'Affordability' measures.....still misleading; Consumer confidence tanking; Taking a page from the 'bull' play book
AUGUST 24, 2011
Affordability measures still misleading:
One comment I often receive is that I don't give enough weight to the impact of purchasing power in analyzing the Canadian real estate market. The argument is that since interest rates are falling, houses are more affordable, and therefore it should be expected that house prices show a marked dislocation from fundamentals like rents, incomes, and per-capita GDP.
I don't dismiss the argument altogether, but there are some major flaws in that line of thinking. Yesterday, Larry MacDonald, on his Canadian Business blog, discussed one of my articles, which was run as a guest post over on Zero Hedge.
Zero Hedge attacks Canada again- Canadian Business
Here's what Larry had to say:
"Zero Hedge is back at it again. This time the U.S. blogger targeted Canadian banks, suggesting they could be in as bad a shape as European banks. Now his blog is taking aim at the Canadian love affair for homeownership: a guest post by Ben Rabidoux, the Canadian blogger at The Economic Analyst, presents data that suggests Canadian homes may be dangerously overvalued.
However, as one commentator noted, it may have also been useful to include an analysis based on affordability measures. These don’t paint as dire a picture because they include mortgage rates in the cost of carrying a mortgage. There is more to benchmarking house prices than just income and GDP."
Larry strikes me as an honest skeptic. Back in April, Larry took Garth Turner and I to task in a column titled, "Are house prices going to tumble?" But then in June, he wrote another column in which he expressed some significant concern for the real estate market: "Stop the housing bubble before it's too late."
Clearly he's willing to look at the issue with a critical eye....unlike many in the media. So I sent him the following email regarding his most recent post:
I see you discussed my guest post over at ZeroHedge in your most recent blog entry. I would like to address a point you made. I have, in fact, looked at the debt service cost of housing in Canada. Here's the issue: RBC's affordability index is inherently misleading, as I have discussed in a recent post.
Looking at affordability with a fixed down payment through time and with no consideration of additional debt burden is entirely misleading. RBC noted the following in one of their recent publications:
"It is an open question whether our affordability calculations are too optimistic or too pessimistic. We use the average disposable income per labour force member, an average home price, a 25% downpayment, a 25-year amortization period and an average mortgage rate. The downpayment assumption may be slightly generous given behaviour in recent years, but the amortization period may be somewhat frugal – these provide offsetting influences, leaving the exercise about right. These affordability figures are contrasted to the average level since 1985."
These clearly are not 'offsetting' at all. The most recent CMHC data suggests that the average downpayment by first time home buyers is roughly 7%. This is in line with findings from the Bank of Canada, released in their most recent review. To wit:
"Allen (2010–11) shows that from 1999 to 2004 most households with insured mortgages borrowed up to, or near, the maximum LTV ratio available at the time they purchased a home. Thus, in that period, the typical LTV ratio for a newly issued insured mortgage was in the range of 90 to 95 per cent."
So let's do some quick math here. The average house price in Canada is roughly $360,000. With a 25 year mortgage and a 25% downpayment, and assuming a 3% interest rate, the monthly nut is $1278. If we extend the amortization to the maximum 30 years and reduce the downpayment to 7%, the monthly payment rises to $1409. Hardly offsetting!
If CMHC were more forthright with their data, we wouldn't have to speculate on what the average down payment is. If RBC's affordability index reflected this reality, coupled with an average amortization length for first time buyers, and the associated burden of other consumer debt such as rising student indebtedness, we would have a far more reliable measure of true affordability. Barring that, I am inclined to lean towards more empirical measures of the true stability of the housing market. A recent article in the Financial Analysts Journal found that house prices relative to per-capita GDP display very strong mean-reverting tendencies. We know what house prices relative to GDP look like in Canada.
I wouldn't brush off metrics like the price-income, price-rent, and price-GDP ratios so quickly. They have served as meaningful indicators in many other real estate markets, and they are not nearly as fluid as 'affordability' measures.
To this email, I would add the following questions:
1) If this market has primarily been driven by falling interest rates, how do we account for a four year period in which house prices and interest rates largely moved in tandem?
