The ‘soft landing’ thesis: Valid, but highly unlikely

It’s getting increasingly difficult to dismiss outright the notion that real estate in Canada is extremely pricey based on measures of fundamental values.  I have yet to receive an intelligent response from the bull crowd addressing these fundamentals.  At best we hear anecdotes (“endless rich Asian investors”), non sequiturs (“a correction hasn’t happened yet, therefore it won’t”), and other arguments that contain an element of truth, but ultimately hold little water when considered rationally (“immigration will save us”, “they’re not making any more land”, “our banks/consumers are more prudent”, etc)

Perhaps the one very valid argument often thrown around is the idea of a soft landing in real estate.  Consider this point raised by a commenter from a previous post:

“I’m merely trying to float the idea that prices might go sideways and prices may not collapse at all or decline very much in the centre of Toronto and Vancouver. All the reasons I stated above (inheritance, inter-generational wealth transfer, wealthy immigrants -ed.) may play a part. But those reasons are either a) discounted altogether by you or b) met by a defensive scoff or c) challenged by your pathetic machismo when faced with an alternate point of view which we’ve seen ad nauseum on every other bear blog.”

My pathetic machismo aside, let’s consider the scenario posited by the bold, anonymous poster….hey, it’s easy to have machismo when you hide behind an internet pseudonym.

The ‘soft landing’ thesis has certainly been suggested in the Canadian media:

Housing achieves a soft landing in conservative Canada

A soft landing or something worse?

….just as it was in the US back in 2004-2006

Housing to make a soft landing

A soft landing for housing

Of course this proves nothing other than the fact that when an economist on either side of the border whose income relies on preventing a housing crash tells you that a housing crash is highly unlikely, consider the source.

Definitions

So how do we determine the likelihood of a real estate crash vs the likelihood of a ‘soft landing?  Let’s start with a couple definitions.

Here’s how I would define a ‘crash’ in an asset market:  The price decline roughly mirrors the rapid price increase in both duration and magnitude.

This is a common feature of asset bubbles:  They are roughly symmetrical in shape and duration.  Consider the following examples borrowed from Chris Martenson’s excellent primer on bubbles:

A ‘soft landing’ on the other hand involves a similar rapid rise in asset prices followed by a plateau in gains while fundamentals catch up.

It’s important to note that virtually all economists today will fall into one of these two camps.  It is exceptionally difficult to find an economist who believes that the price increases we’ve seen in real estate are sustainable into the future as they have massively outpaced income growth and inflation.

VREAA’s examples:

If house prices in Canada are in fact in a bubble, and the price movement mirrors the movement in prior bubbles, what might that look like?

Some possible scenarios were explored in an interesting post by VREAA, where the author used technical analysis to examine potential future price movements in the Vancouver market, arguably the most overextended market in Canada, if not the world.  The author recognized the inherent difficulties in examining price movement in real estate using TA, though it provides some interesting scenarios to consider should the price movements mimic those of bubbles in the past.  The tricky part is knowing where the real estate bubble started, which would then become the resistance point.

I won’t re-post the entire content, though I do suggest you check it out for some interesting insight.

Now this doesn’t prove one way or the other which way the market is likely to move, though I do think VREAA is absolutely right that IF the Vancouver market is in a bubble (it is!), it will very likely return to its support level in a symmetrical manner.

Empirical Data

Enough of my opinion or the opinion of other bloggers.  What does the empirical data say?

Interestingly, the research I read, and I read quite a bit, suggests that soft landings are exceptionally rare when asset prices move significantly out of line with fundamentals.

To wit:

“First, we emphasize that the real estate price peaks which are currently under way in many industrialized countries (one important exception is Japan) share many of the characteristics of previous historical price peaks. In particular, we show that: (i) In the present episode real price increases are, at least for now, of the same order of magnitude as in previous episodes, typically of the order of 80% to 100%. (ii) Historically, price peaks turned out to be symmetrical with respect to the peak; soft landing, i.e., an upgoing phase followed by a plateau, has rarely (if ever) been observed.“

Similarly, an article published in the journal Urban Studies in July 2010 had the following to say:

“A systematic deviation of a price from its fundamental value over a sustained period of time, on the other hand, can only be the result of speculation. Such deviation is thus called a speculative bubble.”  (pg. 1727)

“History tells us that the faster and larger the bubble inflates, the more likely it will burst in the less benign way” (pg. 1728)

This comment follows a discussion on ‘soft landings’ versus ‘crashes’.  The ‘less benign way’ referred to here is in reference to market crashes.

If interested in referencing this article, here is the full reference:

Xiao, Q. (2010). Crashes in Real Estate Prices: Causes and Predictability. Urban Studies, 47(8), 1725-1744.

Key Implications:

While it may perhaps still be debated whether or not the real estate market in Canada is in a bubble, it is become increasingly difficult to debate the fact that prices are straying significantly from measures of fundamental value.  How they will realign with these fundamentals is certainly up for debate, though it is worth noting that significant overvaluation in real estate markets seldom corrects itself by remaining stagnant.

That being the case, I would put the odds of a Canada-wide stagnation in house prices at an absolute maximum of 25%, with the odds of a sustained increase over the next few years at 5%, and the odds of a significant correction over the course of a few years at 70%.

Pricier markets like Vancouver, I would weigh those odds much differently.  I see the odds of a stagnation in prices at less than 10%, a sustained increase over the next few years at less than 5 percent, and a significant correction at well over 80%.

Cheers

Ben