Thursday, 10 May 2012

Is There a Housing Bubble in Canada?

When people ask, "Is there a housing bubble?" they are often also asking a slightly different question: "Will there be a crash in the housing market that will affect the economy in general?"  In many cases, the answers to these two questions are one and the same.  In Canada's case, there may be a difference.
The US economy continues to putter along at a steady, but sluggish, pace, several years after the Great Recession.  People no longer even bother to wish out loud for a "V-shaped recovery."  There's an obvious reason for this: the housing market, which has been flat on its back since 2008, remains a major drag on the economy (for a discussion see my earlier article on housing and the economy).  North of the 49th, many Canucks worry that a similar bubble will cause an unwelcome crash. 
The US housing bubble had two dimensions: sky-high house prices, and tremendous oversupply of housing units.  When working properly, the forces of supply-and-demand ensure that excess supply is brought into balance with demand via lower prices, and vice versa.  It's a testament to just how out-of-whack things got that prices doubled in many markets, despite massive overbuilding that would normally force prices down.  When the double-bubble burst, of course, the crash was disastrous. 
Is there too much supply?
There is little evidence of oversupply in Canada's housing market.  Though there was a period from 2002 to 2007 when new builds exceeded household formation, perhaps half of that excess has been sopped up since (1).  Moreover, this followed a decade-long period of underconstruction (2).  If there was a large inventory of vacant homes it would be apparent in at least two statistics: price and vacancy rate.  Certainly, as noted, in extreme manias price and supply can move upward in tandem, but prices have not fallen.  In addition, the vacancy rate is low.  Last year it was just 2.2%, and is expected to remain stable in the near-term (3). 
What about Toronto's white-hot condo market?  Despite a well-publicized boom - 18,000 new units will be completed this year - the city's vacancy rate is expected to remain low in 2012, at just 1.3% (3).  Besides, oversupply in a certain segment of a certain city, even in Canada's largest metropolis, would not necessarily indicate a broader nation-wide problem.
Even if there was a modest oversupply of housing units, significant net migration is expected in the medium-term, enough to fill any vacancies.  Total net migration was 234 000 in 2011, and is expected to reach    254,000 in 2012 and 259,000 in 2013 (3).  Of note, though, in April, 2012, there were a seasonally adjusted 245,000 housing starts, a 27% year-over-year gain.  While one month doesn't make a trend, sustained building in excess of household formation would naturally lead to a surplus of supply. 
Are prices too high?  If so, why?
There is compelling evidence that Canada's housing market is overvalued.  Historically, the ratio of price-to-income has averaged 3.5, but currently stands at 4.75, leaving the market 35% overvalued (4).  As the basic truism goes, real estate is mostly a local market, and some of Canada's important local markets are grossly overvalued.  Vancouver, for one, sports a 10-to-1 price-to-income ratio, and Toronto is far above the average, at 6.7-to-1 (2).  In addition, the ratio of household debt to disposable income has ballooned to over 150%, just shy of the 160% or so level that US and UK homeowners reached before their housing markets crashed (4).
Several causes have contributed to high prices.  First, very low interest rates.  One study found that of the 45% increase in real prices between 2001 and 2010, 6 percentage points were due to declining mortgage rates (5).  Second, over time many renters have become buyers, pushing up prices.  Part of this has been driven by a shift in mindset, with people considering homeownership not merely a lifestyle choice but as an investment opportunity.  However, very low interest rates will eventually increase, and will likely restrain, or reduce, prices.  And with a high rate of homeownership - 70% - there's little additional capacity for renters to become homeowners (2).  Finally, high prices will themselves cool demand.
Will there be a soft landing or a hard one?
Currently, very few mortgage holders are behind on their payments.  While there's no hard-and-fast limit, borrowers that must devote 40% or more of their income to service debt are at risk of insolvency.  According to some research, only 6.5% of Canadians are at or above that threshold (6).  But how abruptly will this change when interest rates rise?  At first, perhaps, not very.  After all, 68% of outstanding Canadian mortgages are fixed rate (2), as are most refinancings (7).  And the remaining 32% of variable-rate borrowers will have an opportunity to lock-in rates as they begin to climb.  Importantly, Canadians hold 67% equity in their homes, compared to just 39% in the US (2).  Still, with housing prices overvalued by 35%, they would fall by 26% to revert to the average.  Any major shock - the European debt crisis, a sharp slowdown in China - could cause a sharp fall in prices.
There is little evidence of oversupply in Canada's housing market, but ample evidence that it's overpriced.  Prices will eventually fall to meet the long-term average.  This could happen slowly: say, a 3% drop per year, combined with 2% inflation, for a 5% annual real correction for several years.  However, given how frothy prices are, a more severe correction is a real possibility.
But there is little reason to fear the disaster that the US housing market inflicted on the broader economy.  To be sure, a fall in home prices would soften consumer spending due to the "wealth effect," the tendency for people to spend more as their assets appreciate, and less as they lose value.  However, there should not be any significant falloff in new home construction, the related spending that accompanies it - new furniture, yard equipment etc. - or the jobs tied to building.

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  1. Are prices too high and Why?

    You forgot to include the role of CMHC in the equation.
    As well, changes made by government to mortgage rules - ie - 0 down and 40 year amortizations.

    1. Good point. It was a wise and responsible move to tighten mortgage standards, or prices would be even higher. They should not have been relaxed in the first place.