Real estate: Nasty neighbours

As the American housing market sinks, can ours stay afloat?

Could it happen here? The U.S. housing market is bad and getting worse. Builders built too much through the boom, lured by skyrocketing prices that proved as unsustainable as the lending practices that fuelled them. As in any market, the emergence of a big supply/demand imbalance requires sellers to do two things: make less and discount more. So it’s been. Housing starts have dropped 54% from their peak. Home prices are falling in every one of America’s 20 largest cities, down by an average of 13% from their peak.

The scary thing is, though, that even these dramatic declines haven’t been nearly enough to stabilize the market. The supply of unsold new homes stood at 10 months’ worth of sales in February, up from less than four months at the height of the boom. That represents the most bloated inventory levels in 27 years. The American housing bust has yet a ways to go.

Probably the most common question I get these days is, “Could this happen in Canada?” My answer is yes, it could happen here, not least because it has happened here. Canada’s housing busts have tended to be a bit more regionalized than what we’re seeing in the States, but no less profound. It took seven years for Calgary house prices to regain their 1981 peak. It took eight years for Vancouver house prices to regain their 1995 peak. It took 12 years for Toronto house prices to regain their 1989 peak.

The better question, though, is, Will it happen here? Over the long term, my answer again has to be yes — housing markets, with their long lags and sticky prices, are simply prone to this sort of boom and bust. But getting down to the heart of the matter — is a U.S.-type housing bust on the visible horizon for Canada? — my answer is no. I do think housing markets across Canada are likely to slow down ahead, but three things keep me confident that we’re not about to go off the same cliff the United States has.

First, lending didn’t get as out of hand in Canada. In 2006, 26% of new mortgages in the U.S. were to sub-prime borrowers, compared with 3% in Canada. U.S. lenders came to care less about whether the money they lent ever got paid back, knowing that the mortgages they originated would be securitized and sold on to remote investors, who couldn’t know how rotten lending standards had become. At the 2006 peak, private securitizations accounted for 47% of new mortgages in the States, compared with 7% in Canada. Second, unlike the United States, Canada doesn’t look overbuilt. We estimate that the sustainable rate of new home construction in the United States is about 1.6 million per year, based on household formation rates. Actual housing starts were above that level every year between 2001 and 2006. Canada’s sustainable rate looks to be about 180,000. Actual housing starts have been above that level for the past six years — but only after having come in below in each of the prior 11 years. Canadian builders have indeed been building too much of late, but only after building far too little through the entirety of the 1990s.

Third, house prices in Canada don’t look nearly as stretched as those in the States did (and in some cases still do), reflecting that supply and demand in the Canadian market never did get as out of whack. Our proprietary housing valuation models, driven by both affordability considerations and individual market conditions, suggest that Victoria is currently the most overvalued city in Canada, with average house prices at 23% above “fair value.” Edmonton is next, at 21%. By contrast, Miami and Los Angeles both got to more than 60% overvalued at the U.S. peak.

In short, I think conditions look good for a fairly soft landing in Canada’s housing market. The unfolding American bust might even help, as a cautionary tale to Canadian builders, buyers, lenders and regulators. Just how well the lessons are learned, however — or, more properly, how well they are relearned — will go a long way in determining how sanguine we can remain about the Canadian housing market’s prospects.