Canada's Housing Bubble

Feb 28, 2011 Ben Rabidoux financialinsights

“A house may be large or small; as long as the surrounding houses are equally
small it satisfies all social demands for a dwelling. But if a palace rises beside
the little house, the little house shrinks into a hut.”
–Karl Marx

Conspicuous consumption and the new consumer culture

It was Thorstein Veblen who first coined the term ‘conspicuous consumption’ in his 1899 book The Theory of the Leisure Class. The term is now broadly applied to any spending pattern that places value in an item primarily for its ability to convey social status rather than for the intrinsic value of the item itself.

In other words, people buy things to maintain a certain image rather than for the actual value of the item.  And since our consumption patterns are perceived to be a reflection of our income or assets, the greater the consumption, the greater the perceived status.

In one of the great personal finance books The Millionaire Next Door (I highly recommend it), researchers Stanley and Danko brilliantly demonstrate that conspicuous consumption is not a hallmark of the truly wealthy.  Rather it is much more likely that people in lower socioeconomic classes will increase their consumption relative to their incomes in an attempt to appear to have a certain measure of wealth.  Those whose incomes put them in higher socioeconomic classes and who chose to engage in conspicuous consumption to show this typically have much lower net worth than their salaries would suggest.  These same people often have great difficulty sustaining that lifestyle into retirement.

Let me restate that since it is critical to understanding the main point of this post:  People who are conspicuous consumers set themselves up for difficulty in maintaining that lifestyle and eventually have to take measures to correct it.

When conspicuous consumption becomes prevalent in a society, it becomes a feedback loop in which individuals increase their consumption to increase their relative status, but with the net result being that consumption rises but no one is actually better off, either materially or in their relative social status.

Conspicuous consumption and the McMansion culture

There is little doubt among academics who study the psychology of conspicuous consumption that housing is one of the most powerful symbols of status in North America.  Home ownership carries with it a certain status, while a prominent stigma exists towards renting.  When housing as a form of conspicuous consumption is embraced by a large swath of society, the results are predictable.  As Robert Frank noted in a New York Times editorial, “when everyone builds bigger, the primary effect is merely to raise the bar that defines the size of home that people feel they need.”

This raises certain questions with regards to the Canadian housing market:

1)  How prevalent is the ‘keeping up with the Joneses’ phenomenon in Canada? One way we might explore that is to examine how the average house has changed in Canada over time and then compare these changes to what we might expect given the change in demographics.

2) If housing represented a form of conspicuous consumption, we might expect to see evidence that people are going to greater and greater lengths to attain that status symbol.  For example, we might expect a steady erosion in the price-to-income and price-to-rent ratios for houses in Canada.  Similarly we might expect to see a rise in home ownership rates that cannot be accounted for by an aging population alone.  That is to say that we would expect to see a rise in home ownership rates across all age groups.  Is this happening?

3)  If housing has become a social symbol and we have become a society that has embraced a skewed view of housing, will this last indefinitely?  If not, what would a realignment of consumer expectations do to aggregate home prices in a stable demand environment?  What would it do in an environment where demand diminishes and the credit necessary to purchase these large homes is simultaneously squeezed via either rising interest rates of tightening standards?

1)  Are Canadians trying to keep up with the Joneses?

This is a key question in this whole discussion.  Has our perception of what constitutes a ‘comfortable’ house significantly changed over time?  The answer is a categoric ‘yes’!

CMHC calculates that in 1975 the average single family home in Canada was 1050 square feet.  According to the Canadian Home Builders Association, in 2010 the average new single family home in Canada was 1950 square feet….nearly double what it was just 35 years ago.

Interestingly, the size of new single family dwellings actually peaked in the mid 2000s at approximately 2300 square feet and have since fallen to under 2000 square feet, possibly signaling that a shift away from the McMansion era is already underway.  Even at the current 1950 square feet for the average new house, do demographics support a demand in these homes going forward?

If we look at the change in household characteristics, we find that in 1971 the percentage of households that were either ‘one person households’ or ‘couples without children’ totaled 35%.  These are households with a maximum of 2 occupants in the dwelling.  In 2006, that percentage totaled 53%.

