More on the Capital Economics house price report

I was able to get my hands on the Capital Economics report (hyperlink removed at the request of the authors -ed._ .  The report mirrors exactly what I’ve been warning about on this blog…nearly verbatim.  You can understand then why I’m so smitten with it.  Just for kicks, read this post before you read the Capital Economics report.  Compare.

Let’s look at some key quotes and graphs:

On the unprecedented rise in house prices

“The recent housing boom has resulted in the largest rises in house prices ever seen in Canada, which have been similar in magnitude to those during the recent boom in the US.  Unfortunately, the subsequent falls in prices could also be just as severe as those elsewhere.”

On the house price to income ratio

“In Q3 2010, the HPL was around $314,000 and the disposable income per worker is $58,347. This tells us that the general level of house prices has risen to almost five and a half times income, well above the long-term historical average of 3.5. This indicates the fair value was around $205,000 in Q3 2010.”

As I have repeatedly noted, an expansion in the house price-to-income ratio can be supported by either a loosening of credit standards and/or a falling interest rate environment.  Both of those factors are now behind us.

On the house price-to-rent ratio

“The ratio of house prices to rents has risen to a record high, far above the peak reached in the previous boom.”

If you are a potential home buyer, consider comparing the full costs of ownership (including taxes, maintenance, and lost opportunity cost of the down payment) to the costs of renting.  In many cases, particularly in the large centres, the cost of renting is a fraction of the cost of owning a similar dwelling.  I continue to advocate that in such circumstances, the rational approach is to take what the market is giving you: Cheap rent relative to ownership, and bank the difference.  History and logic suggests you will be building equity far quicker in such a scenario.

On the probability of a sideways market (i.e. a ‘soft landing’)

“Without any adjustment in house prices over the coming years, the time it would take for income growth to materially improve longer term affordability would stretch into decades.  This is simply not plausible. The most likely outcome over the next few years is a  combination of modest real income growth per worker and substantial real house price declines.”

“If we assume that real disposable income grows at close to its historical annual average of around 2%, and add to that annual inflation of 2%, then nominal disposable income growth is 4% (which is being slightly generous given that we expect more subdued household income growth and lower inflation). This profile for income would bring the house price to income ratio back to its long-run average of 3.5 beyond year 2020. This is much longer than the previous housing correction of around three years, and therefore seems unreasonable.”

I’ve discussed the likelihood of a soft landing scenario several times already.  While certainly possible, if not probable, in some markets where house prices have not seen significant overvaluations relative to fundamentals, it is extremely unlikely in some of our bubblier markets.  For more, check out the following entry:

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

On demographics, immigration, and excess housing inventory

“The change in population equates to annual average housing demand of 175,000 units. Actual annual housing starts (completions) over this same period averaged 200,000 units. Admittedly, a small fraction of these new units will go toward replacing lost capital stock due to demolition and conversions of older units each year. But overall, this does not suggest there is any shortage of housing units to satisfy the growth in population and household formation.”
Predictions

“...Average house prices must decline by a cumulative 25%. This prediction is almost twice as large as the correction that followed the 1985-89 housing boom, which was close to 15%.”

“It is also worth stressing that our forecasts assume that house prices simply drop back to fair value based on the historical average for the ratio of prices to incomes. In reality, just as they have been substantially over–valued for a long period, they may fall well below fair value for a long period too.”

Not a bad read, though nothing you haven’t heard here before.

Cheers,

Ben

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12 Responses to More on the Capital Economics house price report

  1. LS says:

    5 bucks says the authors of that study read your blog. It’s like it’s cribbed directly from your site! You should demand royalties. 🙂

  2. HHV says:

    The words “per worker” leap out at me. I wonder if this is an error. Seems to me house price to income ratios are almost always measured as median house price versus median household income.

    I don’t dispute that many of Canada’s major centers are overvalued, but in the interest of fairness, Capital has moved some yardsticks to fit their predetermined thesis in this report. Us bloggers get our knickers in a knot often over reports from CAAMP and the CREAs, in the interest of fairness we should take care to identify the gaps in reports that fit our meme too.

    • I disagree HHV. If it was a snapshot that tried to compare one metric with a different historic metric, I would tend to agree. In this case it is charting a pattern over time. Assuming the authors used the same parameter over the entire time frame, their conclusion is still completely valid.

      • HHV says:

        Assuming. I’d agree. But other reports I’ve seen use the metric as I indicated above and come to the same 3.5 times household income versus price ratio. Capital uses one income to come up with their ratio yet it deviates from the “standard” used elsewhere.

        I’m not saying they are wrong, but why do we give them the benefit of the doubt? Shouldn’t we be digging at every industry report equally? I’d be curious to know if the assumed calculations were applied equally or if they used someone else’s historical norm to compare against their own interpretations.

        I’m asking question, not stating they are wrong. My argument is that for those of us who write about this stuff, whether it’s to skim the surface like I do, or to truly get at the data like you do, for the credibility of our writing we should treat all industry data sources with the same skeptical inquisitiveness.

