Bubble? What Bubble?

Yes, the housing market is hot. But a replay of the late-'80s meltdown looks unlikely. Here's why.

There's certainly no shortage of signs we could be headed for another late-'80s-type boom/bust in the housing market. Average prices and new home starts in Canada are both up 50% since 2000, the largest sustained gains since–well, since the late '80s. Housing markets in Australia and the United Kingdom, which had been showing the same sort of strength, have recently hit the wall; the United States looks headed for the same. Perhaps most ominously, there are now more free real estate magazines than free dailies outside my subway stop in Toronto.

But looks can be deceiving. A close examination of the fundamentals suggests Canada's housing market still has some room to run. The first reason is history. The 1990s were something of a lost decade for Canadian housing. New house prices declined on net between 1990 and 1999; resale prices did a bit better, but still fell on a real basis. Some stagnation had to be expected, given the excesses of the late '80s. But even as prices were stumbling along, the fundamentals underpinning Canada's housing market were improving markedly–and have continued to since. Average household incomes have risen 46% in aggregate since 1990, while the standard five-year mortgage rate has tumbled from 13% to below 6%. The improvements in these two areas reinforce each other–more money to spend and more buying power per dollar of that spending–to yield the result that the average family devoting the same proportion of its income to housing can afford to spend roughly 160% more than it could 15 years ago.

Even with the recent boom, average house prices aren't up anywhere close to 160% since 1990. But that doesn't necessarily mean we're OK–after all, we're comparing to a known bubble. To address this issue, we recently introduced a measure of “potential” house prices based on incomes, rates and standard mortgage terms. It shows that Canada-wide average house prices were indeed beyond potential 15 years ago–by 8%–but that they're 27% below potential now. The contrast is even greater in Toronto–we calculate that prices in 1990 were 52% above potential, but are now 20% below. We applied the same metric in those other countries whose housing markets are tiring, and indeed many of the larger cities come out as having reached significantly overvalued levels. (Sydney and San Francisco look most overdone, at 99% and 73% above potential, respectively.)

The difference does not appear to be in the fundamentals themselves–the U.S., the U.K. and Australia have also all seen incomes rise and interest rates fall over time–but rather in the “traction” those fundamentals have found in the housing market. All three countries posted 30%-plus rises in house prices through the 1990s, building strength on strength more recently to yield extraordinary (and unsustainable) gains. In Canada, rather than getting ahead of ourselves, we're probably still playing catch-up after a decade of post-bubble caution.

The second major Canadian advantage is the likely longer-term sustainability of those underlying housing fundamentals, particularly low interest rates. The U.S., the U.K. and Australia all have large, growing current account deficits, which by definition means those economies are increasingly financed, on net, by the savings of others. The lenders have increasingly been Asian central banks, whose accumulation of foreign reserves has provided a cheap, easy source of financing. This will not last forever, and when those inflows fall, interest rates in those countries will rise. Canada, by contrast, has run consistent current account surpluses in recent years–that is, we have been one of those lenders to the rest of the world, more than able to support current activity with domestic savings, and thus do not share this vulnerability.

There are, to be sure, risks ahead. The Bank of Canada will almost certainly resume raising short-term rates on Sept. 7 (though probably not by much). A U.S. housing bust may not be matched in Canada, but it could still have dire consequences for the broader economy. Even if the market as a whole isn't a bubble, there are doubtless pockets of froth. And certainly a long run of the kind of price increases we've seen recently would risk forming a bubble. But for now, the Canadian housing boom looks like it's building on solid fundamentals.