During that same time frame, the average household size has fallen from 3.5 to 2.5.

Despite a significant rise in the proportion of 1 and 2 person households and a significant drop in average household size, the average square footage single family homes in Canada has risen markedly over the past 40 years.

Now there is a limitation in the data.  We know that condo developments have been one of the fastest growing dwelling types.  How many of these 1 and 2 person households have taken to living in smaller condos and not the ‘McMansions’ we’re concerned about is worth considering.

But even if we assume that this it’s true that many of these households are embracing condo life, in order for this trend to exert zero price pressure on aggregate house prices we would have to assume that there will remain a stable demand for large homes as these households will ultimately need someone to sell to in order to be able to make the move.  I have my doubts that this will be the case.

2)  McMansions as conspicuous consumption

As noted above, if in fact Canadians are increasingly seeing their home as a status symbol, we might expect to see several trends:

Erosion in the home price-to-income ratio:  As consumers increasingly embrace home ownership across a society, the natural repercussion is for all consumption to shift higher.  Where 50 years ago a 2000 square foot home was a symbol of very high socioeconomic standing, today it is no more than average.  As a result, 5000 square foot homes are arguably the new wealthy standard.  In order to classify real estate as a new status symbol and a form of conspicuous consumption, we would expect to see people stretching ever further to attain it.  Alas, the recent report from TD sheds some light on how this ratio has changed over time.  Indeed we see a steady increase in home prices from the relatively stable long-term mean of 3-3.5 times income last seen in 2001 to 5.9 times in 2010:

Depicted as a line graph it looks something like this (as calculated by the Bank of Canada)- Note the ‘bubble’ of the late 1980s which ended in an abrupt realignment in house prices with incomes followed by a decade of stagnant growth:

Increase in house prices relative to rent:  If people increasingly embrace home ownership and shun renting, we might expect to see that the price of a dwelling rise over time relative to the rent it would receive.  Indeed this is very much the case as the home price-to-rent ratio for all of Canada has never been higher:

A rise in home ownership rates across all demographics:  If home ownership has become a status symbol, we might expect to see a rise in ownership rates.  However, as our population ages we might expect a natural increase in ownership rates regardless.  The smoking gun would be a rise in ownership rates across all demographics (though it is worth noting that while the average aging of the US population is similar to that of our own, their ownership rate has dropped from a high of just over 70% to its current level of 64%).  Let’s start with the total home ownership rate in Canada:

We are now very near or even above 70% ownership rate.  This alone suggests pressure on future house prices.  With total population growth expected to slow to 1.5% by 2015, it begs the question of who will continue to buy the homes that people will need to sell as they age and eventually find the upkeep overwhelming.  But as I said, we would need a smoking gun of a rising ownership rate across all demographics.  Here it is courtesy of Stats Canada:

Despite some variability along the way, every single age group has a higher home ownership rate today than in 1971.  Enough said!  Together with the massive change in home prices relative to incomes and rents, it suggests that there is a strong psychological element that is sustaining real estate prices.  Indeed this was explored in an earlier primer where we saw that bullish sentiment on real estate in Canada prevails by a large margin.

3)  The future of the McMansion:  Demographics set to squeeze Canadian real estate on several fronts

The demographics are certainly troubling.  I’ve explored the potential repercussions of our current demographic on long-term house prices in an earlier primer.  In that post I suggested that the data indicates that there is a substantial number of near-retirees who are planning on accessing the equity in their home to partially meet the funding need in retirement.  Yet how a large group of them will be able to do that if demand for large homes begins to wane is perhaps the trillion dollar question.  Even the reverse mortgage option has its limitations if the value of the home begins to drop.

Over half of the average net worth of Canadians is tied up in real estate.  I suspect that the median number is even higher as the very wealthy have a disproportionate amount of wealth in their business or other investments while real estate typically accounts for a smaller share of their net worth.  An article in the October 2010 issue of the Journal of Financial Planning indicated that equities are still overwhelmingly the investment of choice among high net worth individuals.

Ultimately, the numbers used in my primer on demographics don’t prove anything, but they do hint at a prevailing sentiment:  That real estate is expected to fund the retirement of a portion of near retirees.  But demographics are currently set to disappoint many people.  The only thing driving the current demand for houses is the prevailing psychology or consumer sentiment of the times….itself notoriously prone to sudden and permanent shifts.

