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:
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.”
“...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.