Is Canada in a bubble? Housing experts face off

Welcome to the Great Debate. Each month, Globe Investor will invite two experts to debate one of the big questions facing the business and investing world.

This month, we look at whether Canada is experiencing a housing bubble. Today, our debaters present their opening arguments defending and opposing the motion: Canada is experiencing a housing bubble.

(Click here to read the Day 2 and Day 3 arguments by David Madani, Canadian economist at Capital Economics, and Helmut Pastrick, chief economist for Central Credit Union 1.)

Defending the motion: David Madani, Canadian economist, Capital Economics

Housing bubbles can last a long time. Over the last decade, the housing boom has resulted in the largest rises in house prices ever seen in Canada, which have been similar in magnitude to those during the recent boom in the US.

More importantly, Canadian house price appreciation has consistently outpaced household income growth, which has pushed traditional house price-to-income indicators to dangerously high levels. Although far from perfect, we think that these indicators, particularly at these elevated levels, are the most reliable sign as to what we might expect for housing prices in the years ahead.

During a housing bubble, factors such as population growth, land shortages, financial innovation and low interest rates are often used to justify high housing valuations. While these factors have some merit, they fall short of explaining the full story.

Recent housing studies by the Bank of Canada indicate that house prices are significantly higher than what economic fundamentals suggest, including today's low interest rates. We think the missing piece to the housing puzzle is "animal spirits," the term that John Maynard Keynes used to describe emotions which influence economic behaviour.

In short, human greed creates the conditions of rapidly rising house prices. When greed ceases to motivate buyers, then house prices begin to decline. Once this begins to happen, the fear of falling house prices turns more potential buyers away. We think that there is a high chance of this narrative playing out in Canada, which would obviously create the conditions for a housing slump and a self-perpetuating decline in house prices.

The bottom line is that housing bubbles can last for several years, but, eventually, time reveals that it was too good to be true. Trying to predict the exact timing of housing corrections, though, is beyond the scope of economic forecasting models.

Canada's most overvalued housing market, Vancouver, seems to have already cracked. Some other large markets may soon follow. Looking ahead to the next few years, though, we seriously doubt that household incomes will catch up to high house prices. The more plausible scenario is likely to be moderate growth in income and outright declines in house prices. To put a number on it, we expect house prices to decline by 25 per cent over three years.

Against the motion: Helmut Pastrick, chief economist for Central Credit Union 1

Record high house prices in Toronto and Vancouver and continuing warnings from top politicians and bankers about the dangers of high household-debt levels have led many people to fear there is a bubble that will soon burst, sending prices crashing to Earth.

The U.S. housing boom/bust experience with prices in some markets off more than 60 per cent and the high number of foreclosures is seen by many as a warning of things to come in this market.

The fear is understandable, but this perception ignores some economic fundamentals.

Those worried about a bubble believe house prices are disconnected from fundamentals such as income and rents and cannot be sustained. They are right that affordability is an issue and one that families will deal with as they always have in the past – changing their purchases to reflect their situation.

But the key factor that bubble predictors seem to ignore is the other side of the market equation – supply determines price as much as demand.

For example, a recent widely reported study by the International Monetary Fund looked at demand factors such as income, mortgages and demographic factors, but did not include supply factors. It concluded Ontario and B.C. house prices are overvalued.

Research shows that in markets with restricted supply, most of the adjustment occurs in house prices rather than in expanding supply. Geography is one of the most important determinants of housing supply inelasticity.

The price of the house you buy is a combination of two factors – the price of the land it sits on and the cost of construction, mainly labour and materials. Accurate data is scare in the Toronto area, but there is no question that lot values have been rising, more than doubling in some suburban areas from 2000 to 2010, while the rise in construction costs has been much less.

Over the next 25 years, Toronto metropolitan area population is projected to grow by 45 per cent, increasing the demand for land and population density. This demand increase suggests the average sale price will rise 60 to 95 per cent in current dollars, by 2036.

Consider that in the past 25 years Toronto's average sale price has risen by 235 per cent in current dollars, or 80 per cent, after inflation.

This is a long term projection, but that doesn't mean there won't be a price correction as housing markets contract during economic recessions.  In none of the post-war housing downturns was price or overvaluation the trigger.

Ultimately, housing overvaluation is in the eyes of the beholder, but when house prices drop, it won't be due to overvaluation and it won't be permanent.