for $1 million. Is there any wonder why we struggle to take control of our financial lives?
Our mental models around personal finance are largely broken. Failing to invest early is the greatest of these weaknesses. Business Insider recently told this age-old story graphically using imaginary investors — Bill and Susan.
Susan invests $5,000 each year between the ages of twenty-five and thirty-five, for a total investment of $50,000. As I hope you never would, Susan stops investing at age thirty-five.
Meanwhile, Bill doesn’t start investing at age twenty-five. But he smartens up at age thirty-five and starts investing $5,000 per year (as Susan did for only a decade). Bill decides to make up for his failure to invest early by investing longer than Susan. He invests $5,000 every year between the ages of thirty-five and sixty-five. Overall, he invests $150,000 of initial capital compared to Susan’s $50,000.
But, in spite of investing a third of the initial capital, Susan’s portfolio at sixty-five is significantly larger than Bill’s. Due to the power of compounding and the principle of investing early, Susan has $602,070, while Bill has only $540,741.
But we Canadians are prudent folks, aren’t we? Surely most of us live more like Susan than Bill? Actually, statistics suggest otherwise. The household savings rate in Canada has plummeted in the past few decades from around 20 percent in 1981 to slightly below 5 percent today.2 There are a lot more Bills than Susans. Pun intended.
Bill is probably average. But on the lower side of the average, many people have next to nothing in their retirement accounts. Failing to invest early is the biggest, nastiest risk of all the retirement risks. But who can blame Canadians for not saving early? Life is expensive, and many people simply don’t have any cash left over at the end of the monthly bills. Plus, who wants to live a spartan life without some of the simpler enjoyments, like a family vacation or two every year and a car that doesn’t squeal?
I won’t (yet) talk about Canadians’ tendency to borrow money to purchase expensive liabilities like boats and vacations. But even without these needless expenses, many people don’t have the resources to get started investing young. Hence the savings rates are low. This is the changing nature of our personal finance environment. It sounds bad, and for many it is bad. But, more than anything, it simply represents a change in the marketplace — and Canadians need to adapt.
You can change your approach, however, so that you can take advantage of massive sources of capital that are just sitting there, right now, to be used. Tapping into this “dormant equity” will allow you to overcome this first major hurdle on your way to a successful retirement. It will allow you to invest early and, therefore, profit longer.