Canada's Overvalued Housing Market
It has been said, that aside from hockey, real estate is Canada’s national sport. But it is not all fun and games. A number of sources have claimed that the Canadian housing market, particularly in large Canadian cities, is overvalued, and has been for several years. An overvaluation implies an imbalance with a market correction down the line. Such an imbalance could have serious destabilizing effects on the Canadian economy and potentially the global economy depending upon the severity of the overvaluation and abruptness of the revaluation. While most analysts agree that an overvaluation does exist, no one seems able to agree on by how much. Estimates are varied; recent estimates from January have ranged from a modest 7% by the IMF to a whopping 60% by Deutsche Bank.
It should be noted that uncovering imbalances in housing markets is more art than science. Simple measures such as loan to value and price to rent ratios provide one way of looking at the situation. These are simple to understand and useful in some respects, however they are not always complete. Definitions vary across countries, and the effect of macro variables such as interest rates, are left out. More advanced econometric methods use fitted values from models and compare them with actual data in order to detect an imbalance. These methods vary greatly from study to study and each has its short comings in terms of assumptions, sample sizes and data availability.
The Debt Implication
At the center of the housing market debate, is the issue of Canadian household debt. Canadian household debt has skyrocketed past incomes in recent years and hit a record high in Q3 2014. Recent estimates show that the debt-to-income ratio is now over 160%, meaning that Canadians owe $1.60 on every dollar earned. While the large size of mortgages is not the sole cause of this explosion, debt levels are uncomfortably high and represent a huge downside risk to the economy. Connected to this issue is the fact that homes are major assets for many households and are often treated as a form of savings for retirement. A correction in the housing market could have wide-ranging macroeconomic effects on household savings and private consumption.
The Job Market
Another troublesome detail comes in the form of jobs in the housing sector. While manufacturing job numbers have fallen over the past 25 years, jobs building condos have been increasing. These jobs have been fueled by ever-increasing real estate prices. The Canadian economy relies heavily on construction and real estate sector jobs as they have been a large part of the post 2008 economic recovery. Losing them in a hurry would have very destabilizing effect on the wider economy.
While there is a lack of data regarding foreign buying, it is estimated to be a factor in rising house prices in certain key markets, such as Vancouver and Toronto. The impact of foreign buying is difficult to assess. On one hand, it is believed to have pushed prices high, placing certain houses out of reach for the citizens working and living in the market. On the other hand, it means that if there were a correction in prices, the impact on the Canadian financial system would be limited.
A drastic correction in the housing market could have wide-reaching macroeconomic effects. Downside risks are plenty. Historically-high household debt levels have left Canadian families particularly exposed to any adjustments. Thus, if housing prices are indeed highly overvalued, a correction would undermine households’ abilities to service their mortgages or sell their properties. Subsequently, housing starts and investment would likely fall, impacting growth in the medium term. If this doesn’t sound dire enough, falling prices and a potential credit freeze could hamper any recovery for years as buyers would be either unable to finance a house or unwilling to do so in anticipation of lower prices. This would also put pressure on Canadian lenders who rely on mortgage sales for an important portion of their profit.
Such a correction may be triggered by a number of events that effect Canadian households’ ability to service their mortgages and there are significant fears that lower commodity prices could embody this trigger. This is particularly worrisome in Alberta and Saskatchewan where new house prices have seen significant growth in response to the past oil boom. Now that capital investment in the energy sector is falling and oil sector firms are trimming staff, this trigger is looking more plausible than ever. Alberta saw a sharp drop in housing starts and resales during the end of last year, although in other regions housing sector activity was still strong. The concern is that any contraction in Alberta could spill over into the other provinces.
Such fears have not come to pass and there are several possible reasons for this. The overvaluation may be very modest and prices may be more in line with market fundamentals than a real estate bubble. Indeed, Canadian cities have witnessed a population increase due to significant domestic and international migration over the past 10 years, providing a substantial tailwind to housing demand in metropolitan areas.
Another force behind strong demand is recently-lowered interest rates. Although interest rates are not expected to rise any time soon, there is an incentive to move quickly when it comes to buying a house in order to enjoy lower mortgage rates for a longer period of time. Also, the market has proven to be robust in the face of previous crises. Measures taken by the Department of Finance and the Canada Mortgage and Housing Corporation (CMHC) to cap amortization periods and loan to value ratios as the post-financial crisis housing market was heating up may have improved the position of potential home buyers. Furthermore, Canadian banks are well capitalized, exceeding standards set by the Office of the Superintendent of Financial Institutions as well as Basel III, thus allowing them to draw down should conditions deteriorate.
Lastly, although the Teranet monthly yoy growth rates have been volatile, they have moderated in comparison to past rates (see chart below). Decreased demand, as an indirect result of lower energy prices, may be offset by recently lowered rates thereby providing a soft landing for housing prices as opposed to a crash.
What the Future Holds
Although debt to income levels in Canada are at historically-high levels, they are stable, as reported in the Bank of Canada report on the housing sector. Delinquency rates are still low and there is evidence that some home owners are using the period of low rates to deleverage, possibly in anticipation of lower income growth in the future. There are many mixed signals when it comes to the Canadian housing market, leading the wide variety of projections, estimates and opinions. The Canadian regulators should maintain a close watch on the vulnerabilities in the housing sector, including external risk from weak growth in the Euro area; weakened demand from China; and a drastic increase in interest rates in the U.S. that would prompt a similar increase in Canada. Focus Economics’ Consensus Forecast panelists foresee Canadian housing starts moderating over 2015 and 2016 and reaching a level in line with fundamentals in the longer term thus demonstrating a ‘soft landing’ for the Canadian housing market.
Written by: Robert Hill & Angela Bouzanis, Economists
Date: April 9, 2015
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