Housing: A bug in search of a windshield

Emotions…

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.

  • 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.

Probabilities

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.

Cheers,

Ben

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27 Responses to Housing: A bug in search of a windshield

  1. Jordan says:

    Nice post. I have two comments:

    …we now have a housing market and pseudo economy that are the envy of many nations… — High house prices make people wealthy on paper and can provide a good living for those who earn their income from the spoils, but they represent a long-term drain on the economy as money is diverted from consumer spending to debt service. I think everyone reading this blog recognizes this, but it constantly amazes me that high house prices are seen by the public at large as a good thing for the economy. To me it just means more non-value-added money being spent on housing.

    …with Vancouver taking the prize as the most unaffordable city in the entire world… — Strictly speaking, this isn’t true — the survey looked only at Aus., NZ, UK, Ireland, USA and Canada. So it’s the most unaffordable city in the entire English-speaking world. Still a dubious distinction, but not quite the same thing.

  2. jesse says:

    “Could the government step in later and orchestrate an upturn in new demand?”

    Well they have a funny way of doing it by yanking MI underwriting on HELOCs and moving to 30 year from 35 year ams. In 2013 we’re going to look back and look gobsmacked at how much the rules will have changed since 2008. As the US found out, orchestrating new demand is a bit tricky when prices are falling.

  3. Ed Sager says:

    Excellent analysis. It would be great if the mainstream media would carry this.

  4. John in Ottawa says:

    And this may be the windshield. The Globe & Mail is reporting that the Government will announce changes to mortgage and HELOC rules today.

    Amortization is expected to be reduced to 30 years and the amount of equity that will qualify towards a HELOC will be reduced.

    Mr. Debunk feels the government is going to be supportive of RE, but this is not a supportive move.

  5. John in Ottawa says:

    Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia is giving a speech today: The Scope and Responsibilities of Monetary Policy

    He makes the point that monetary policy is not the appropriate tool to set the “correct” price of any particular asset class. I would maintain that fiscal policy can be just as blunt an instrument and suffers from exactly the same issues as Plosser describes in the snip below. The whole article is worth a read.

    Another challenge in addressing asset-price bubbles is that contrary to most of the models used to justify intervention, there are many assets, not just one. And these assets have different characteristics. For example, equities are very different from real estate. Misalignments or bubble-like behavior may appear in one asset class and not others and may vary even among a specific asset class. But monetary policy is a blunt instrument. How would policymakers have gone about pricking a bubble in technology stocks in 1998 and 1999 without wreaking havoc on investments in other asset classes? After all, while the NASDAQ grew at an annual rate of 81 percent in 1999, the NYSE composite index grew just 11 percent. What damage would have been done to other stocks and other asset classes had monetary policy aggressively raised rates to dampen the tech boom. During the housing boom, some parts of the U.S. housing market were experiencing rapid price appreciation while others were not. How do you use monetary policy to burst a bubble in Las Vegas real estate, where house prices were appreciating at a 45 percent annual rate by the end of 2004, without damaging the Detroit market, where prices were increasing at less than a 3 percent annual rate?

    Because monetary policy is such a blunt instrument, asking monetary policy to do what it cannot do, such as seeking to deliberately influence the evolution of asset prices, risks creating more instability, not less. Moreover, the moral hazard created by the belief that the central bank would intervene if prices of a certain class of assets became “misaligned” might, in fact, cause more inefficient pricing and more instability, not less.

    The same can be said for government intervention. We’ll have to wait and see what the result of today’s mortgage adjustments will be, but I see a high risk of unintended consequences.

  6. debunking says:

    @John
    The result of today’s changes, if anything will bring forward more buyers to qualify before march 18th putting more pressure on prices. Except our government to do this many more times in the future.

    @ Ben
    Nice charts. I have no time to elaborate on your facts, but I can say that even if they are true, there is no correlation between your facts and a future price decline in home prices, if indeed that is what you want to show.

    1) House prices are near historic highs when measured against the rents they generate
    Me: Prices for most things we know are near historic highs, it is the magic of inflation. This does not mean that they will come down.
    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.
    Me: We live on an environment where price/income ratio is stretched for most assets. 1 to 2 years US bills are yielding 0%. House yields reflect that too.
    3) House prices have outpaced inflation and wage increases for nearly a decade,
    Me: This is more reason for future stagnation so wages catch up with inflation.

    4) House prices are at the upper boundary of their historic measures of affordability…..with interest rates still hovering near historic lows.
    Me: Makes sense , interest rates are low; people can afford to borrow more. Default rates are at historical average. Statistical data does not support your fact.
    5) Interest rates cannot get meaningfully lower, but absolutely can and will at some point get considerably higher.
    Me: This is not a fact but pure speculation. Interest rates can stay low for much more than you think, look at Japan.
    6) Home ownership rates are at historic highs.
    Me: More reason for the government to be attentive to this majority of voters. There is no reason why ownership can’t go to 80%.
    7) Total population growth is a meagre 1.3% nationally. Our immigration policies, while accommodative, are not exceptionally different than the US policies
    Me: This is wrong. US does not have an immigration program as Canada. US gives 55k visas/year through the lottery program and unless you are member of a family class you cant enter US or get residency. Canada gets around 250k a year permanent immigrants.
    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.
    Me: Are you saying that just because we can’t drive more than one car at a time, there can’t be more cars bought than there are drivers?
    9) Even with projected immigration, net household formation is expected to fall over the next 25 years.
    Me: This is not a fact; it is speculation and future projection.

    • Wow…..you’re really reaching here.

      “Prices for most things we know are near historic highs, it is the magic of inflation.”

