Another day, another glum housing headline. The latest market to feel the tug of gravity is Toronto, where the Teranet-National Bank house price index published this week shows that prices fell by 0.6 per cent in October from the previous month; nationally, prices were 0.2 per cent lower over the same period.
Economists such as CIBC's Benjamin Tal have long argued that a modest housing correction is in the cards. The question is whether the downturn will really be a modest correction or something worse.
The problem with trying to determine the likelihood of a so-called soft landing is that no one seems able to agree what a soft landing looks like. We only know what it doesn't look like – the U.S. housing crash provides a vivid portrait of a hard landing, in the same sense that a tomato exploding when hurled at a brick wall constitutes a hard stop.
Mr. Tal says a U.S.-style crash is unlikely to happen in Canada, citing the higher quality of our mortgage debt, the measured rate at which we accumulated it and the close relationship between our home buying and our rate of household formation. So where can we look for a glimpse at what may come next?
Australia, perhaps. Its housing market is often said to have experienced a soft landing, after home prices spiked in the late 1980s, eased back, then recovered, essentially retracing their steps between 1989 and 1997.
But as French economist Betrand Roehner pointed out in a widely cited 2006 paper on housing bubbles, the downturn in the early 1990s wasn't exactly soft: "In spite of prices falling at annual rates of 8 per cent to 10 per cent, real estate experts would continue to use such euphemisms as 'the flat market in Sydney' or 'the market has cooled down.' "
Whether Canada follows the U.S. or the Australian model, our tomato is still almost certainly cruising for a bruising. The question is not whether prices will revert to the mean – even the bulls seem to think they will – but which mean will they revert to?
The chart at left shows two scenarios for the Toronto market. If, as market bulls have argued, prices have been rising for good reasons – such as limited space and immigration – they will likely correct back to their 1976-2012 growth trend. In that case, they would drop as little as 6 per cent.
On the other hand, if bears are right, and Torontonians have been engaged in an orgy of real estate speculation for the last decade or so, then nominal average prices in Toronto might revert to the growth trend established between 1975 and 2002, before home prices took off. In that case, prices would drop roughly 27 per cent. Now that's a hard landing.
The biggest reason for optimism is that Canadian homes are still fairly affordable, largely because of low interest rates. RBC's Affordability Index (shown on chart) tracks the percentage of pretax annual income the average homeowner has to pay for mortgage payments, utilities and property taxes. It indicates that homes are more affordable today than they were during the real estate runup in the early 1990s, when mortgage rates were in the double digits.
However, Finance Minister Jim Flaherty's announcement this summer that he was reducing the maximum amortization period on government-insured mortgages to 25 years from 30 may have significantly altered the game. According to the Canadian Association of Accredited Mortgage Professionals, 40 per cent of new mortgages last year were amortized over 30 years.
Mr. Flaherty's decision will deter some marginal home buyers from entering the market. But RBC's Affordability Index doesn't register the change, since it only tracks mortgages with 25-year amortizations, not 30-year ones.
In retrospect, what kept the Australian slowdown from turning into a full-scale disaster was that, unlike in the U.S., mortgage lending did not seize up. After home prices began their early-90s dip, Australians quickly resumed taking on mortgage debt, fuelling a rebound in prices. Mortgage debt rose rapidly, peaking at almost 90 per cent of GDP in 2010, suggesting that perhaps the country borrowed its way out of a crash.
Canada may be able to do the same. But, one way or another, count on this tomato being squeezed.