B of A / Merril Lynch on Canadian housing…part 2

We’re discussing the questionable findings of a Bank of America Merril Lynch report titled “Our Homes Have Four Walls” in which they argue that strict lending standards and the generally conservative nature of the Canadian consumer will allow house prices in Canada to remain at what the report itself notes are “stretched valuations metrics”.

Let’s pick up where the first post left off….

On signs of a bubble:

Canadian home valuations look stretched, with the average estimated asking rental yield at all time lows. Housing affordability still looks relatively good, but will be likely to decline as mortgage rates are set to rise and lending rules are tightening.

“Canadian home ownership rates are near record highs of close to 70%. Real estate assets represent a near record 38% of total household assets.”

“Canadian mortgage debt to disposable income has reached a record high of 93%. Indeed total Canadian household debt is now similar to the levels in the US.”

On (the lack of) potential tipping points:

Canadian home sales as a percentage of housing stock remains below the 10-year average, suggesting the turnover is not excessively speculative.

Of course not.  Why would people sell when they are overwhelmingly convinced that real estate will rise?  The second half of 2010 was characterized by a joint buyer and seller strike where sales withered but available inventory was also well below normal.  The huge unanswered question is, “what will 2011 look like, particularly once the new mortgage rules take effect in 3 days?”  About perceptions of real estate returns, the report had this to say:

Also, in the latest Canadian Association of Accredited Mortgage Professionals (CAAMP) survey, 38% of respondents were relatively bearish on home prices, versus only 29% who were bearish the same time last year.  Bearish sentiment is hardly a sign of speculative behaviour.

I’m not even sure where they’ve come up with this stat.  I dissected the referenced CAAMP report at length in several prior posts.  Here is the data I believe they are referring to.  The actual survey question is listed below:

“To What Extent Do You Think Housing Prices in Your Community Will Go Up or Down in the Next Year?”


I’ve colour-coded them into three groups:  Those who indicated 1,2, 3 or 4 are bearish on real estate.  That group was coloured red.  Those who indicated 5 or 6 are fairly neutral on the prospects of real estate and were coloured yellow.  Those indicating scores of 7,8,9,10 are bullish on real estate.

The results:

Bears:  13%         Strong bears (1 or 2):  2%

Neutral:  47%

Bulls:  40%          Strong bulls (9 or 10):  7%

Interestingly, only 13% of people surveyed believed that real estate was set to decline over the next year, while 40% believed it would rise, and 47 believed it would basically be flat.  I’m not sure where they came up with their numbers.

Of note, last week RBC released a report in which they had Ipsos Reid (perhaps the most respected statisticians in the country) conduct a similar survey.  I wrote about it in an earlier blog post.  RBC found that 90% of Canadians felt real estate is an excellent investment.  So exactly where did this report get its data?  It is highly, HIGHLY suspect to suggest that with regards to real estate, nearly 40% of the Canadian population is relatively bearish (a term the report interestingly chose not to define).

Back to the report:

Housing completions in 2009 and 2010 have averaged around 160k, just below the natural formation rate of around 170k. From 2003 to 2008 home completions averaged 180k, certainly not enough to create an excessive over supplied housing market.

Yet another highly suspect “fact”.  According to CMHC and Stats Canada, this is blatantly false.  While household formation has in fact been averaging 170-175K for over a decade, housing starts have been well above this.  Note that between 2003 and 2009, there is not a single year when completions did not outpace the rate of household formation.  In fact, during the 2003-2008 stretch, housing completions outpaced household formation by and average of 40,000 per year.  Source:  CMHC

Someone’s numbers are off……I’d suggest it’s probably not Stats Canada and CMHC.

On Canada’s economic rebound:

And most importantly, economic conditions in Canada continue to improve. The unemployment rate is trending lower, employment levels are above pre-recession levels, wages are growing and financial conditions remain very easy.

In a previous post dealing with this same line of thinking, I suggested that this is cart-before-the-horse mentality.  It’s important to remember what was the single largest contributor to GDP growth coming out of the recession:  Consumer spending.

We know that the experience of any country that has undergone a housing correction is for its consumers to retrench and begin saving as the all-powerful wealth effect (whereby people spend more because they feel richer) is suddenly working in reverse.  So it begs the question of just how much of our economic growth since the recession has been dependent upon the continued growth in house values.  It’s a feedback mechanism and one we should not discount as its power in sustaining consumer spending is immense.

With regards to employment, this statement is also misleading as the jobs lost have been regained, but with a heavy bias towards public sector, construction, and part-time employment.  Furthermore, with the total number of job seekers increasing, our unemployment rate is still substantially higher than pre-recession.

Finally, with regards to ‘easy financial conditions’, let’s see how things play out after the axe falls on Friday.

Conclusion:

There’s more I could say, but I think you get the point.  I’m wholly unswayed by this report as it contains some highly questionable ‘stats’ and some glaring holes in their logic.

