No Real Estate Bubble in Canada?

Most of my focus on the bubbly Canadian real estate market has been on Western Canada.  This is primarily because over the last 10 years, Eastern Canada, i.e. everything east of Manitoba, has not much mattered in the global scheme of things as global investor demand has been focused on Western Canada, where things can be dug/mined/drilled etc. out of the ground.  It is out west where the bubbly activity in the housing market has occurred.

Worthwhile Canadian Initiative - one of my favourite economics blogs - cites data from Teranet to bolster their argument that Canadian home prices are not in a bubble.  It is an index akin to the Case-Shiller index in the US that tracks the changes in home prices in six Canadian cities - Vancouver, Calgary, Toronto, Ottawa, Montreal and Halifax.  According to the Teranet index, home prices rose 8.9% per year from 2003 through 2007 across the six cities in the index.

 

That may fast, but it is not a bubble.  So props to the economists.  There has been no bubble in all of Canada.

But there was no bubble in all stocks in the 1990s either.  Instead, there was a bubble in a select group of stocks, in particular technology and some growth and large-cap stocks.  Equal-weighted indices of stocks began peaking out at the beginning of 1998 while the bubble continued for two years. 

Thus, what is interesting is what occurs underneath the indices.  And from 2003 through 2007, home prices out west exploded.

 

Home prices doubled in Calgary and nearly doubled in Vancouver whereas they grew more slowly out east.

This is a graph scanned from Garth Turner's book, Greater Fool, of the Calgary real estate market from 1992 to 2006. (I apologize for the low quality.  Here at Running of the Bulls, you get what you pay for!)

This is what a bubble looks like.  It does not matter if the bubble is in stocks or real estate or commodities or paintings or fine wines.  When prices go unrelentingly straight up, this is almost always a sign that prices are disconnecting from fundamentals.

We also noted here and here the utter silliness of home prices in Saskatoon, where prices doubled in two years, and became a more expensive city to buy a house than most cities in the United States, even though Saskatoon is completely surrounded by farmland, is -40C for at least part of the year, and the population of Saskatchewan is about the same as it was 60 years ago.

Western Canada is where all the action has been. The demand for raw materials pushed up the value of the Canadian dollar, aka "the loonie," which was enormously positive for Western Canada but hammered the manufacturing base in Eastern Canada.  While Western Canada boomed, Eastern Canada struggled, at least relatively.

Worthwhile Canadian Initiative  posted these graphs to support their argument that home prices in Canada are rational.  I think they are wrong, at least out west, and I am going to tell you why.

First, the price of homes in the US and Canada.

They argue that if you scale house prices to gross national income, homes are not expensive.

 

They argue further that the improvement in gross national income is because of the improvement in Canada's terms of trade, i.e. the world wants more of Canada's stuff in the ground relative to what Canada wants from everyone else.  They note that half of Canada's increase in per capita income this decade has been because Canada's terms of trade improved.

There a few problems with these arguments.

First, people do not buy homes with gross national income.  They buy homes with after-tax income.  Thus, you should compare the prices of homes to household income, not gross national incomes.

I went to the Statistics Canada site to find the growth in income from 2003 to 2007, but CANSIM wanted me to pay them 36 bucks!  Well, that's not happening, so being the cheapo that I am, the free Canada Census data had growth in median income from 2000 to 2005.  For our six cities, growth in median incomes was as follows.

Halifax 2.1%

Montreal 0.4%

Ottawa 5.8%

Toronto 1.1%

Calgary 5.1%

Vancouver -3.6%

That is total growth over those five years, not per annum growth.

From 2003 through 2005, home prices rose 21.8% in Halifax, 30.5% in Montreal, 16.4% in Ottawa, 18.6% in Toronto, 24.9% in Calgary and 40.8% in Vancouver.  Thus, home prices far outstripped growth in income. 

Of course, it is not only income that matters when purchasing a home but also affordability, in particular mortgage rates and average monthly payments made by home buyers.  However, as you can see, incomes and affordability would have had to double in the western cities in 2006 and 2007 for incomes to keep up with the prices of homes, and that did not happen.

The other potential flaw in logic in their argument is assuming that changes in the products driving improvements in the terms of trade are rational.  Since Canada's terms of trade were driven by increased prices in commodities, the question becomes whether or not the changes in commodity prices are rational?  

This is far from clear.  Certainly, some of the price moves are rational.  With the inclusion of China, India, Brazil, et. al. into the global economy, along with supply bottlenecks, there has been a structural shift upwards in the global price curves of most commodities.  But how much of rising commodity prices is due to structural shifts and how much is due to speculation is unclear. 

Was oil at $147 rational?  Today, oil has more than doubled in four months to $70 yet inventories are at 20 year highs.  Is it rational for oil to be at $70?  Maybe, if the recovery absorbs all the excess inventory, but without a doubt, financial market speculation has and is playing a significant factor.

This is an important concept to understand - If the underlying security is being supported by an asset bubble itself, even if the security appears fairly priced, then the underlying security itself is in a  bubble. 

For example, financial stocks did not look expensive in 2006 based on current earnings.  However, earnings were based on asset markets which were egregiously over-valued.  Thus, when home prices collapsed, so did the earnings of the financial companies.  Financial stocks were very over-valued because the true profitability was overstated by the bubble in home prices.

