House inside a bubble
Welcome to Day 3 of 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 closing arguments defending and opposing the motion: Canada is experiencing a housing bubble. (Click here to read the Day 1 and Day 2 arguments by David Madani, Canadian economist at Capital Economics, and Helmut Pastrick, chief economist for Central Credit Union 1.)
For the motion: David Madani
We all know that recessions negatively impact housing markets. The recent U.S. housing boom/bust, however, clearly shows that housing markets are not always bystanders.
Many housing experts thought that U.S. house prices at the peak would keep rising because of strong demand and housing shortages. Many experts also dismissed what traditional price-to-income and price-to-rent ratios were warning them.
One important lesson from the U.S. experience was that the strong demand caused by changes in household formation created "perceived" housing shortages. These perceived shortages (or pent up demand) eventually led to excessive new home building and speculation in existing housing markets, pushing house prices too high. But now that the bubble has burst, the housing shortage problem has vanished.
In Canada, we think that the relaxation of CMHC mortgage insurance underwriting since 1999 has been central to the strong demand for housing and solid household credit growth. CMHC has artificially boosted household formation rates, reflected by the decade-long upswing in Canada's home ownership rate, to almost 70 per cent from roughly 63 per cent over 10 years ago. This is a big change over such a short period of time.
Sharply rising house prices over the years of course have enticed many younger people to jump into home ownership much sooner. We hear many stories about younger people buying because they fear being priced out in the near future.
Overall, these and other factors have created a self-fulfilling upswing in home prices, easily outpacing household income growth. This upswing looks eerily similar to what happened in the U.S., which we can agree on was a bubble. This similarity should serve as a big warning sign. It is wishful thinking to simply assume that house prices can keep rising relative to incomes forever, especially now that bank lending rules are being tightened by government.
Anything that would break this blind faith in ever-rising house prices is all that is needed to trigger a housing slowdown. Since the willingness of home buyers to pay higher and higher prices relative to income is ultimately a confidence game, anything that upsets household confidence over the near term could be a trigger. We doubt the Bank of Canada will raise interest rates any time soon. But policy tightening by OSFI and other government institutions could bring about a material slowdown. Even without a trigger, housing bubbles eventually end on their own. As the economist Robert Shiller once said:
"A bubble occurs when exaggerated expectations of future prices increase unusual demand either by people who fear being priced out of a market or by investors hoping to make a lot of money fast. A bubble is a self-fulfilling prophecy for a while, as successive rounds of buyers push prices higher and higher. But the willingness to pay higher and higher prices is fragile: It will end whenever buyers perceive that prices are no longer going up. Hence bubbles carry the seeds of their own destruction. Only time is needed for bubbles to end."
Against the motion: Helmut Pastrick
Most, if not all, housing markets operate with land supply constraints caused by geography or by regulations and usually both exist in varying degrees.
Research shows that markets with a restricted land supply experience larger swings in prices when demand changes, since the supply curve is relatively inelastic. The boom/bust cycle in markets associated with more land restrictions is largely due to these fundamentals not to speculation.
High turnover in existing housing markets is not sufficient evidence of speculation, unless turnover is defined as short-term buy and sell transactions, rather than the buy and hold transactions of most home purchasers. A high level of sales and a number of real estate TV shows are not sufficient evidence of speculation.
Also, high prices are not sufficient evidence of a bubble or extensive speculation. Prices can be high because of economic and market fundamentals. Market excesses can develop and occur under certain conditions.
That speculation increases in rising markets is clear, but the question remains as to the extent of this activity. In Vancouver, data exists to measure short-term buy and sell transactions and provides hard evidence that current speculative activity is low and has been low since the 2008 recession.
Easy credit is a necessary condition for speculation to flourish. Credit is currently cheap in Canada but is not made available to any and every loan request. Conservative practices by mortgage lenders, tighter mortgage insurance conditions, and more regulatory oversight since the last recession mean tighter, not easier credit.
Canada's housing starts are currently in the 215,000 unit range this year, compared to 194,000 units in 2011. My estimate for average annual household formation is 190,000 households. Allowances for replacement demand and vacancies are added to this to yield an average annual total housing starts requirements estimate of 205,000 units.
Supply has been below this level since the recession. Since people live in completed units, the key number is housing completions, which in 2009, 2010 and 2011 were 176,441, 186,855, and 175,623 units, respectively.
The number of new completed and unoccupied row and apartment units in Canada is currently lower than in late 2010 and early 2011. Toronto's MLS residential active listings are well below normal and reflect a shortage.
Toronto's apartment condominium market is undergoing high levels of new investment and overbuilding could occur. If so, it is likely to be limited to that sector and have little or no effect on other markets. Housing markets are local in nature, not national.
Housing prices are not determined by incomes and mortgage rates alone since supply determines price as much as demand. Long-term prospects are for higher population densities, more intensive land utilization, higher housing prices, and a higher price-income ratio.
The next housing recession will occur with the next economic recession and not because the price-income ratio is high. The trigger for every post-war housing recession in Canada has been external to housing and the next time will be no different.