|A sky-high view of global real estate markets: Is Canada really different?|
Oct 13, 2011 Ben Rabidoux theeconomicanalyst.com
Yesterday I discussed the fact that we all have what psychologists often refer to as 'recency bias'. It's what makes us believe that our recent past represents a stable and predictable norm. It's what allows us to believe, for example, that house prices in Canada can continue to outpace incomes, GDP, rents, and inflation by 2-3 times into the indefinite future. Common sense may tell us otherwise, but it's amazing how easily we can be lulled into thinking that this is 'normal' price appreciation. It's not. And yesterday, we saw just how unusual our current real estate upturn has been in the context of our own history and in relation to booms in other nations.
Today we turn our attention to an Organization for Economic Co-operation and Development (OECD) paper written in late 2010:
Let's dive in.
On housing and the broader economy:
During the 2001 recession, house prices disconnected from the business cycle. Low interest rates and mortgage market innovations fuelled
This describes Canada perfectly. In fact, the idea of mortgage equity withdrawal boosting private consumption is a key topic on this site as it is critical in understanding why a housing correction would be associated with a nasty recession. You can read about that concept here and here. Interestingly, the Globe and Mail also recently featured an article exploring this very topic, in which my research featured prominently.
On real (inflation-adjusted) house prices:
You may recall that it was Robert Shiller who noted that house prices tend to pace inflation over long enough time horizons. This means that the real rate of return for real estate is close to zero. We discussed this concept when we looked at Canadian house prices relative to inflation. On this topic, the paper noted the following:
Between 1995 and their latest cyclical peak, which was reached between the third quarter of 2006 and the first quarter of 2008 depending on the country, real house prices had nearly tripled in Ireland, had been multiplied by about two and a half in the United Kingdom and had approximately doubled in nine other countries in the sample, including many European countries, as well as Australia and New Zealand
Interestingly, real house prices are said to have increased by over 50% between 1995 and 2008, although that doesn't jive with the graph they included below. Furthermore, we also have to keep in mind that between 1995 and 2000, real house prices actually declined. Nevertheless, the fact that house prices have so significantly outpaced inflation ought to give us concern.
On residential investment:
It's a funny thing that as real estate values rise, the demand for housing also rises as people are compelled by a "buy now or be priced out forever" mentality. In a recent speech in Vancouver, Bank of Canada governor Mark Carney described it as follows:
"The risk is that expectations become extrapolative, prompting the classic market emotions of greed and fear—greed among speculators and investors—and fear among households that getting a foot on the property ladder is a now-or-never proposition."
This is the bizarre mass psychology that drives any asset bubble. As it intensifies, it leads to mis-allocation of capital in the broader economy, nowhere more evident than in the massive rise in residential investment. As more and more of the economy is driven by people buying and selling homes, it becomes more unstable. If you doubt this is happening in Canada, one look at the proportion of our GDP derived from housing-related industries should convince you otherwise:
The OECD article notes the following:
From 1995 to its peak, real residential investment has approximately doubled in the Nordic countries and Canada and has risen by about 70% in the United States.
That's clearly not sustainable, particularly given our changing demographics which are set to sap demand rather than add to it. A return to a long-term sustainable norm is not possible without adversely affecting the broader economy.
On the price-rent and price-income ratios:
Yes, fundamentals matter. House prices are not 'worth' what someone is willing to pay for it. That's simply a transient measure that reflects our irrationality. Among the most important measures of fundamental value and sustainability within a housing market are the price-rent and price-income ratios. On this topic, the OECD paper had this to say:
The price-to-income and the price-to-rent ratios are two widely used indicators of housing market conditions. Historically, these ratios have generally tended to revert to their long-term average, even though they often deviated from it for protracted periods.
Hence, large deviations of the price-to-income and price-to-rent ratios from their historical level could indicate over- or under-valuation of houses. The price-to-income ratio can be interpreted as a measure of the affordability of housing. When house prices rise relative to per capita disposable income, it becomes increasingly difficult for households to buy dwellings. They will normally reduce their demand, driving prices down. The price-to-rent ratio –measured here as the ratio of nominal house prices to the rent component of the consumer price index – reflects the cost of owning a house relative to that of renting it. If prices increase relative to rents, more households should choose to rent rather than to buy, driving rents up and prices down.
Makes sense. Here's how we compare to the US:
It's concerning no matter how you look at it. We know real estate is intensely local, so for a closer look at the price-rent and price-income ratios in various Canadian cities, check out the following posts: House prices and rents in Canadian cities (here and here), house prices and incomes in Canadian cities (here...part 1 of a three-part series)
Interestingly, the article discussed a concept often brought up here by some commenters: Price-rent ratios and price-income ratios should reflect the purchasing power of credit given today's low interest rates. The article addressed this issue:
Nevertheless, comparing the evolution of “fundamental” and actual price-to-rent ratios indicates the important role of interest rates in explaining price-to-rent ratios and provides a rough assessment of the over- or under-valuation of housing markets. The picture which emerges from figure 5 is that, in most countries, declines in interest rates reflected in the “fundamental” ratios are able to explain a great part of house price increases between 2000 and 2004. But after 2004, sustained house price appreciations were no longer supported by the evolution of the user cost of housing. Around 2007, actual price-to-rent ratios started to move back towards their “fundamental” value. Recently, as a result of policy actions to fight the recessions, mortgage rates have moved down significantly in many countries. As a result, “fundamental” price-to-rent ratios have often gone up.
In this case, note the divergence between the fundamental price-rent ratio as determined by mortgage rates, and the current price-rent ratio.
You'll note that the fundamental price-rent ratio as determined by government bonds is very close to the current price-rent ratio. Unlike in the US where mortgage rates are closely tied to the 30 year government bond yield, here in Canada, our mortgage rates are tied to the 5 year bond or the overnight interest rate from the Bank of Canada, meaning this metric is not nearly as important in determining a fundamental price-rent ratio in Canada as it is in other countries.
The bottom line is that falling mortgage rates explain some of the movement in the price-rent ratio, but certainly not all. It's still a major concern.
On consumer debt levels:
The paper compared consumer debt burdens (as a percent of personal disposable income) across a handful of OECD countries. The results are interesting:
We look like a relative bastion of fiscal prudence compared to consumers in other parts of the world. It is a question that has been raised before: If other countries can ramp up consumer debt to such high levels, why can't we? It's a great question and I suppose the answer is likely that we can if we want to. But I think that misses two more important questions:
1) Would a more prudent approach not be to look at how other economies have experienced hardship as a result of their consumer debt burdens, which are comparable to our own? The US comes to mind.
2) I have long maintained that using a 'debt to disposable income' measure is not the best way to compare debt levels since tax regimes are so different between countries and they can change from year to year. Rather, a look at consumer debt relative to GDP is far mroe telling. In this regard, Canada does not look so angelic. Please consider this chart taken from a recent report by the Canadian Association of Certified General Accountants. Again, this is looking at consumer debt relative to GDP:
Note that while countries like the UK, US, and Ireland have been deleveraging over the past couple years, Canada is still ramping up consumer debt levels, rapidly closing this gap. Also keep in mind that Australia seems to have hit the skids, with their housing market now in serious trouble. It again highlights that the more important question should not be CAN we ramp up consumer spending to match the leading countries, but SHOULD we.
There's much more to the paper than I am able to show here. It is well worth the read. It once again highlights that when people are willing to look critically at our housing and consumer debt levels in Canada, they note that there are very valid reasons for concern. To dismiss these concerns entirely is to put the blinders on and embrace recency and confirmation biases. They can cloud our judgement....but only if we let them.
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