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the economics of housing

Canadians are obsessed with whether or not our housing market is going to suffer a "U.S.-style" correction. It's by now widely accepted that corrections are happening in key Canadian cities. Sure, there are still pockets of strength – Calgary and the detached market in Toronto, for example – but most markets are seeing rising inventory and falling sales, which typically foretell price weakness.

I don't believe that what happened in the U.S. is going to happen in Canada. The U.S. housing crash was the greatest destruction of wealth in human history. House prices dropped 35 per cent nationally from peak to trough, inflicting a crippling and long-lasting blow on their economy and labour market.

But that doesn't mean we have nothing to worry about. As I've argued before, there are a lot of very negative outcomes between "painless soft landing" and "U.S.-style collapse." And given that the Canadian economy and labour market are significantly more reliant on housing-related industries than the U.S. ever was, even at market peak, I am extremely skeptical that policy makers can easily orchestrate a soft landing without significant collateral damage.

Here are three ways Canada compares to the U.S. in terms of some important house price fundamentals, and why there may be cause for concern:

1) Average resale price

Admittedly, the average is not a perfect measure of house prices due to it being easily moved by outliers. For example, people will point out that Vancouver's crazy-high house prices artificially distort the Canadian average. But this same dynamic is also at work in the U.S., where states like California push the average price higher. For reference, California accounts for 12 per cent of the U.S. population, while British Columbia accounts for 13 per cent of Canadian population. Call this a wash.

Note that average resale prices in Canada and the U.S. have always tended to track each other closely, which one would expect given similar income and per-capita GDP figures and comparable borrowing costs. Today, however, we find that Canadian house prices command a 55 per cent premium to U.S. prices. See this chart for details.

2) Real house prices

I've previously written about real (inflation-adjusted) house prices in Canada. The idea here is that over time, house prices tend to pace inflation, with perhaps a slight upward bias. Record-high real house prices were one of the warning signs economist Robert Shiller pointed to when he presciently warned of a U.S. housing crash. Real house prices in Canada are at record highs, while the U.S. is back to what might be considered a fundamental level. This chart shows that.

3) House prices relative to per-capita GDP

There was an interesting article published in the May/June 2011 edition of the Financial Analyst Journal titled "The margin of safety and turning points in house prices." In it, the authors studied house prices in developed countries and found:

"These data, when detrended, reveal long-term mean-reverting relationships between house prices and other macroeconomic variables – in particular, GDP per capita. ... Hence, when prices deviate from the mean, the question is not if they will revert but when."

As seen in this chart, the average Canadian home now sells for a record multiple of per-capita GDP. That's something that should concern us all.

Ben Rabidoux is a Canadian analyst and strategist with U.S.-based Hanson Advisors, as well as the author of The Economic Analyst blog.