Each week brings another round of fresh reports arguing whether we are in a midst of a Canadian housing bubble or not. My view on this topic continues to evolve, but I reckon we are in a frothy housing market and that homes are overvalued. Before we continue I want to point out that I understand there are regional and segmental (multi-residential vs. single dwelling) effects in this story but overall the picture is very clear given the situation in the majority of Canadian cities. Also, that there are many interesting sub stories, such as the influx of wealthy foreign buyers into the Canadian market etc. Below I have listed a few of the most credible reports that attempt to estimate the nature of overvaluation in the housing sector:
Of course there is the contrarian view championed by realtors, builders and mortgage brokers. There is no consensus on this topic really. I’m fairly certain the same sort of debates took place in the US prior to the housing collapse. In Canada, most of us have heard the anecdotes of run-down townhouses sparking bidding wars, bidders removing essential clauses such as home inspection in order to win an auction, but ultimately having to walk away empty handed even though their final bid was 115% over asking. But the Canadian housing boom has been going on for some time (since the late 1990’s), and like most I have been incorrectly calling an end to this boom for years now. Unfortunately, I feel as though we are closer than ever to the end of this run. Below I have normalized the Teranet National Bank Composite House Price Index – over the past 15 years, home prices in Canada have increased by a multiple of 2.5x on average, which equates to a compounded annual growth rate of approximately 6.3% (Ranging from 4.7%-7.6%). Needless to say, I highly doubt that the average Canadian household income has increased two and a half fold during the same period. Actually this 6.3% annual increase in home prices far exceeds the annual after-tax household income growth rate of approximately 2.6% during the same period. We will come back to this serious deviation a bit later on in this post, as it is absolutely unsustainable and has continued only due to the ability of households to juggle enormous debt loads with the help of record low interest rates.
Source: Teranet – National Bank Composite House Price index
Since the start of the great recession, even more fuel has been added to this raging fire due to the drop in interest rates. Unfortunately monetary policy is indeed a blunt instrument, and regulators in Canada have no choice but to move in line with the policies set forth by our neighbour down south. Not only that, but also the overall weakness in the economy and the need for low interest rates in order to stimulate all sectors has outweighed the concerns regarding the housing sector. During sustained periods of low interest rates the economy is very much like a delicious pizza in a hot oven. The crust will rise unevenly, and bubbles will form, much like they do in the economy. The delicious cheesy bubbles on a pizza are analogous to the dangerous asset bubbles in the economy, as some bubbles burst and others fizzle away.
Increasing interest rates in order to slow down the housing boom therefore has been out of the question. Hence, the introduction of two rounds – I have highlighted them as (1) and (2) on the graph below – of new policies and regulatory measures in order to slow down residential mortgage growth. In fact, both these rounds of policy changes have managed to cool down the hot housing market, but possibly too little too late, as households now carry record level debt burdens. When you find yourself in an unprecedented interest-rate environment such as today, interesting things tend to happen.
(1) In 2008, the federal government introduced a few changes to the rules regarding government-backed insured mortgages by reducing amortization periods and increased the minimum down payment required for home buyers. (2) In 2012, regulators introduced a new guideline that sets out requirements for prudent mortgage lending and the amount that banks can lend through a home equity line of credit.
Overall the following major changes have been implemented in order to cool down the frothy housing market:
• The maximum mortgage amortization period was reduced from 40 years to 25 years.
• Home buyers are required to provide a down payment of at least 5% when previously no minimum down payment was required. Additionally a down payment of 20% is no mandatory for non-owner occupied properties.
• Home owners can now borrow only up to a maximum of 80 per cent of the value of their homes when refinancing their mortgage as compared to 95 percent previously.
• Limiting the maximum gross debt service ratio (borrower’s gross household income needed to pay for home-related expenses) to 39 per cent and the maximum total debt service ratio (share of a borrower’s gross income needed to pay for all debts) to 44 per cent.
• CMHC mortgage insurance is now available only for homes with a purchase price of less than $1 million. Borrowers buying homes at or above this amount will need a down payment of at least 20 per cent if their financing is from a federally-regulated financial institution.
In the midst of this housing madness my favourite line of all time has to be (and the title of an excellent read by Reinhart & Rogof) “this time is different”. There are a few related arguments that I will share with you;
1) Oil and gas along with other commodity industries will support the Canadian economy for years to come. Undoubtedly the commodities boom especially in the west coast has been a driver in the Canadian economy but our overdependence on the commodities sector leaves us more susceptible to commodity related shocks.
2) The Canadian banks have been far more prudent than their American counterpart in avoiding subprime loans. That is true, but you don’t always need predatory lending in order to form an asset bubble.
3) CMHC guarantees such a high percentage of the loans, there is nothing to worry about. Moral hazard anyone?
