|No Real Estate Bubble in Canada?|
Aug 16, 2009 runningofthebulls.typepad.com
Most of my focus on the bubbly Canadian real estate market has been on Western Canada. This is primarily because over the last 10 years, Eastern Canada, i.e. everything east of Manitoba, has not much mattered in the global scheme of things as global investor demand has been focused on Western Canada, where things can be dug/mined/drilled etc. out of the ground. It is out west where the bubbly activity in the housing market has occurred.
Worthwhile Canadian Initiative - one of my favourite economics blogs - cites data from Teranet to bolster their argument that Canadian home prices are not in a bubble. It is an index akin to the Case-Shiller index in the US that tracks the changes in home prices in six Canadian cities - Vancouver, Calgary, Toronto, Ottawa, Montreal and Halifax. According to the Teranet index, home prices rose 8.9% per year from 2003 through 2007 across the six cities in the index.
That may fast, but it is not a bubble. So props to the economists. There has been no bubble in all of Canada.
But there was no bubble in all stocks in the 1990s either. Instead, there was a bubble in a select group of stocks, in particular technology and some growth and large-cap stocks. Equal-weighted indices of stocks began peaking out at the beginning of 1998 while the bubble continued for two years.
Thus, what is interesting is what occurs underneath the indices. And from 2003 through 2007, home prices out west exploded.
Home prices doubled in Calgary and nearly doubled in Vancouver whereas they grew more slowly out east.
This is a graph scanned from Garth Turner's book, Greater Fool, of the Calgary real estate market from 1992 to 2006. (I apologize for the low quality. Here at Running of the Bulls, you get what you pay for!)
This is what a bubble looks like. It does not matter if the bubble is in stocks or real estate or commodities or paintings or fine wines. When prices go unrelentingly straight up, this is almost always a sign that prices are disconnecting from fundamentals.
We also noted here and here the utter silliness of home prices in Saskatoon, where prices doubled in two years, and became a more expensive city to buy a house than most cities in the United States, even though Saskatoon is completely surrounded by farmland, is -40C for at least part of the year, and the population of Saskatchewan is about the same as it was 60 years ago.
Western Canada is where all the action has been. The demand for raw materials pushed up the value of the Canadian dollar, aka "the loonie," which was enormously positive for Western Canada but hammered the manufacturing base in Eastern Canada. While Western Canada boomed, Eastern Canada struggled, at least relatively.
Worthwhile Canadian Initiative posted these graphs to support their argument that home prices in Canada are rational. I think they are wrong, at least out west, and I am going to tell you why.
First, the price of homes in the US and Canada.
They argue that if you scale house prices to gross national income, homes are not expensive.
They argue further that the improvement in gross national income is because of the improvement in Canada's terms of trade, i.e. the world wants more of Canada's stuff in the ground relative to what Canada wants from everyone else. They note that half of Canada's increase in per capita income this decade has been because Canada's terms of trade improved.
There a few problems with these arguments.
First, people do not buy homes with gross national income. They buy homes with after-tax income. Thus, you should compare the prices of homes to household income, not gross national incomes.
I went to the Statistics Canada site to find the growth in income from 2003 to 2007, but CANSIM wanted me to pay them 36 bucks! Well, that's not happening, so being the cheapo that I am, the free Canada Census data had growth in median income from 2000 to 2005. For our six cities, growth in median incomes was as follows.
That is total growth over those five years, not per annum growth.
From 2003 through 2005, home prices rose 21.8% in Halifax, 30.5% in Montreal, 16.4% in Ottawa, 18.6% in Toronto, 24.9% in Calgary and 40.8% in Vancouver. Thus, home prices far outstripped growth in income.
Of course, it is not only income that matters when purchasing a home but also affordability, in particular mortgage rates and average monthly payments made by home buyers. However, as you can see, incomes and affordability would have had to double in the western cities in 2006 and 2007 for incomes to keep up with the prices of homes, and that did not happen.
The other potential flaw in logic in their argument is assuming that changes in the products driving improvements in the terms of trade are rational. Since Canada's terms of trade were driven by increased prices in commodities, the question becomes whether or not the changes in commodity prices are rational?
This is far from clear. Certainly, some of the price moves are rational. With the inclusion of China, India, Brazil, et. al. into the global economy, along with supply bottlenecks, there has been a structural shift upwards in the global price curves of most commodities. But how much of rising commodity prices is due to structural shifts and how much is due to speculation is unclear.
Was oil at $147 rational? Today, oil has more than doubled in four months to $70 yet inventories are at 20 year highs. Is it rational for oil to be at $70? Maybe, if the recovery absorbs all the excess inventory, but without a doubt, financial market speculation has and is playing a significant factor.
This is an important concept to understand - If the underlying security is being supported by an asset bubble itself, even if the security appears fairly priced, then the underlying security itself is in a bubble.
For example, financial stocks did not look expensive in 2006 based on current earnings. However, earnings were based on asset markets which were egregiously over-valued. Thus, when home prices collapsed, so did the earnings of the financial companies. Financial stocks were very over-valued because the true profitability was overstated by the bubble in home prices.
Likewise, if Canadian home prices appear fairly valued based on incomes while commodity prices are over-valued, the country's terms of trade are skewed and underlying incomes supporting home prices are too high. If, for example, the structural long-term average of the price of oil is $50, the terms of trade for Canada will decline, incomes will decline (or grow slowly) and home prices are currently too high.
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