Welcome to Day 2 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 rebuttals defending and opposing the motion: Canada is experiencing a housing bubble. (Click here to read the Day 1 and Day 3 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 supply and demand are what determine house prices. The issue. though, is over what type of supply and demand are doing most of the work in Canada's current housing boom. Geography and population growth are undoubtedly crucial to analysing long-run changes in the housing market. But if we want to understand the fluctuations in house price inflation from one year to the next, these long-run supply and demand factors are irrelevant.
Research also shows that certain housing markets with land restrictions are more prone to boom/bust cycles. This is largely because of speculation behaviour motivated by high expected returns. Canadian TV shows such as HGTV's Home to Flip and The Big Flip speak volumes to this point. Evidence of speculation is supported by the high turnover in existing home markets, which correlates with the past outsized gains in house prices.
Canada's overvalued housing market isn't due to a housing shortage either, because housing supply has already adjusted. Housing starts have been running above household formation. This view is supported by CMHC data, which show an excess inventory of unsold housing units, especially in apartment condos.
We think that (easy) credit conditions are key to understanding Canada's decade-long housing boom. The role of government (CMHC) in the mortgage insurance business has been central to this story.
To sum up, our analysis of Canada's housing market has focused on both house price-to-income ratios and mortgage payment-to-income ratios because we believe that there is a significant correlation between income and house prices. When house prices move far out of line with incomes for too long, a correction usually follows. When house prices drop (which we seem to agree on), it is likely to be due to these excesses that typically accompany overindulgence. Of course, any slump in housing will never be permanent, but it might feel that way for several years before the housing market eventually begins to recover.
In short, the housing bubble alarm bells are ringing louder than ever and policy makers are worried.
Against the motion: Helmut Pastrick
Price-income ratios are not the most reliable predictor of the housing market. To argue that high prices or poor affordability, as expressed by this ratio, will lead to a housing recession resulting in a 25-per-cent drop in national prices over three years – about twice the 2008 drop – fails to recognize the cause and effect of recessions. Also to argue that prices are high in part due to greed lacks substance and evidence.
Housing recessions almost always begin due to negative demand conditions or events as occurred in 2008, 1990, 1982, 1975, 1970, and 1966. Lesser contractions occurred in 1993 and 1984. In none of these housing contractions was price overvaluation or affordability the cause or trigger. Prices decline as a result of recessions, not the other way round. High housing prices cause market adjustments by buyers, sellers, and suppliers but not recessions.
The price-income ratio is on a long-term uptrend and will climb in the future. Consider that Toronto’s ratio in 1970 was 2.5 and was 5.0 in 2011 by my estimate. The 2012 ratio will be higher. Basically, the fundamentals of housing supply and demand are driving prices higher indicating a relative scarcity exists and that scarcity is land.
If greed creates the conditions for rapidly rising prices, then speculation must be extensive. However, most home buyers are existing homeowners and some are renters or other first-timers with principal residence their main motive, not greed or speculation.
Investors who take a long-term view are not necessarily greedy, though investors or buyers who are in it for the quick profit or flip are speculators. The extent of speculative buying is a key determinant of whether the market is diverging from fundamentals and in a bubble.
Data for Vancouver shows less flipping exists now than in the 2005-2007 market and far less than in the 1980-1981 and 1988-1989 markets. Similar data are not available for Toronto.
Vancouver’s housing market has not cracked. Yes, the average sale price is down 11 per cent year-over-year and 4 per cent year-to-date in May, while unit sales are down 16 per cent y-o-y and 18 per cent y-t-d, but the market is not tanking. The average sale price is an unreliable market indicator in this instance since it was skewed upwards last year by high-end property sales.
Far superior price measures are CREA’s new Home Price Index and the Teranet-National Bank HPI since they are not skewed by the changing composition of property sales. Both HPI measures show Vancouver prices higher than last year and rising each month, though at a slowing pace.
As for sales, last year saw a surge prior to the change in mortgage insurance rules. Seasonally adjusted sales have come off in most recent months, though. Vancouver’s market is softening but not tanking. There is no housing price bubble and prices are generally fairly valued given land supply constraints and housing demand dynamics.
Canada’s housing prices could decline 25 per cent if a severe economic recession hits but not because of high prices and a high price-income ratio alone.
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