Rising prices, stagnant wages and mounting debt loads could send the housing market into a tailspin.
Click here to read what Mike Holmes has to say about housing
Is this the year the housing market finally crashes? So far, it sure doesn’t look like it. Sales activity over the past 12 months has been strong, and prices have continued their unstoppable march upward—despite a tepid domestic economy and turmoil around the world. The average price for Canadian homes sold in November stood at $360,396, according to the Canadian Real Estate Association. Meaning that in just 10 years, prices have doubled.
Optimists may find comfort in the market’s resilience. In fact, a December press release from Re/Max boasts of a residential real estate market that “defied conventional logic and exceeded expectations in 2011.” But why should we take comfort in a market that defies logic? That is one of the key elements of a financial bubble.
Keep in mind the market’s strength hasn’t just surprised conservative economists. It has even defied the perpetually sunny logic of the real estate industry itself. There is little argument among economists that houses in most major Canadian markets are, at the very least, overvalued. By some metrics, houses are less affordable now than at any point over the past 30 years. Rising prices draw people to the market in part because they’re afraid they will eventually be shut out. But what many fail to consider is that when ordinary Canadians are unable to afford real estate—even when borrowing at unusually low interest rates—the market will adjust. Unless our incomes go up, house prices have to come down. And there is a very good chance this will happen in 2012.
Over the past decade or so, many developed nations experienced a real estate boom. Canada’s happens to be among the longest running, according to Scotia Capital Economics. But in the wake of the global recession, prices in most other countries have fallen back to earth. Canada was one of only three developed nations tracked by Scotia to post gains in the third quarter of the year. Both the U.S. and the U.K. have already suffered crashes north of 20%. While different factors underlie their real estate markets, it nevertheless stretches credibility to believe that Canada will remain an anomaly.
The heads of three of the country’s major banks (CIBC, RBC and BMO) expressed concern about the housing market at an investor conference this month. All agreed that increasing housing supply and growing debt means the market is reaching its peak. While they don’t foresee a crash, they acknowledged prices are likely to drift downward. Bank of America Merrill Lynch, meanwhile, predicts prices could fall between 5% and 10% this year. There is also a possibility prices will drop much farther over the next few years, perhaps as far as 25%. The scary part is that the direction of the economy ultimately might not even matter. If interest rates rise and the monthly cost of carrying a mortgage edges up, there’s little doubt that prices will fall, as rising rates make homes less affordable. But interest rates don’t have to rise for the boom to come to an end.
To see why, it helps to understand how we got here. For decades, interest rates in Canada were either sky high or fluctuated wildly, making it risky to take on hefty mortgages. But when the Bank of Canada started managing inflation in the early 1990s, rates fell, ultimately leading to a surge in home ownership. In 2006, the federal government made it even easier for citizens to buy homes by permitting the Canada Mortgage and Housing Corp. to insure 40-year-long mortgages with no down payment required. (The government eliminated this option in 2008.) Interest rates have remained at unprecedented lows since the financial crisis in 2008, providing more incentive for Canadians to jump into the housing market.
All of this buying activity has pushed prices up faster than wages. Median home prices are currently at 4.6 times our gross median household income, but Demographia, an urban planning research firm and consultancy in the U.S., argues that prices become unaffordable when they exceed three times income. How did Canadians manage to keep paying more? By borrowing: the country’s household debt to personal disposable income ratio has climbed to a record high of 152.98%, according to Statistics Canada.
This puts the housing market in a precarious position: a large gap between prices and incomes, worsening affordability, and an indebted nation of homeowners less able to withstand economic shocks. None of these conditions has improved over the past 12 months. “The bubble has become worse,” says George Athanassakos, a finance professor at the Richard Ivey School of Business. Athanassakos argues the market is headed for a severe correction. Like many, he thought it would be showing more signs of strain by now. Instead, “house prices continue to go up, and debt continues to go up.”
David Madani, an economist with Capital Economics, says that the reason prices keep rising, despite fundamentals that indicate they should be moderating, is because a bubble mentality is driving the Canadian market. “It’s this belief that prices are going to continue to go up, which becomes a self-perpetuating force,” he says. He explains that in good times, rising prices create a sense of urgency among home buyers who don’t want to miss out on the chance to benefit from soaring prices. So people pile in, pushing prices higher. This creates the appearance that housing is an asset that can only rise in value, and even more pile in.
But this line of thinking can reverse, and people can overreact to a declining market too. The greed that previously drove buying behaviour turns into fear that prices will fall indefinitely. This can be a self-perpetuating force. The result is that prices can dip farther than where economic fundamentals suggest they should be.
If psychology is indeed driving the market, then any event that destroys confidence can touch off the fall. There are plenty of risks globally that could shock the Canadian economy, such as a renewed flare-up in the European Union debt crisis, or a slowdown in China’s rampant growth, which is showing signs of overheating. For risks on the domestic front, look no further than the country’s condominium market, where oversupply is fast becoming a concern. New condo construction accounts for roughly two-thirds of all housing starts, which is high from a historical perspective. The Bank of Canada, in its December economic review, noted “signs of disequillibrium” in this segment of the market. “The supply of completed but unoccupied condominiums is elevated, which suggests a heightened risk of a correction in this market,” the review stated.