Through all this hysteria there is some data that continues to keep me grounded while reinforcing my thesis. My apologies in advance as these graphs are gathered from various sources and are mostly not original (for that you have to thank Statcan for having such a wonderfully updated public database)
A. Income Levels Do Not Support Current Home Valuations
Source: The Economist
These two charts highlight two essential metrics of understanding home valuations: the house price-to-income and price-to-rent ratios in Canada normalized to year 2000. Current Canadian price-to-rent ratio is 85% above its historic average. This means that at current income levels in Canada, home owners cannot demand the same yield as they could have historically. Why? Because current income levels cannot support the same historic price-to-rent ratio. Although household income has increased, it has done so at a much slower pace than the increase in Canadian home prices. The average house in Canada currently costs 5.3x the average household’s income and this metric historically has hovered around 3x household income. It is then easy to see that current income levels cannot support these lofty prices indefinitely, especially given the prospects of rising interest rates.
B.The Fragile Canadian Household
I am afraid the Canadian household appetite for debt is not limited to just mortgages. Canadians have amassed debt in the form of personal lines of credit and credit card loans at an unprecedented rate over the past 15 years.
Source: Deutsche Bank
Now, let’s pause for a second. I am not all gloom and doom. I actually happen to agree with the report from TD that Canadian household debt-to-income ratio is not as bad as people say it is, especially when compared to our American neighbours. Yes, Canadian debt levels are inflated, but you cannot make an apples-to-apples comparison between the headline household debt-to-personal disposable income ratios, the two countries are not exactly identical, and the ratio is not calculated the exact same way. Household income must be adjusted for measurement differences as well as the effect of out-of-pocket spending on healthcare amongst other things. Therefore it is preposterous to compare the current level of household debt to disposable income of Canadians (1) to the 2007 debt to disposable income of the Americans (2). By comparing the adjusted ratios, it is clear that we are still in a better spot than the Americans found themselves in 2007 (3 vs 4). What is alarming is the directionality of the ratios for each country – we have continued leveraging up while Americans have been deleveraging.
Source: Updated TD research
The current all-time record level of 162.7% household debt-to-disposable income ratio is therefore extremely disturbing, and cause for great concern even though it is way below that of the US (177%) at the height of their housing bubble. Highlighted by the graph below, as the cost of borrowing has declined and interest rates have dropped, the Canadian consumer has levered up and become more sensitive than ever to the possibility of a rate hike or an exogenous shock in the future.
Source: Statistics Canada
C. The Booming Construction Sector too Big for its Own Good
The construction sector in Canada now accounts for 7% of overall employment, which is significantly higher than the US number during the height of their housing bubble. If this number was to trend back to its historic norm of 5.5% it would lead to the loss of 250,000 jobs, which could have devastating economic implications.
Source: Deutsche Bank
In the previous section, I highlighted the metrics for understanding the lofty valuations in the housing sector and their deviation from historic norms. Furthermore I argued that the consumers who carry these high debt loads are highly susceptible to either interest rate changes or some form of exogenous unforeseen shock.
Having said all this, it is quite possible going forward for incomes to rise at a faster rates than house prices, unemployment to decrease even faster than expected or for the population to grow in order to support further demand; these all would bring values closer to sustainable historic levels without prices having to come down. This would mean house prices would stagnate, and allow for the fundamentals to catch up to reflect current prices. Unfortunately this is the best-case scenario, and wishful thinking. Also, as far as the interest rates go, the Bank of Canada is not going to raise interest rates in a random fashion out of malicious spite. The Bank of Canada will increase interest rates when signs of inflation greater than the target rate creeps into the economy. At the moment the exact opposite problem is facing the Bank of Canada. Already the divergence between the US and Canadian economies is threatening to have a severe impact on the Canadian Dollar, exports and imports as Janet Yellen has hinted to a US rate increases around April 2015 while Stephen Poloz lowered Canada’s rate merely weeks ago from one per cent to 0.75 per cent.
The possibility of external shocks is the unknown factor that will threaten to push this fragile system off balance. These exogenous shocks/black swan events are the fat tails of the distribution that everyone conveniently ignores. It is possible we are in the middle of experiencing this exogenous unpredicted shock in a form of lower oil prices. Home sales in Calgary are falling even as the number of listings are increasing, according to the most recent January data provided by the Calgary Real Estate Board, January sales are down 34% from a year ago, while listings are up 22%. Could this be the beginning of the end for the Canadian housing boom driven by the success in the commodities sector and the availability of cheap debt? Would the negative effect in the housing sector be felt only in certain geographies? I will be as honest as I can be in answering these questions. I do not have a clue.
My diagnosis given the information above and my personal understanding, is that the Canadian housing sector is extremely frothy if not downright bubbly in some markets. Canadian consumers are only a “shock” away from feeling the burden of record level debt which they are able to service purely due to historic low rates. I did warn that this was a dramatic unfinished story, in reality the climax, falling action and Denouement have not taken place in this story. Stay tuned as the situation unfolds…