Ultimately, with valuations in real estate currently so rich, it implies that a great degree of growth has already been factored in.  In other words, it implies that people have forecast a best-case scenario going forward.  In such instances, if that best case scenario unfolds, it has already largely been factored into house prices.  At best you would expect them to pace inflation over a defined period of time….say 5-10 years.

But what if the future unfolds in a less cheery manner? In such a world where best-case scenarios have already been priced into real estate, what happens then?

High valuations relative to fundamentals = higher risks.  Period.  Unprecedented highs in the key measures of price/rent and price/income imply a level of risk perhaps never before seen in Canada.  If the future is exceptionally bright, perhaps real estate might manage to pace inflation.  But we are living in an uncertain world where our perception of safety and stability can shift in an instant. Assets are most risky when they are priced such that expectations of future stability have been extrapolated indefinitely from the current state. The dangers of going ‘all in’ on an asset perched at such a dangerous position should be evident to readers of this lowly blog……even if it escapes the fine folks over at the Bank of America.

Cheers,

Ben

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18 Responses to B of A / Merril Lynch on Canadian housing…part 2

  1. jesse says:

    “While household formation has in fact been averaging 170-175K for over a decade, housing starts have been well above this”

    You need to account for demolitions. I think there is a large mis-allocation of housing due to the bubble, people either buying more house than they need or remaining in a home larger than they need after their family size decreases. I’d argue underutilized housing is of even more magnitude than empty dwellings.

    The irony I see is childless families can afford more expensive and expansive properties than those with children due to higher incomes and lower expenses. Did it always use to be this way, people affording more house than they need?

  2. Sams Mango says:

    Ben, just still believe you are too early on your forecast for any correction.

    1. Of course rental yields will be low, they will follow market yields. I would expect the yields to also rise with rates.

    2. Subprime in Canada does exist, but not on a large scale.

    3. Canada’s balance sheet is healthy, jobs are good. Remember, housing correction, would still not mean housing default. NO MARGIN CALLS on housing.

    • Dylan says:

      Do you expect rental yields to rise in a higher market rate environment because home prices will fall or because rents will rise? I can’t really imagine landlords successfully passing on all of their higher interest costs to renters for a number of reasons. If you’re thinking that higher rents will mean lower house prices, I couldn’t argue with that.

      BTW, there’s no margin call on housing, but mortgage resets when rates are rising can have a pretty similar effect on overstretched buyers. They have to come up with more capital that they might not have to hang onto a leveraged asset. It’s sort of like a margin call in slow motion.

  3. Kevin says:

    This whole report is shoddy at best.
    “Real estate assets represent a near record 38% of total household assets.”
    That was true in 1999.
    In 2005 real estate assets represented 42% of total household assets
    http://www40.statcan.gc.ca/l01/cst01/FAMIL109-eng.htm

    In 2011, real estate assets represent 48% of all total household assets. This is according to the Vanier Institute. With the run up in house prices since 2005, I would disagree with that.

  4. Kevin says:

    Oops, last sentence should read “I would NOT disagree with that”

  5. chris says:

    I live in Vancouver and salivate over the “cheap” prices in other cities, including Toronto. I don’t believe most of Canada is in a bubble, just Vancouver. Or maybe I have just gotten used to seeing SFH sell for $1M and anything less seems “affordable”…

  6. Sams Mango says:

    The Van SFH @ 1M$ – what earnings for household income to qualify to buy one?

    • jesse says:

      I pulled my old Joe Howmuchamuth calculator out and, at 4.35% 30 years, it’s about $165,000 to max out on an $800,000 loan. A 1% increase in rates increases the qualifying income to $184,000.

      On Vancouver west side, honestly, that’s a pittance. If you have to ask about the price…

  7. serge says:

    I’d be curious to ask homeowners: how much more you be willing to pay to buy your own home?

    • chris says:

      Our family income would qualify for that $800K mortgage @jesse calculated, however, there is absolutely no way we would want to carry that much debt with interest rates expected to rise in the future. We would be house poor and that is why we choose to rent in Vancouver.

  8. Dave says:

    Did you really just compare the Canadian Real Estate Market with the thousands of deaths in Japan? Some would say that’s in poor taste.

    • Dave,
      I’m not ‘comparing’ it at all. My thoughts and prayers are with the people of Japan. My point is simply that our perception of safety and stability can shift in an instant. Assets are most risky when they are priced such that expectations of future stability have been extrapolated indefinitely from the current state.

      Nevertheless, to avoid offense, I’ve reworded that paragraph.

    • jesse says:

      Too soon! Ben, I think it’s a good point that risks need to be looked at objectively. Emotions surrounding real estate cloud adequate risk assessment, IMO, and risk assessment extends to all means of disasters, from personal to regional to global.

      Some relatives of mine just dropped off an earthquake kit at my place. Are they acting in poor taste too?

      • John in Ottawa says:

        I just spent two weeks in California visiting my ageing parents. If it weren’t for them, you couldn’t pay me to go any where near the west coast.

        One earth quake is all it will take to end the debate about Vancouver property prices.

        Poor taste? More like a loving gesture.

  9. pascal says:

    A picture worth 44 Billion dollars:

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