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the economics of housing

With Canadian real estate prices near record highs and sales in many Canadian cities starting to weaken significantly, recent articles have sought to quell fears by reminding readers that housing is an excellent hedge against inflation. The argument is that house prices stand to benefit from rising inflationary pressures, which some suggest are just around the corner.

The advice is simple: If you're a first-time buyer, forget all the talk of a potential housing correction and jump into the market. Inflation will be your friend. Setting aside the reality that the bond market has firmly rejected the notion that a high inflation environment is coming soon, let's take a closer look at the relationship between inflation and house prices.

It is true that real estate has historically provided a hedge against inflation. In other words, as inflation pushes up the costs of goods and services, real estate values have risen with it.

Yale economist Robert Shiller famously created a U.S. house price index back to 1890. It showed that over that entire period, prices more or less paced inflation, with at best a very slight upwards bias. Certainly there were periods where prices rose notably faster or slower than inflation, but those periods tended to be followed by periods where prices did the opposite and reverted back to the mean over time.

The oldest housing data in the world also confirms this trend. In a study of house prices along the Herengracht Canal in Amsterdam back to the 1620s, Piet Eicholz of Maastricht University found that while prices were volatile in the short term, they tended to track inflation over time.

This is an important point. Real house prices, defined as house prices adjusted for inflation, tend to be flat over time. What these studies tell us is that periods where real house prices are rising - when house prices rise faster than inflation - are invariably followed by periods where real house prices fall.

This chart makes that abundantly clear. In it, a reading of 100 represents a "normal" market. In both Canada and the U.S., real or inflation-adjusted house prices have always reverted back to this level over time. The U.S. housing bubble, in which real house prices rose substantially above their trend, has now been fully retraced. But here in Canada, real house prices remain well above their long-term trend.

This, by the way, is not only due to the effect of a couple expensive markets skewing the national reading. Real house prices in every large Canadian metro are at record highs with each of them between two and three standard deviations above their long term trend.

Real house prices in Vancouver have risen particularly quickly, prompting economist Robert Shiller to recently compare Vancouver's rise in real house prices with California's. Prices in many California cities have fallen 40 to 50 per cent from their peak. Whether Vancouver will experience a California-style crash is a topic of particular relevance at this time, one that I will explore in this upcoming seminar.

Although Calgary experienced a real estate correction several years ago, it did not fully retrace the run-up in real prices. Listings and sales in the city are well-balanced at present but a return to the boom years seems very unlikely at this time.

Toronto real prices are now above those experienced in the previous peak, which was followed by a 25 per cent decline in average resale prices in the city over the next five years.

Real house prices in Ottawa are the most out of line relative to historic levels, at nearly three standard deviations above trend.

Montreal house prices have also significantly outpaced inflation over the past decade. This is very unlikely to persist going forward, particularly given declining sales and the unprecedented MLS inventory currently on market.

What this tells us is that no matter what happens to inflation over the next few years, it is highly unlikely that house prices will pace inflation, let alone beat it handily, as they have for the past decade.

The reality is that house prices can temporarily rise faster than inflation for a number or reasons, but the most recent surge in real house prices in most Western nations has coincided with falling interest rates, a mortgage credit boom tied in part to loosening credit standards, and a secular shift in attitudes towards home ownership, as evidenced by rising homeownership rates. In a number of countries, including the U.S., England, Ireland, France, Australia, Spain, and Greece, real house prices have reversed course. It is highly likely that Canada will now follow suit.

Equally important in this discussion is the reality that interest rates are in large part determined by prevailing inflationary trends. As inflation rises, so too does the interest rate people will demand in order to lend their money.  Few people will lend their money out at 2 per cent for five years if inflation is expected to be 10 per cent. They would be losing their purchasing power each year. Because of that, the bond market - which is the biggest determinant of mortgage rates - is very sensitive to changes in inflation.

Without question, a rising inflationary environment would be coupled with rising mortgage rates.  RBC's housing affordability index shows that affordability is already stretched relative to historic norms in most Canadian cities - and this is during a period of record low rates. Higher inflation, and the accompanying higher interest rates, will certainly not help house prices in the short term given the current (un)affordability situation.

Looking ahead to the next five years, the stimulative conditions that have allowed exceptionally strong real house price growth over the past decade will no longer be in play: Interest rates remain near record lows with little downside potential while credit availability is being tightened by prudent new rules implemented by Canada Mortgage and Housing Corporation and other Canadian regulators.

It is exceptionally likely that real house prices will fall over the next five years. And if this should coincide with a low inflation environment, as I suspect it will, we will likely be looking at outright price declines, and potentially significant declines at that.

Ben Rabidoux is a Canadian housing analyst and macro strategist with Hanson Advisors.

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