Virginia Tech economist Arthur C. Nelson has calculated that North American households with children will fall from 50% to closer to 25% of all households by 2025.  There is little doubt that demand for large homes will remain subdued as this plays out.  Nelson has suggested that over the next 15 years, demand for larger single family homes will decline by 40%.  This assumes a stable demand environment to begin with.  That is to say that the demand for all housing types will remain constant with a shift in demand towards smaller, urban dwellings.  It holds that price pressure will result in such an environment.

But what if demand broadly declines?

The impact of a ‘credit squeeze’ on house prices

Houses have become a status symbol and have been allowed to rise in price primarily due to the prevailing direction of interest rates over the past decade and the prevailing trend in lending standards over the same period.  At this point interest rates can not fall meaningfully from their current levels, but there is a whole lot of room to move upwards.

Remember that each increase of 1% in interest rates amounts to a 9% increase in mortgage payments.  Even more importantly, each 1% increase in mortgage rates also reduces the amount of available credit that can enter the system, as the incomes of new home buyers can now support less and less mortgage debt.

The stability of a housing market and the subsequent ability of people to unload their large homes at their current prices depends on the availability of adequate credit in the system and the abundance of new buyers entering the system.

While the rate at which interest rates will rise may be debatable, their ultimate direction is not.  So in addition to interest rate pressures which will cut the amount of new credit entering the system, we also are entering an era that is fundamentally opposite to the one that has prevailed over the past decade:  An era of tightening lending standards.  CMHC loosened their lending standards over the past decade.  However, as of mid March we will see the second tightening of lending standards in the past 12 months and the third since 2008.  Exactly what effect this will have is certainly debatable, but there is no denying that this will act as a downward pressure on credit expansion going forward.

In an environment where available credit is falling, the McMansions will be hit hardest.

Changing consumer psychology = bad news for house prices

It’s worth noting that aggregate house prices could fall significantly even in the presence of sustained demand IF that demand shifts away from the McMansions of today and back towards a more conservative sentiment towards housing.

But with house prices sitting at precarious levels when compared to measures of fundamental value, it’s worth exploring what might happen to consumer psychology should house prices fall significantly.  Although I don’t expect a US style correction, I absolutely can envision a 25-30% decline in aggregate national house prices, pulled lower by carnage in a handful of particularly bubbly locales.  While not the US experience, the pain would nonetheless be acute.

How have Americans adjusted their expectations as they have seen house prices fall?

Americans want smaller homes, not McMansions- USA Today: August 25, 2010

Bye, McMansion. Americans go for smaller homes- New Urban Designer: October 13, 2010

Americans are moving on up to smaller, smarter homes- USA Today: March 17, 2009

American dream shrinks as smaller homes gain favor- USA Today, December 2010

There are literally hundreds of articles examining this new and prevailing consumer mentality towards homes.  While some articles point to economic reasons underlying the shift, I would suggest that the reason is overwhelmingly psychological:  People are simply reevaluating what they consider needs and wants.  We would be foolish to assume that such a reevaluation is not possible here in Canada.  Indeed it is outright probable.

Conclusion

The McMansion era is coming to an end in Canada as it is in the US.  This will occur either by a voluntary realignment in consumer perceptions or via a lid on credit expansion and unstoppable demographic trends.  This post has not even delved into the impacts that a rapid rise in fossil fuels and heating costs would have on demand for larger homes, or how the demand for such homes will change in the face of the inevitable raising of property taxes to meet spending requirements at the municipal level.  Needless to say, they will add downward pressure as well.

While I believe a significant nationwide housing correction is in the cards, the pain will most acutely be felt in the segment of the market we might term as the McMansions.  This will be the segment of the market that will turn stubbornly illiquid first and remain illiquid the longest.  While these homes may not constitute mansions by today’s standards, they certainly represent a massive expansion in society’s perception of ‘normal’.  Perception that may well experience a conservative shift as the ebb and flow of consumer expectations inevitably change the demand landscape.

Cheers,

Ben