Fears of a Canadian housing market crash overblown – RBC report
Summary
- The sharp decline in housing resale activity since the beginning of the year has ignited fears that the Canadian market has started to crash.
- In large part, such concerns are based on the belief that the spectacular run-up in prices in the past several years reflected bubble-like conditions, which will inevitably end up in a gut-wrenching correction.
- While we agree that housing prices are currently historically elevated, we do not believe that any major slump will necessarily ensue.
- Housing affordability - the best indicator of underlying market tensions, in our view - has deteriorated in recent quarters but remains much better than it was in the late 1980s and early 1990s when bubbles clearly caused the Canadian market to meltdown in the years that followed.
- The further expected modest erosion of affordability in the period ahead is seen to cool housing demand not deep-freeze it.
- Home prices, overall, are generally expected to stay above water in Canada, although there are some local markets, such as such as Vancouver and, possibly, Montreal, where very poor affordability could well lead to declines to correct these imbalances.
Details
The 30% drop in seasonally-adjusted monthly housing re-salesin the first seven months of this year has raised fears that a full-blown slumpis in the works for Canada. Last year's spectacular rally, which not onlycontrasted sharply to the moribund state of housing in most other parts of thedeveloped world but also heated up conditions to even greater levels than thosewhich prevailed in 2007, are perceived by some as evidence of a bubble threateningto burst anytime.
Such fears are rooted in the significant price gains since2001 that far exceeded household income growth in Canada. Home prices nearlydoubled nationally during that period, while disposable income grew by lessthan 50%. The ease with which the Canadian market recovered the losses incurredduring the (short-lived) downturn of the latter part of 2008 and early 2009 andwith which prices surpassed previous record highs during the rally only feedthe notion that the Canadian market is being driven by irrational behaviour.
However, we find little compelling evidence of irrationalityor bubbles in the overall Canadian market relative to historical patterns.
The best measure of underlying stress - housingaffordability - does not flag any major misalignment with respect to prices. Atmost, it points to a moderate degree of overstretching on the part of Canadianhouseholds - something that can be righted in time without causing asignificant disruption in the market.
A natural benchmark to gauge the market's vulnerability to asevere downturn is the level of affordability that prevailed in the late 1980sand up to early 1990, the last time that the Canadian housing market was widelyviewed as being in a ‘bubble', which was a period during which speculativeactivity was a prominent phenomenon and prices skyrocketed to irrational highs.The bursting of the bubble in late 1990 and its aftermath weighed of theCanadian market for the better part of the 1990s.
While housing affordability has been on a deterioratingtrend again since the middle of last year - after improving significantly in2008 and early 2009 - levels still remain much better than those in 1990. Inthe first quarter of this year, RBC's affordability measure for a typicalbungalow in Canada was 41.1% compared with 54.2% in the second quarter of 1990(the higher it is, the less affordable homeownership is); nonetheless, this wasmodestly above the long-term average of 38.9%, suggesting some greater thanusual underlying tension at present.
Exceptionally low mortgage rates are a key factor that havekept homeownership costs from spiralling out of households' reach.
These low rates are also a key reason why affordabilitymetrics cause much less alarm than valuation measures such as the price-to-incomeratio or the price-to-rent ratio, both at or near record levels presently. Homeprices are indeed elevated, but the monthly mortgage payments (i.e., the cashflows associated with those prices) are still well below dangerous levels.
The risk, then, is that as interest rates rise,affordability will deteriorate further. We have looked into the issue andsimulated where affordability measures would be under more ‘normal' mortgagerates - defined as the long-term real rate plus an inflation premium of 2percentage points. We found that affordability in Canada would currently beabout as poor as it was in early 2008 (more than 46% for the typical bungalow)but still significantly better than at the worse point in 1990. (The normal rateused in the simulation is approximately 150-basis points higher than themortgage rates prevailing at present.)
Since the monetary policy renormalization is expected totake place during the next 12 to 18 months, the effect of rising interest rateson affordability will be gradual and, therefore, will not constitute a suddenshock to the housing market. Meanwhile, an expanding economy will spurhousehold income growth, which will provide some offset. Consequently,underlying pressure is unlikely to erupt and devastate the Canadian housingmarket. In our view, the expected path of affordability will work to continue tocool demand for housing in Canada from its recent red hot pace. We do notbelieve demand will go into a deep freeze.
The implications for home prices are that, overall, they aregenerally expected to stay above water because supply will adjust in responseto weakening demand.
It must be noted that this assessment focused on the overallmarket in Canada. Naturally, there are regional differences. Affordability measuresflag more intense pressures then evident nationally in areas such as Vancouverwhere homeownership costs are still near record-high levels and far aboveanywhere else in the country. Montreal also has seen a notable erosion inrecent years although affordability remains attractive relative to Canada'sother major cities. In the case of Toronto, measures point to modestly worsethan average affordability (historically), but the situation continues to besignificantly healthier than it was in the late 1980s and early 1990s.
Bottom line
Affordability measures suggest that housing marketfundamentals are comparatively stronger than those that prevailed in 1990, therebyminimizing the risk that a 1990s-style crash will occur.
Nonetheless, because the cost of homeownership is likely toremain higher than average, a slower pace of housing market activity and moresubdued pricing environment than we have experienced from 2002 to 2008 andagain during the second half of last year should be expected.
Written by RobertHogue - Senior Economist RBC