The Vancouver and Toronto condo markets are the most vulnerable, as new construction continues at a breakneck pace. A recent report from Toronto’s economic development committee showed 132 highrise buildings were under construction in September, far more than the 88 buildings in Mexico City, or the 86 in New York City. Chicago is similar in size to Toronto, yet it only has 17 condos in development.
In fact, Toronto boasts the most oversupplied condo market in the country, according to Sheryl King, an economist with Bank of America Merrill Lynch. Back in October, she calculated just how many units are set to hit the market. If builders in Toronto stopped developing entirely and merely completed projects that are already scheduled and underway, there would be enough units to supply the market for five years. “We have data going back to the early 1980s, and we’ve never seen that big of a building wave before,” King says. The rate at which the condos are being sold is running at about twice the pace of natural household formation, which indicates investors are scooping up a sizable portion of them. King estimates investors hold anywhere between 40% and 60% of pre-construction units. “Investors are not recognizing that there is this glut of inventory coming on the market,” she says.
With so much stock becoming available, developers could find that units take longer to sell, and they may be forced to start cutting prices. Investors holding pre-built units will start to sweat. Unlike home buyers, they’re only in the market to turn a profit, and won’t hold on to a declining asset for long. They’ll try to flip their units when they can to get out before prices fall any further. Supply will increase when investors start dumping their units, further pushing down prices, and the cycle continues. King estimates Toronto condo prices could fall as much as 15%.
If wages were rising fast, consumer confidence could dampen the downward spiral. Unfortunately, wage growth has been lousy in the wake of the recession. Economists are optimistic that income growth will just barely outpace the cost of living this year. Rock-bottom interest rates have lowered mortgage carrying costs, but affordability nevertheless decreases, the faster prices rise out of line with income. Eventually, the gap just becomes too large. Furthermore, many economists forecast inflation will remain low, so debt will be harder to pay off, creating a bleak picture for housing affordability down the road. For all of these reasons, Madani at Capital Economic projects that home prices in Canada will fall 25% over the next few years.
The breaking point for affordability is impossible to determine, but Canada is looking stretched. Demographia rated six Canadian markets as “severely” unaffordable, including Vancouver, Toronto and Montreal, in a report on housing prices released last year. Of the 35 Canadian cities examined, three were ranked “seriously” unaffordable and 17 as “moderately” unaffordable.
The firm argues that median house prices should be no more than three times larger than gross median household incomes to remain affordable, and to prevent housing bubbles. Right now, prices in Canada are 4.6 times the median income. That means valuations in Canada are approaching the level the U.K. hit just before its market tanked. And we’re already far past the level the U.S. peaked at, which was 3.7 in late 2006.
An argument sometimes used to defend the strength of the housing market is that foreign investors, predominantly wealthy Chinese citizens, are buying property here because Canada is a safe haven in a turbulent global economy. There are no actual data to support this claim, however. Even assuming it’s true, the presence of financially motivated buyers helping to prop up the market doesn’t inspire confidence. “They’ll just liquidate their positions,” Madani says. “They’re a much greater flight risk.” Any listings they dump on the market will only serve to drive prices down further.
When prices do start to fall, don’t expect a quick rebound like we saw three years ago. The average home price fell by 8.5% between August 2008 and March 2009, according to the Teranet-National Bank House Price Index, in a decline sparked by the financial crisis. By November, the market had already recovered. Part of the reason for the quick rebound was massive government intervention.
The Bank of Canada moved fast to slash interest rates to unprecedented lows, allowing banks to continue lending to businesses and consumers. The federal government also established a $125-billion program to buy mortgages it had already insured from banks and financial institutions, providing even more liquidity. The government ultimately bought mortgages worth a stunning $69.4 billion. The Bank of Canada has less room to manoeuvre today. The overnight rate is now 1% compared to 3% in August 2008. Cutting rates to stimulate the market is hardly an option this time. Banks have less flexibility, too. A five-year fixed rate mortgage is roughly 3.8% today, down from 5.7% in late 2008.
All of the scenarios thus far have discounted the possibility that the global economy actually starts to improve. But even if that happens, there will be consequences for the housing market. In a growing economy, the Bank of Canada will have to start raising rates to temper inflation, in effect shutting off the credit spigot that has allowed so many Canadians to buy homes. Sales activity will slow down, and prices will plateau. It could also provide the psychological shock that drives the market down even further.
That doesn’t mean that those considering buying a house today should necessarily let the prospect of a correction deter them. A house is firstly a place to live, not an investment. Bubbles occur, in part, because we forget that distinction. So buyers need to be comfortable knowing their houses might not increase in value over the next few years—and also that they could be worth much less.