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It seems like everybody has agreed that there is a price bubble in the Toronto residential real estate market.  And all bubbles end (eventually).  So, the next question should be: how to put your money where your mouth is?  How to profit from this knowledge?  The answers reveal a lot about real estate markets. 

The obvious answer is to sell an asset before its price falls.  A recent story in the Globe and Mail notes that some people are already doing that, either by selling the property and then leasing it back or by selling in Toronto and buying somewhere else.  In other words, you do not need to own a property to live someplace nice.  If you sign a long term lease or include a right of first refusal clause in the lease then you may be able to buy back the same property at a lower price.

This example illustrates one of the special features of a real estate market: its asymmetry.  Buying one or more homes to profit from a price increase is easy.  In a stock market, if you think that prices will fall then you can profit by “shorting” the stock (i.e. sell shares that you do not own with the promise to replace later).  Since it is difficult to sell a house you do not own, there is a built in bias to price trends.

When the US market started to crash, the price of a share in well-known home builders fell.  So, maybe, you should short the shares of such companies.  The problem with implementing this advice is that many home builders are not publicly traded and most of the traded companies are national rather than narrowly exposed to Toronto.

One of the most robust bits of advice for people wishing to reduce their risk is to diversify.  Some somebody should study the correlations between various stocks and the state of the housing market.  Most people suspect that the banking sector would be positively correlated (think of mortgages).  While true, mortgages are only a small fraction of the portfolio for a Big Five bank and, in any case, Canadians have a habit of not defaulting on mortgages even when times are tough.

There are other ways to profit in theory from a crash but the needed institutions are not well-established in Canada.  Robert Shiller’s book Macro Markets is a good introduction to the issues.  Similarly, introducing “shared appreciation mortgages” would change this discussion.

So, it is hard to profit from knowing that a price bubble will end, even if you were certain that it will end next Tuesday.  For all of the certainty offered by pundits, nobody is offering that guarantee.  So, maybe the next questions should have been: do you know all that you need to know?

Shorting a market requires courage, especially if others disagree with you.  Bubbles are strange economic phenomena because they are unstable.  Some people think that they can get out in time: a few are right but most exaggerate their ability.

It is true that young home owners are highly leveraged and that, on the day that the price falls, they will regret having bought.  Older home owners will regret not selling.  But, if they live in a house that they like and do not move for many years then slow inflation eliminates any paper loss when they do sell.  As a long term investment, real estate is not that risky in nominal terms.

Finally, note that real estate markets are illiquid.  The transaction costs associated with buying or selling are substantial and come in many forms.  In addition to taxes and commissions, finding the right person and negotiating a good price takes time and emotional energy.  So, the price does not represent profit.  Further, liquidity can change when market conditions change.

So, who is willing to put their money where their mouth is?

PA

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