In our never-ending quest to profit from the works of others, we here at Running of the Bulls present to you two papers on the Canadian housing market, which is a bubble, or kinda bubble-like, at least in some places.
Canadian home prices in May 2010 (Exhibit 1.1) were up 13.6 percent from a year earlier, according to the Teranet - National Bank National Composite House Price Index™. The 12-month gain was strongly influenced by Vancouver, up 17.1 percent, and Toronto, up 16.0 percent. In the other four markets surveyed, the 12-month rise ranged from 5.6 percent in Halifax to 11.4 percent in Ottawa. In Calgary it was 7.8 percent and in Montreal 8.5 percent.
During the 10-year span between May 2000 and May 2010, housing prices increased 96 percent nationwide, 118 percent in Calgary, 116 percent in Montreal, 69 percent in Toronto and 126 percent in Vancouver. Doubling of housing prices over the 10-year period coincided with the all-time highs in nominal terms in the three major cities except Calgary where prices remain 8.6 percent below their stratospheric highs set in August 2007. Year-over-year and from May to June 2010, nominal home prices edged higher in all key markets without any surprises.
Home prices should rise at the nominal rate of GDP, plus or minus variations in local markets. Home prices are also affected by other factors, such as mortgage costs. Doubling of home prices in 10 years implies a compound rate of 7% per year, above the long-term trend in nominal growth.
The significant decline in sales year-over-year was observed uniformly across Canada ... The new mortgage regulations and exhaustion of an adrenaline boost from the HST scare in British Columbia and Ontario inflated sales volumes in the months preceding June 2010, and led to very disappointing, albeit predictable, results in June.
In June, volume from a year ago fell 40% in Calgary, 19% in Montreal, 23% in Toronto and 30% in Vancouver.
It is an old adage in trading that a market rising on declining volume is a market not to be trusted. It is a hallmark of a market top. That does not mean that the Canadian housing market is topping, but it is a sign that it may be. The exact same thing happened in America at the top of the US housing bubble when prices continued to rise even though volume fell off a cliff.
Commencing 2007, the new dwelling starts, completions and units under construction experienced a sizable correction. Despite these changes, the number of units set to be constructed in 2010 now exceeds the long-term average, indicating a continuous oversupply of homes. The sharp reduction in number of new starts and completions was softened by the 2000-2007 swelling of dwellings under construction. The number of units remaining in the pipeline will fuel additional supply of homes released into the market and in spite of the declining dwelling starts the overbuilding is expected to continue for into foreseeable future.
Supply is increasing whle demand is decreasing.
In one of my first Econ 101 classes, I learned about the elasticity of supply over the short and long run. Elasticity of supply means how supply changes based on the change in pricing. My professor used housing as an example. In the short run, housing is very inelastic, i.e. small changes in demand for housing has a disproportionate affect on pricing since homes cannot be built in a day or two. It takes a while to build a house. Over the long-run, however, the supply of housing is very elastic. As home prices rise, builders respond by building more homes. There is a lagged response but the supply gets built. This is what can make homes a bad investment. Demand for housing can change dramatically while supply is being brought onto the market, exacerbating negative shifts in pricing.
Not only is home supply rising, so are vacancy rates. Apartments add to the supply of housing. When vacancies rise, supply has risen faster than demand.
Affordability has improved but it is still expensive to buy a house.
It is more affordable to buy a house now compared to the 1990s only because mortgage rates are so low.
Carrying costs continue to rise.
Any increase in interest rates will have a dramatic affect on the affordability of homes.
That is because incomes have not kept up with home prices.
On annual basis, Demographia compiles a report to cover price-to-income ratios in 270-plus markets in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States. The Demographia International Housing Affordability Survey employs median house price divided by gross annual median household income in each market to rate housing affordability values. Demographia uses the following scale to rate housing affordability:
- Severely Unaffordable 5.1 & Over
- Seriously Unaffordable 4.1 to 5.0
- Moderately Unaffordable 3.1 to 4.0
- Affordable 3.0 or Less
The scale calibration is derived from historical values observed over a period of time. According to Demographia, the Median Multiple has been remarkably similar among the nations surveyed, with median house prices being generally 3.0 or less times median household incomes. In late 2009, Calgary and Montreal were rated ―seriously unaffordable‖, scoring 4.6 and 4.9 respectively. Toronto made it to the ―severely unaffordable‖ hall of fame with a score of 5.2. Vancouver ranked the most unaffordable city amongst the 272 markets surveyed with a price-to-income ratio of 9.3 (Exhibit 4.1).
And the price of a home relative to rental income in Canada is amongst the highest in the developed world. Not good.
Pestov compares Vancouver real estate to the Nasdaq
Though I think the two markets are not entirely analogous - the Naz fell 80% top to bottom after the bubble collapsed, a decline that would shock me if it occurred in Vancouver real estate - I sympathize. Some argue that such comparisons are facetious but I think they are a good representation of human psychology.
Pestov concludes that a crash in Canadian real estate is not necessarily pre-ordained, and I agree with that. Prices can instead stagnate for many years. However, the risks of a crash are high, particularly given the enormous problems and imbalances in the global economy, from which Canada is not immune.
Pestov does good work. Take some time and read the whole paper.
A recent paper from the IMF differs somewhat. The conclusions tend to be more sanguine.
Canadian house prices have increased significantly between 2003 and early 2008, with a marked downward trend since mid-2008, especially in the resource-rich western provinces. This paper estimates the evolution of equilibrium real home prices during this period in key provinces and finds that, following recent declines, home prices are now generally close to equilibrium throughout Canada. However, house prices in Alberta and British Columbia remain around 8 percent overvalued at the end of the sample (second quarter of 2009). Despite the limitations of econometric estimates of house-price dynamics, the measured small degree of overvaluation suggests that the Canadian housing market is essentially at equilibrium.
Frankly, I do not put stock in their conclusions. The paper uses an equilibrium model. Here are the assumpitons of the model.
The error-correction model postulates that the growth rate of real houses is explained by a combination of the following factors (depending on the province considered) ... :
- Past growth rates of real house prices. For most provinces, we find that the current growth rate is positively correlated with the past growth rate.
- Reversion to fundamentals implied by the long-run equation. We find that for most provinces (with the exception of Quebec and British Columbia, which is not statistically significant), the growth rate of house prices shows long-run reversion to the equilibrium prices derived from the model, implying that prices would tend to fall when they are out of line with fundamentals.
- Economic fundamentals. For all provinces (except Quebec which is statistically insignificant), we find that the growth rate of house prices is positively affected by (per capita) real income growth, which increases households’ purchasing power and borrowing capacity. The growth rate of house prices is positively affected by mortgage credit growth (higher rates indicate that households are less credit rationed) in the case of Alberta. Population growth (as a proxy for the growth rate of households) positively affects house prices only in Saskatchewan.
In other words, their model of current home prices is at least partly based on past home prices.
In 2006, Fed chairman Ben Bernanke testified in front of Congress that he didn't think housing prices were overpriced. He doubted that home prices would fall much since home prices had not fallen for 60 years. As we now know, that reasoning was an enormous logical fallacy.
Given that home prices are nine times income in Vancouver, the highest in the English-speaking world, it is hard to believe that home prices in Vancouver are only 8% over-valued. Investors should ignore this paper.