      Inflation that does not similarly increase rents and incomes is meaningless in maintaining high house prices. This is a ridiculous statement.

      “We live on an environment where price/income ratio is stretched for most assets. 1 to 2 years US bills are yielding 0%. House yields reflect that too.”

      Dude….income is referring to household disposable income. But your point is important in showing that all asset classes are affected by interest rates. In the case of housing, that correlation is particularly acute.

      “This is not a fact but pure speculation. Interest rates can stay low for much more than you think, look at Japan.”

      Do you understand just how significant the deflationary pressure has to be for interest rates to remain this low? I love your example. During the time you reference, Japanese real estate lost 80% of its nominal value. Great point.

      “More reason for the government to be attentive to this majority of voters. There is no reason why ownership can’t go to 80%.”

      Pick up a newspaper. Flip to the business section. Read the major headline from today.

      “US does not have an immigration program as Canada.”

      Net migration rate in Canada is 5.64 per 1000. In the US it is 4.25. The programs are not identical, but the total numbers are not massively different. Sorry, but immigration is NOT the holy grail you’d like to believe it is.

    • John in Ottawa says:

      I’m not sure I understand. Are you suggesting that if the government keeps tightening mortgage standards prices will keep going up?

    • asia man says:

      dear debunking: in japan where I live, housing dropped 75% in my downtown tokyo neighbourhood eventhough interest rates didnt change. even with the historically low interest rates, the prices are peaked out. that bubble was almost 20 years ago and the prices are still down there. take note, or dont, at your own peril.

  7. Dmitri says:

    John in Ottawa:

    this will definitely pull some speculative demand forward, thus exacerbating future decline in sales.

  8. debunking says:

    @ Ben,

    “Inflation that does not similarly increase rents and incomes is meaningless in maintaining high house prices. This is a ridiculous statement.”

    I could say that just like house prices are at historic highs so are food prices, so are my utility bills, so are my insurance bills etc etc, yet my wage did not go up to compensate. Your statement that prices are the highest in history without similar rent increase, prove absolutely nothing as to the future of RE prices.

    You see, if your torture your data enough, it will eventually confess to anything you want.
    I rent and can’t afford to buy at those prices and sure would be glad to get a house at 50% of the price. But this is not a sufficient reason why the prices would come down by such amount.
    I think you do a good job trying to gather data and post it, but you should try to interpret the facts on a un- biased way, which is very hard to do when we have this bias and hope for lower prices.

    I don’t need to read the newspapers, but I know that property bubbles are an enormous source of tax revenue, which is why governments everywhere encourage and support them (with a little help from their Central bank enablers).
    In an environment where incomes – and thus income tax revenues – are stagnant (such as we have had for the past ten+ years) governments go to extraordinary lengths to support and prolong housing bubbles.
    Thus, I would say that it is probably premature to assume that our housing bubble is about to pop. Before it does, the government will throw everything but the kitchen sink at it to keep it going.

    Can you explain why Australia housing bubble which has the same rate of ownership as us, same unaffordability and very similar economic fundamentals has not popped despite moorage rates above 8%?

    What makes you think that we won’t go the same way?
    Comparing Canada to the US is irrelevant and you know it.

    We need to go deeper to uncover not when our bubble will burst but why it might stagnate for 20 years.

  9. Dmitri says:

    @Debunking:

    on of the ways to check whether the price of a dwelling is in line with the historical trend is to convert it to the rent equivalent (basically how much exactly the same dwelling will cost you in rent). My experience (for the Toronto anyways) is that it is about 30-40% cheaper to rent in the same neighborhood than to buy (taxes, insurance, maintenance etc. included).

    Japanese scenario is a good example of prices eroding in a ZIRP environment however, Canadian situation is “different”, in a sense that unlike the Japanese most of our public debt is not held by Canadians. Also, don’t forget, while Japanese scenario has been playing out in the 90’s, most of the other economies were doing good, thus pulling Jpn. along. This is not true now.

    Also, think about it – what happens to the broader economy when year after year we have huge malinvestements and rerouting of funds into something inherently unproductive – cardboard boxes that can be produced at a price of under 20k a pop (using modern technology).

    How long can you think this be sustained and how long do you think Canada will be able to keep it’s productivity edge (if there is even such a thing)?

    I can’t tell for sure that there will be a “pop”, but I’m quite certain that inexorable reversion to mean has already begun. Be there a misfortune of some sort of economic black swan event (i.e. the price of oil shoots up due to the instability in mid.est.)- we could easily see a “pop”.

  10. debunking says:

    @ dimitri
    No, I dont think at all that this is a good thing for us, it is horrible situation to be in, but you cannot deny reality just because you dont like it.

    Interesting story in GM how inflation is running ar 3.2% for the last year in UK and CB has kept interest rates at 0.5%. This year they expect inflation to be at 4% and CB has yet to make his first 0.25% move.
    Have the home prices crashed in UK? My friends in London tell me that they are as expensive as ever. Stagnation for house prices at very high level is a real possibility.

    http://www.theglobeandmail.com/report-on-business/economy/uk-inflation-leaps-to-8-month-high/article1874010/

  11. Don says:

    “5) Interest rates cannot get meaningfully lower, but absolutely can and will at some point get considerably higher.”

    I could easily see the U.S. inflating it’s way out of the massive debt it has but the above is not necessarily true. What would happen in a deflationary environment?

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  13. patriotz says:

    “What would happen in a deflationary environment?”

    You mean like in Japan? Or here during the Great Depression?

    Has there ever been a period of general deflation, anywhere, that has not seen a significant drop in house prices?

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