2) How do we account for the fact that house prices began their marked deviation from underlying fundamentals roughly in 2003, well before the cratering of interest rates we saw in 2008. Coincidentally, this is the same year the maximum mortgage ceiling was removed by CMHC, meaning mortgages of any size would be insured with less than 20% down....perhaps the greatest policy blunder of the decade.
3) How do we account for the fact that in the US, house prices really are at exceptionally affordable levels and yet house prices are falling? Right! The loss of consumer confidence and the restoring of crippled balance sheets have a lot to do with it. We would be very foolish to discount the role of the 'animal spirits' of consumer psychology in driving asset prices....regardless of their affordability.
And that brings us to topic of consumer consumer confidence.
Consumer confidence tanks:
I've often said that asset markets are driven in the short term by mass psychology and consumer sentiment, but in the long term they are driven by underlying fundamentals. We know that the fundamentals are anything but sound. But Canada's real estate market has been blessed by a consumer base that has continued to look positively upon real estate as an asset class, and has remained relatively confident in the economic/financial prospects for the country in general and themselves in particular.
People who are fearful about the future tend to delay major purchases. More to the point, during times of declining confidence, they start to assess their ability to pay back their debt. Taking on a massive mortgage to purchase a home starts to look less and less appealing when people start to worry that perhaps the future won't be as big and bright as the recent past.
Today, the Conference Board of Canada released their latest consumer confidence readings. They are ugly to say the least:
The Index of Consumer Confidence in August continued its recent downward trend, dropping 6.6 points to 74.7 (2002 = 100).
When asked if they are better or worse off financially than they were six months ago, 16.4 per cent of respondents said better, a decrease of 0.5 percentage points. As well, the proportion of respondents who said they were worse off rose 0.6 percentage points to 21.2 per cent. This situation continues to prove worrisome for consumer spending in Canada, as negative responses have outnumbered positive ones since late in 2008.
...Responses to the question about major purchases proved the most pessimistic in August. The survey asks consumers if they think that now is a good time to make a major purchase and, this month, only 38.6 per cent said yes. This is down 3.9 percentage points from July and is at its lowest level since April 2009.
Hmmm....an increasing percentage of respondents consider it a bad time to make a major purchase. Not a stretch to think that MLS resales will come in below expectations over the next few months.
Taking a page from the 'Bull' play book:
Finally, I want to caution readers not to embrace the same tactics that we often rip on the real estate industry for using. I've often critiqued real estate boards who use monthly comparisons to show an artificial rise in house prices without mentioning the role of seasonality. I've also been critical when boards have emphasized outsized price gains using only a tiny sample size. Finally, I've been hesitant to call a trend after only one or two months of data due to other temporary factors that can affect prices and sales over a short period of time.
So let's not use those same tactics to try to show a market as being weaker than it may actually be. I'm thinking specifically of two articles from yesterday.
The first was by Larry Yatkowsky who showed a major drop in house prices in Kitsilano, a ritzy neighborhood on Vancouver's west side. This article has been discussed on several real estate forums. Let's put things in perspective....the 'plunge' is based on a grand total of 3 homes used in the data set. I am HIGHLY hesitant to attach any weight whatsoever to a data set this tiny. Of note, Larry specifically discussed this in his post, but that didn't stop some from interpreting this tiny data set as a harbinger of the imminent collapse in the Vancouver real estate market. What may be more telling is the house sales relative to inventory. With 3 homes sold out of 47 listings, it implies nearly 16 months of inventory in this neighborhood. That is a concern, but again, it is one month of data. Let's not get ahead of ourselves.
The second article was by Garth Turner who discussed the massive drop in single family resale prices in the 416 region of Toronto from May to mid-August. Resale prices have tumbled by almost 23% in that time. It is an alarming drop, but it should have been mentioned in the article that seasonal influences cause a significant price drop over this time frame every year. Average prices for SFHs in the 416 routinely drop by over 15% as the spring buying season fades into the summer and fall doldrums. While the recent drop is outsized relative to years past, once again, I'm not sure it is the harbinger of a collapsing market in Toronto. It is noteworthy, but let's wait for a few more months of data before we ring the alarm bell.
Here's the bottom line: There is plenty of data to suggest that house prices in Vancouver and Toronto are dangerously out of sync with fundamentals (see this article for plenty of proof). Time will fix this. We should be very careful not to embrace the same tactics of hyperbole and fear-mongering that have often been employed by the real estate boards.