This is the final post about the CAAMP report discussed in the prior two posts. I want to discuss the idea of home owner equity as an indication of a healthy market.
In the CAAMP report, the discussion on home owner equity begins on page 27. First, a couple notes on methodology before we analyze the content.
CAAMP estimated home owner equity by taking the average mortgage amount (145K) and then taking the value of the average home, as estimated by the homeowner. The idea of basing total home owner equity on the estimated value of a home by its owners provides data of questionable reliability to say the least. Empirical studies routinely find that homeowners overestimate their home’s value by 6-10%. Point number 1 is that the value of the homes in question are likely 6% lower than reported, reducing the total equity they believe they have.
My second issue with the methodology is that it does not consider mortgage debt on rental properties within its calculation. Despite the fact that this report clearly indicates that mortgage debt has topped $1 trillion here in Canada, they use a total of $820 billion for their calculations in table 4-7. The footnote on the bottom of page 27 indicates the following:
“This total of $820 billion is less than the total amount of residential credit outstanding (reported by the Bank of Canada as about $1.008 trillion as of August 2009) as the estimate developed here does not include rental dwellings, investment properties, or vacant units.”
Why not? I would love to hear the rationale as to why those equity calculations are not included.
Current home owner equity in Canada…..a healthy 72%
From the report:
“Canadian home owners have about $2.08 trillion in home equity, which amounts to 72% of the total value of their homes”
That’s a great number. Really it is! But I wouldn’t mind putting that number into context.
With the exception of the minor blip in 2009, we have experienced one of the greatest ever bull markets in real estate in Canada since the early 2000s.
Home owner equity tells us nothing of the future state of the housing market. It is not a reflection of more prudent homeowners or better regulation. It is simply a reflection of the fact that homes have increased at a significant (I would argue unsustainable and unwarranted) clip for well over a decade now.
For an additional insight into this, consider the American experience. This experience is being echoed in Ireland, the UK, Spain, Italy, Portugal, France, etc, so it is not as though I have chosen the ‘worst case scenario’ to highlight a point. Ireland has seen home equity evaporate far worse than the US has.
To my point: Homeowner equity sat consistently around 60% in the US for several years before their bubble burst. Now before noting that Canadians have 10% more equity than Americans did, also remember that interest is tax deductible in the US. Because of this tax difference, homeowner equity has seldom reached the same levels as in other countries where interest is not treated as a deductible expense, thus creating a tax incentive to maintain a higher mortgage balance. From sources I’ve read, Ireland and the UK both had similar homeowner equity levels prior to their bubbles deflating.
The point is this: Homeowner equity always looks good after a massive bull market in real estate. But it doesn’t provide any predictive value in terms of the overall future health of a market. Here’s the complete version of the same graph:
You’ll notice that home equity evaporates very quickly in a real estate downturn as leverage losses quickly mount.
The point is simple: 70% equity sounds like a lot, but it is eaten very quickly in a even a mild real estate correction. Therefore I don’t consider the fact that Canadians have an average of 70% homeowner equity as any indication that we are any more insulated from the real estate woes currently gripping most Western nations.