Likewise, if Canadian home prices appear fairly valued based on incomes while commodity prices are over-valued, the country's terms of trade are skewed and underlying incomes supporting home prices are too high.  If, for example, the structural long-term average of the price of oil is $50, the terms of trade for Canada will decline, incomes will decline (or grow slowly) and home prices are currently too high.

Comments

[psychodave]

Nice work. I liked the Calgary real home prices versus trend very much.

"This is an important concept to understand"
uh oh. I was a lot more interested in comparing debt-to-income and loan-to-value ratios in the bubble areas compared to those in the non-bubble areas.

Have they reached record levels in the bubble areas like they did in the U.S.?

I liked the 2000-2005 growth in median income even before I learned their low low price. Figure you've got some over-leveraged asset inflation out in west Canada ... reminds me of Bullwinkle and his hat trick. "This time for sure Rocky [cuz its a 'New Era']!"

Naw, if you were a real trader, instead of an investor looking at solid fundamentals, but with a bit of a thrill-seeking side to him, you'd be recommending Canadian homebuilder stocks.

[FY]

I think you almost get it right to relate real estate price to household income.

However, you argument is weakened by using an arbitrary time period (income growth 2000-2005 vs index growth). Someone could say perhaps in 2000, the house price was undervalued.

The proper way is to use house price to household income ratio. Better yet, median house price vs median household income. For Canada as a whole, that's about 300K/60-70K=4-5x. High at the national level (US national peak was 4.5x).

However, there are some nuances need to iron out in this argument:

1. US national avg peaked at 4.5x, 30 yr avg 2.6x. However, in big cities, the peak like 10x, while 30 yr avg is like 5-6x. The primary reason is in big cities, large number of low income households would never afford a house anyway, so a house/income ratio is higher.

Would the same effect be more profound for Canada, given that the population is largely concentrated in a handful of cities ? In other words, cdn national avg is more like US big cities ?

In Toronto, for example, 55% population are renters, probably perennially.

2. Avg house price or even median house price is a nebulous concept. Over the years, the portion of condo/townhouse/detached change, so the number is not easily comparable over time, even when used in price/income. Take a look at the RBC report, you will see what I mean. It's clear from the report, that median household simply can not afford detached 2-story houses in Toronto or any city. They can only afford at the max a condo. That means 50% of the household can never afford a detached house.

One thing that I think any rational person would not dispute is that the West is out of whack. No need to convince anyone. Vancouver's house/income ratio is at 10x, outrageous even by US big city standard.

I recommend get RBC's report on real estate affordability report this year. It contains lots of good data points for different cities.

[dave]

@psychodave,

Hadn't thought about it in a long while, but i do a great Bullwinkle impersonation (holding a chair upside down over my head).

How can you have a real estate bubble with more meese than people ?

p.dave, how does it feel to have a currency named after you ?

I'm really feelin' Canadian since i finally saw http://www.youtube.com/watch?v=87bUBB-rwFc

and then http://www.youtube.com/watch?v=fVaABnGMCCo

[psychodave]

"p.dave, how does it feel to have a currency named after you ?"
Silly. Loonies aren't psycho ... right? [crickets]

[Natural Skin Care]

I was looking for Canadian House Price data as it relates to averages, just last week. I wanted to measure these statistics against the USA data. And it is amazing at just how little is available and more so when trying to do an evaluation.
However, it seems to me that if the average house price in california is now in the 250 to 300 range,

[John Beck Property Vault]

i think According to the Teranet index, home prices rose 8.9% per year from 2003 through 2007 across the six cities in the index.

[Jonh SIcler]

Indeed,
In this case I want to announce that it is true there is a large price deflation Fort Lauderdale Real Estate but it has attracted much attention as many countries as Panama is having a great growth in population and tourist visiting this country which increases the development sales of large-scale housing which in most cases their apartment building, premises, houses and others. It is incredible that we are presenting "deflation" as this small country is proving quite the contrary the same driven by real estate companies cone is renowned for Tribaldos Real Estate Corp which is the number 1 on buildings in this country.
Thus we should take example and develop a new method to drive more and more to our country's overall development Real Estate.

http://www.tribaldos.com.pa

[alex deiden]

unfortunately, vancouver house market does not have any connections to Canadian economy and does not relate to Canadians affordability to buy the house. Vancouver house market became as a safe heaven for 'laundrying' money from South America, China, USA, Afganistan, and etc... it will be great comparison to see how many of properties in West Vancouver, North Vancouver, West Side of Vancouver has been purchased for CASH. Canadian dollar is up because of OIL prices and billions of dollars are ending up in Vancouver real estate as safe heaven for ROI for next 5 years until USA market may recover. THe prices for houses will go up in next 2 years in good area in Vancouver also because of low inventory and lack of land. But it is definitely very risky business for regular Canadian to buy house in Vancouver - the bubble can burst after Olympics, autumn 2010, or autumn 2012-13. I think it will go down by at least 40% by that time prices. let's wait and see.

[soamie]

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[tam]

How do you think immigration factors in? What if there is a correction in Chinese curency?