The resilience of the Canadian housing market continues to confound experts. Last April, I wrote about the hot housing sector in Canada. Since then this sector has become even hotter, exhibiting strong signs of a classic bubble. More than ever before, I believe that Canada's housing market is due for a severe correction.
Bubbles are hard to see in advance and even harder to know when they will burst. No matter how high prices go, there are always analysts who try to justify them by arguing that "this time things are different". This was the case during the dot com bubble in late 1990s and this is what has been happening nowadays with the housing bubble in Canada.
I have heard many arguments of why this time it is different. Toronto, for example, is becoming New York or London and current prices are thus justified. Bank economists are also justifying current house prices with convoluted explanations arguing that this time things are different ignoring multiple signals of overvaluation that have worked very well historically and in other environments. But as Sir John Templeton said, the most misused expression in the world is "this time is different". It is never different.
Statistics never lie One can massage the data to give them a twist to support one's argument, but unadulterated data do not lie. House price increases have not been matched by underlying increases in fundamentals such as growth in disposable income, growth in GDP per capita, inflation, population growth, annual immigration growth or the rental indexes produced by CMHC. The ratio of house prices to rent (a ratio equivalent to price to earnings ratio used to identify valuation risks in stocks) is now higher in Canada than in any other developed country.
Moreover, average house prices are now 12 times personal disposable income, way above historical averages. This ratio reached 9.7 times in the last housing bubble in the late 1980s. As a result, household debt as a per cent of disposable income has risen to over 153 per cent in Canada, reaching record levels and coming close to the levels that the U.S. reached before the housing crash.
In economics, it all comes down to demand vs. supply. Canada has a significant excess supply of housing that sooner or later will have to be reflected in lower prices. Toronto, for example, is at the top of the world when it comes to the number of condo buildings under construction.
Housing investment as a share of GDP climbed towards a record high last year. It reached 7 per cent of GDP as at the end of 2011 vs. a 50-year average of 5.8 per cent and previous peaks of about 7.26 per cent in the late 70's and 7.18 per cent in the late 80's. After residential housing investment as a percentage of GDP peaked in the previous two cycles, the housing market crashed within a few years. This ratio peaked at about 6.1 per cent in the U.S. in the mid-2000s at the height of its housing bubble, and toward the end of the 1980s in Japan, when that country was nearing the end of its own property boom.
At the same time, the home ownership rate has reached 70 per cent in Canada – it was 69 per cent in the U.S. at the peak of the housing bubble there. Where will demand come from in light of aging population and negative demographic trends?
And all this happens when unemployment problems are finally hitting Toronto and other white collar cities. Recent employment statistics show that employment in finance, insurance and real estate has tumbled for five straight months as of January. In fact, job levels in these industries have fallen by 4.6 per cent since last year. And these are jobs lost in Toronto, which now has an unemployment rate of 8.6 per cent well above the national 7.6 per cent, and in other large metropolitan areas.
Two developments have propped up the housing market in Canada and have delayed the correction. First is globalization which has benefited Canada as the country has been an oasis of stability in an uncertain world. Over 60 per cent of all new condos in Toronto are bought by investors – the number rises to 80 per cent in the centre of the city. Influx of non-resident Chinese and world investors have driven condo prices in key cities. Foreign investors are buying up to five properties each.
Second, low interest rates and the belief that real estate holds its value better than other forms of investing are also driving the housing market in Canada. Small down payments along with CHMC mortgage insurance, loosened lending standards and mortgage rate competition by Canadian banks have all helped the housing boom.
"We do not see a catalyst for the bursting of the bubble", many bank economists and real estate agents argue. But it is normally what we do not anticipate (or we do not know that we do not know) that pricks the bubble. On the other hand, events we may expect to cause the bubble to burst are:
- faster than expected economic growth, especially in the U.S., may prompt the Fed to raise interest rates aggressively to quell inflation fears that the excess liquidity in the system, resulting from various stimulus packages and Quantitative Easing programs, can easily ignite;
- an unexpectedly improving economy and a better performing stock market may hit investing in real estate as less economic uncertainty may shift funds away from perceived safe havens, such as government bonds and real estate, into alternative investments; and additional government regulation against housing speculation; and
- increasing opportunities in other parts of the world may also hurt real estate prices in Canada.
Canada's high house prices in relation to incomes, combined with record household debt levels and overinvestment in residential construction, combined with a slowdown in demand, will cause a severe correction in the real estate market. This time it is not different. It never is.
George Athanassakos