Primer #2: Is there a housing bubble?
In our last primer we looked at how money is created and destroyed in
our fractional reserve banking system. We examined the implications of
this process on inflation (which buoys asset prices like real estate)
and deflation (which crushes asset prices).
In that primer I suggested that one of the main catalysts for a
contraction in the money supply would be a decline in real estate prices
which become self-feeding. This will dampen demand for mortgages and
home equity lines of credit, the two largest generators of bank-created
money, and will also cause people to save and pay off their debts as
they no longer feel as wealthy. This has the effect of 1) Shrinking
the aggregate money supply, and 2) Slowing the velocity of money. In
this primer we will examine the question of how fairly valued Canadian
real estate really is. We will use quantitative measures that are
universally accepted to examine this question, rather than the
qualitative fluff that is rampant in most discussions of real estate
values (example: “they’re not making any more land”, “real estate only
goes up”, “buy now or be priced out forever”, bla bla bla)
Now it is important at the outset to recognize that real estate is
priced based on local conditions. Some areas will definitely be hit
harder in a real estate correction than others. However, there are only
a handful of communities in all of Canada that are at or near their
historic norm when it comes to real estate prices (as measured by the
quantitative factors we will examine shortly). Furthermore, in a period
of persistent deflation, all assets are ravaged, including those that
are ‘fairly’ valued. So it is of particular concern that we are
entering a period of deflation with such widespread overvaluation. So,
for the sake of having a meaningful discussion of the state of Canadian
real estate in GENERAL, I have used data provided for the Canadian
market as a whole.
Let’s first start with the definition of a bubble. While there are
lots of definitions, the easiest way to think of an asset bubble is as
follows: An asset bubble exists when the prices of assets are
over-inflated relative to historic norms, as measured by widely accepted
fundamentals. Bubbles are a product of mass psychology (the topic of
our next primer). They occurs when people flock to a particular asset
class, such as real estate creating excess demand.
I know I referenced Chris Martenson in my last primer, and I don’t
usually borrow too heavily from any source, but he does an excellent job
of explaining asset bubbles in a straightforward manner in this chapter of his Crash Course.
So let’s dive in. There are three metrics that are commonly
referenced with regards to guaging the relative value of real estate:
affordability (usually measured as the percentage of the average income
needed to carry the average house), price-to-income (average price
divided by average family income), and price-to-rent (the value of a
house divided by the annual rental income that the house would
Any discussion of the relative value of real estate is meaningless
without referencing one of these three metrics. Otherwise, we revert
to anecdotes, second-hand stories, and the generally accepted wisdom of
our culture. None of which prove anything.
So, let’s take a hard look at these three metrics to try to
determine just how fairly valued real estate is. If anyone would like
to post a rebuttal to this post, please refute these facts with facts
of your own rather than anecdotes.
Let’s start with affordability. This one is misleading in some
ways. Record-low interest rates have kept affordability at what would
seem to be a reasonable level. In May, RBC released a study in which they concluded that affordability was quickly eroding due to house price appreciation.
Affordability is well above historic norms, and that is with record
low interest rates. Earlier in 2010, we hit new highs in house prices,
despite the facts that income growth has been slightly negative in the
past couple years and has been unchanged over the past decade when
adjusted for inflation. Should mortgage rates normalize, which they
must at some point, you will see affordability rapidly detereorate past
the 2008 lows. Any rational person would conclude that affordability
has to detereorate now that there are new mortgage rules tightening
lending standards, and higher interest rates around the corner.
Additionally, the Canadian Association of Accredited Mortgage
Professionals has recently released a report
indicating that 375,000 households are reporting that their ability to
make mortgage payments is already an issue. This is with RECORD LOW
interest rates! Think about it for a moment!
On to the price-to-income ratio. This one is perhaps most
important, as you obviously need a higher income to support the
increased costs of real estate. I’ll let the second graph at the
bottom do the talking on this one (thanks to David Rosenber at Gluskin
Sheff for this one)
Note that any time you pass the one standard deviation from the
mean, there is always a reversion to the opposite. We are currently
well above one standard deviation from historic norms. So, there are
only two possible options here: Either house prices decline to a level
where incomes can support them, or house prices remain level for a
period of time while incomes catch up. I think mass psychology (it’ll
make sense after the next primer) and the state of the economy in
general make the second option quite remote.
Now let’s consider the price-to-rent ratio. This one is akin to the
popular price-earnings multiple used to value stocks. Essentially, it
is a quick measure of whether or not it makes sense to rent a house or
buy the equivalent house. In this one, the graph is shocking.
As you can see, we are dealing with a two standard deviation event.
Based on rents, homes are 60% above their long term intrinsic value.
Finally, let’s look at home ownership rates. They are at historic highs
(now breaching the 70% level, above the level the US experienced prior
to its crash). You need a steady supply of new home buyers to keep the
real estate game going. So it begs the question of who will be the new
buyers. You may be prone to say that immigration will be our short-term
salvation. I would beg to differ. Net household formation in Canada
is running at 175K per annum. That includes imigration and ‘organic’
household formation. Currently housiung starts are running at +200k per
annum. It’s not hard to see that there is oversupply in the pipeline
for the near-term future.
You’ll note that all three of these valuations have concrete upper
boundaries. You cannot have price-to-income ratios increase forever.
Clearly. And you can`t have price-to-rent increase forever, or people
will stop buying. Clearly. Affordability cannot detereorate to the
point that people require 80% of their net pay to service the costs
associated with the average home. Clearly. So consider the
implications. Weigh them out. Then, for the bulls out there, please
formulate a rational response that explains why real estate will do
anything but decline over the next few years. I don`t expect any
As always, don’t follow the crowds. The danger of ‘crowd thinking’
will be abundantly clear after the next primer. Think for yourself.
You’ll do fine!
Cheers and blessings,