        Capital is in the business of selling market research to investors. They are hardly unbiased in this discussion, even though they are less biased than the “economists” that work in the real estate and lending industries.

  3. HHV….I 100% agree. If I thought there was an issue with the data, I believe I would have called them on it. From what I’ve read, 3X median household income is a good approximation of long-term house prices. 3.5X disposable income per worker would not be entirely unreasonable. At the end of the day, I still maintain that as long as they are making an apples-to-apples comparison over time, it’s the pattern over time that matters most. There are a number of metrics they could have used. The more important thing in my mind is that they kept that metric constant.

    I am curious to hear why you think Capital Economics is ‘hardly unbiased’. Granted everyone has a bias, self admittedly included. Is there something you know about CE that I don’t? Your point that we tend to gravitate towards information sources that supports our position is well taken. It’s a human tendency. I would be naive to think that I am not equally prone to the same blunder as the bull crowd I often find myself opposing. The reality check is always welcome.

    Cheers

  4. HHV says:

    I’ve just finished reading the report and I still am unclear on whether or not their ratio is based on a consistent measurement. It’s highly likely that it is, but it doesn’t explicitly state that it is. In their bullet points on the first page, they talk about “nominal household income.” They then use the “disposable income per worker” metric elsewhere. Worker could mean household, but that’s highly unlikely.

    The first fishy smell for me in this report was the actual number: disposable income per worker = $58,347. I’m completely unsure of how they’ve calculated this number. What exactly is included as “un-disposable?” Is this the after-tax average income? Here’s what Stats Can gives us: $74,600 after tax per household in 2008

    Anyway, it’s doubtful that my questions can be answered and it’s highly likely that I’m being overly skeptical anyway.

    You asked why I think they’re biased. It’s for the same reason I think Garth Turner is: he’s making a living off his ability to convince people that real estate is not a good investment. I’m certain, although I can’t guarantee, that he’s picking up private equity clients through his real estate commentary. He’s definitely selling books and speaking engagements–most often sponsored by equity investment companies.

    Capital has a unique product: research. Capital stands to gain financially should they convince people who are interested in investing to buy their research. There’s more than a few Canadians who look at the current market valuations and see problems, especially if they have some savvy when it comes to finance and economics. Capital is likely appealing to them.

    I’ve been on their site and they appear to be European-based. You’ll note that many of their graphs state they’re using themselves as a source for their house price measurements. You’ll also note that they don’t make any reference to Canadian housing market research products on their website. Perhaps they’re positioning themselves to start that as a product offering? If they did, they’d be competing with Teranet and Landcorp.

    Of course, the CD Howe Institute already went after the CMHC for similar reasons recently so this isn’t exactly ground breaking research on Capital’s part. I think they likely have a shrewd PR person/department working for them that seized an opportunity to get their business in the news, and I’m strongly suspicious there’s a motive why.

    I freely admit that this doesn’t make their research flawed. I’m actually not concerned in the slightest by their bias. I agree with their conclusions completely. But they introduced something new metric-wise and the skeptic in me woke up startled.

  5. John in Ottawa says:

    I have a real problem with Chart 2. They get the CS index correct at 175. However, they have the Canadian “CE” index at 225, much higher than CS. Stats Canada has the Canadian index, normalized to 1995=100, just shy of 175.

    If their CE index is incorrect, then every calculation based on it is incorrect as well.

    • So according to Stats Canada, Canadian house prices have gained only 75% in 15 years, or an average compunded annual increase of 3.8%. Does that strike you as odd given that house prices have gained an average of over 7% annually for the past decade? I wouldn’t mind seeing the source you cited. It might be worth digging into their methodology. Unfortunately the CE report does not include a description of their method. However, I’m a little skeptical that house prices would have lagged money market funds over the last 15 year period.

      • John in Ottawa says:

        Hi Ben,

        House prices fell from 1995 and didn’t recover until 2001. That’s why the average return is so low. The further back we go, the worse the return. The 7% rate has been just in the past 10 years.

        I’m using data from The Economist, which cites as it’s source Stats Canada. I’m still trying to get my hands on original source data.

      • John in Ottawa says:

        I was just looking at CANSIM Table 327-0005 (the free version). It tracks new house prices and land.

        The index starting at 1991=100 undulates within +/- 2 all the way to 1999 before finally remaining positive and only reaching 114 by 2003. All the growth has really been in the past 10 years. Us old-timers really haven’t gotten wealthy on our house investment. As I pointed out earlier, housing hasn’t kept up with inflation over the past 30 years.

        I’ll be digging further into source data as I get time away from my septic tank problem. I’m not pleased that there are so many sources of housing data, but very little information on where and how the data is collected. This is something I need to resolve.

        In the meantime, I’m not inclined to take kindly to yet another source, the CE index, which is not well sourced.

  6. Pingback: Capital Economics on the Canadian economy: Housing downturn to hit hard | Financial Insights

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