For some reason, most discussions about the future prospects of housing in Canada are emotionally charged. We seem to have staked our collective national pride on the fact that we were able to stop a hemorrhaging real estate market in 2009 by plugging it with government stimulus and sacrificing property virgins who were lured by emergency low interest rates. Our government was able to do what the US government was not. And because of it (not to mention the massive consumer debt accumulated in the past few years alone) we now have a housing market and pseudo economy that are the envy of many nations.
Many seem to have also staked their personal pride on the fact that for most families, their home has been the best investment they have ever made….or at least think they’ve made before subtracting carrying costs, maintenance, taxes, and selling fees from their windfall.
It’s an interesting phenomenon that people will so adamantly defend the housing market as though merely pointing out the fact that housing is significantly overvalued by historic norms is somehow akin to a cheap shot at their mother.
A great example is the heated discussion that took place over the weekend in the comment section of my last post. I’ll address one particular comment in a moment, but for now it suffices to illustrate the feelings that these discussions generate.
Facts vs. Anecdotes
Let’s cut through the emotions for a minute and let’s put some indisputable facts on the table. While it’s possible to disagree on the exact implications of these facts on the future direction of real estate prices, it’s important to note that these are in fact……well, facts. They all apply to the broad Canadian real estate market, and it’s important to note that while the aggregate trends suggest an extreme valuation in real estate on a national basis, it should not be construed to mean that EVERY city will be affected equally.
- 1) House prices are near historic highs when measured against the rents they generate
- 2) House prices are 30-50% above the long-term price/income multiple, with Vancouver taking the prize as the most unaffordable city in the entire Western world.
- 3) House prices have outpaced inflation and wage increases for nearly a decade, with massive differences in the past 5 years.
- 4) House prices are at the upper boundary of their historic measures of affordability…..with interest rates still hovering near historic lows.
- 5) Interest rates cannot get meaningfully lower, but absolutely can and will at some point get considerably higher.
- 6) Home ownership rates are at historic highs. This is not simply a reflection of an aging population. Home ownership rates have risen across all age groups, suggesting that wide-spread group think, rather than demographics, best explains this now historic level of home ownership.
7) Total population growth is a meagre 1.3% nationally. Our immigration policies, while accommodative, are not exceptionally different than the US policies. Even with our current immigration, total population growth is projected to continue slowing to 0.5% in 15 years.
8) Net household formation has been running at approximately 175K since the mid 1990s. Yet housing starts have averaged closer to 200K in that time. It’s very difficult to explain this without using the terms ‘speculation’ or ‘demand being dragged forward’….it’s impossible to explain how this trend can continue indefinitely absent rampant speculation.
9) Even with projected immigration, net household formation is expected to fall over the next 25 years.
These are the facts. Taken together they certainly suggest that the broad Canadian housing market has come through a period of unprecedented growth and now faces a very uncertain future. The first six facts suggest to me that current valuations are extremely rich across much of the country, though most significantly in several larger centres. The remaining points suggest to me that demographics are set to overwhelm even projected immigration, weighing on housing demand. Immigration, by all estimates, will not be the holy grail that will allow house prices to defy fundamentals indefinitely.
With these facts established, let’s discuss probabilities:
1) House prices continue to rise unabated, outpacing inflation and income growth.
- Not likely, though certainly not impossible over the short term. But what would the end game be? Average house price breaches a cool million while household incomes average 100K, consuming 70-80% of income? Let’s agree that this is impossible over the long term without a massive expansion in allowable amortizations, which even then would have its limits. Over the next 5 years I would weigh this option as having less than a 5% chance of occurring.
2) House prices stagnate while incomes/inflation catch up.
- Also completely plausible. I would put the probability at less than 20%.
- This is where I’ll take issue with a comment left on my last post. The commenter suggested that I simply brushed off the suggestion that this is possible and that I’ll “have none of it”. What the commenter fails to mention is that I devoted an entire post to the topic in which I used empirical data to discuss the validity of the ‘soft landing thesis’. If the comment was meant to imply that I think a soft landing is unlikely, then yes, I suppose I’ll ‘have none of it’. But the implication that I simply dismissed it without first weighing out the merits of the argument is factually incorrect. Allow me highlight some key quotes from that post. The quotes are taken from published academic journals. Sources can be found in the original post:
- “First, we emphasize that the real estate price peaks which are currently under way in many industrialized countries…share many of the characteristics of previous historical price peaks…. 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.”
- “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…..History tells us that the faster and larger the bubble inflates, the more likely it will burst in the less benign way”
3) House prices fall in a fairly rapid manner (i.e. over the course of several years) back in line with fundamentals.
- If you are keeping up with the math, I put this likelihood at over 75% for all the reasons often discussed on this blog.
Will the government save housing?
This is a huge discussion best saved for a separate post. The bottom line is that the government can at best kick the can down the road towards a point of future reckoning. They certainly could theoretically introduce legislation that would favour more house price appreciation over the short term (extended amortizations, tax deductibility of certain carrying costs, kidnapping the children of renters and ransoming them until the parents buy a house). All of these are possible, and all three are equally likely at this point. It’s becoming increasingly obvious that the next federal budget will be targeting the credit excesses in the housing market, not trying to encourage more of it.
Could the government step in later and orchestrate an upturn in new demand? Sure…..over the short term. But they can’t orchestrate income gains, which is a huge caveat. Without a comparable increase in incomes, housing simply consumes a greater percentage of income over the life of the mortgage, leaving less to be spent in the broader economy over time.
In this case, it would still make sense to rent a home in most cities. The fallout will only be magnified at some point in the future. The renter who has diligently banked the difference between rental costs and ownership costs and has invested it wisely will still prosper.
Ultimately, it should be obvious to any honest person that there are very significant headwinds lining up against real estate in Canada. We are starting today from a point of (at best) very rich valuations and at worst a full out bubble.
If you live in a part of the country that meets the description above, consider this. If it seems logical to you to buy an asset at these extreme valuations in the hopes that the government will keep you from suffering the economic pain of your ill-advised choice, feel free. But be prepared for disappointment.