Book excerpt: The role of housing in boosting GDP
JUNE 02, 2011
The following is an excerpt from my upcoming book. Enjoy!
The role of housing in boosting GDP:
We’ve seen that demand for housing has increased in the past decade with housing starts well above what would be expected given demographics. We’ve also seen that the demand for new homes has also increased sales of existing homes. This has had a substantial positive impact on Canada’s labour market. However, as we’ve also seen, demand for new housing, and subsequently sales of existing homes, can experience significant declines during periods of falling house prices. With such an unusually high proportion of Canadians employed in housing-related sectors, the possibility of a significant housing downturn should concern us.
If house prices were to fall significantly, what impact would that have on economic growth? Below we see the percent of gross domestic product (GDP) that is derived directly from the construction of residential real estate. You’ll note that the last peak above seven percent was followed by a nation-wide housing correction. We passed that mark in 2008, then again in 2010.
A realignment back to the long-term average would strip over one percent from GDP growth going forward. However, as you can see in the chart, realignments seldom stop at the average. Rather they tend to overshoot to the upside or the downside. The fact that home ownership rates are substantially higher across all demographics than they were at the previous peaks coupled with the looming demographic imbalance, it suggests that the fall could be even more substantial than during previous corrections.
Beyond the impact on construction, a housing downturn would further affect the finance, insurance, and real estate industries. Since the mid 2000s, the contribution of these industries to economic growth in Canada has increased dramatically:
If sales of new and existing homes fall, as they would during a housing correction, it would substantially diminish the contribution of these industries to Canada’s economy. In fact, a realignment with long-term trends would mean a nearly two percent drag on economic growth in Canada.
Finally, note the recent surge in home renovations as a percentage of GDP:
The proportion of economic growth in Canada derived from home renovations is at historic highs. I believe this is symptomatic of a broader cultural shift in Canada that is captured in the rising popularity of the Home and Garden Channel (HGTV) which features numerous shows about home improvement and renovations. This shift has been further aided and abetted by various incentive programs on the part of the Federal and Provincial government, particularly the Home Renovation Tax Credit.
While I cannot entirely prove this causality, there are some interesting data points that lend credence to this assumption. For example, consider a 2009 publication by Canada Mortgage and Housing Corporation (CMHC) which examined home renovations in Canada. It found that the overwhelming majority of renovations were considered improvements or alterations (73%) as opposed to maintenance. Furthermore, over half of all respondents indicated that their primary motivation behind the home renovation was to enhance value or to prepare to sell (52%).
This is evidenced in the types of renovations that were most common which were predominantly aimed at improving cosmetics as opposed to general maintenance or increasing efficiency: Remodeling of rooms (34%), painting or wallpapering (29%), flooring (27%), major landscaping (22%). You may note that these percentages add up to more than 100 percent. To be clear, the numbers indicate what portion of home owners who renovated their homes undertook each type of project. Clearly some homeowners did multiple renovations at the same time.
A survey of households conducted by BMO in 2011 also contained some interesting data. Respondents reported that the three largest factors in influencing their decision to renovate were the properties of friends and neighbours (25%), TV shows (20%), and magazines/newspapers (16%). It also found that respondents were primarily seeking lifestyle improvements (90%) and added value (79%).
If we use the experience of other countries as a guide, we see that home renovations are correlated with house price increases. Here is the experience of the United States, which saw home renovations rise as their housing bubble grew throughout the past decade, then suddenly plummet as house prices peaked and began to fall:
I believe that there are several reasons why home renovations tend to be correlated with increasing house prices. The first is that many home renovation projects are at least partially funded through home equity lines of credit. As house prices fall, home equity shrinks. The correlation between the use of home equity lines of credit and house price increases in Canada and the United States has been extremely strong over the past decade. People are far more willing to borrow against the value of their home when they are confident that the price will continue rising, but they show a strong aversion to extracting home equity when prices are falling. This is a concept we will discuss in more detail in a later chapter.
The second reason is more closely tied to psychology and the perceived ‘worthiness’ of real estate as an asset. As we’ve discussed already, it’s an inherent human tendency to extrapolate current trends into the indefinite future. This is problematic when it comes to investing in general as people tend to pile into the latest investment fad just in time for it to implode and revert to its long-term mean. Every year, DALBAR, a prominent financial research and consulting firm, compares the average return earned by individual investors to the returns of the stock market. The results are sobering. Between 1985 and 2005, the return earned by the average individual investor lagged the broader stock market by 9% annually! How can that be? The primary factor for this massive underperformance is the propensity to chase the latest fads. For example, many people lost a great deal of money by piling into tech stocks just prior to their peak. This ties in with mass psychology, which we discussed earlier. The point is that we base our assumptions of future returns on the recent past. This is as true of housing as it is of the stock market. As it relates to home renovation, one of the primary reasons why households renovate is to enhance value, as discussed above. If they no longer believe that their renovation ‘investment’ will provide a healthy return, they will find other uses for those funds.
The risk now posed by the unprecedented contribution of home renovations to GDP is that this trend will very likely experience a sharp reversal if Canada experiences a widespread and significant housing correction. A reversal to the long-term mean would exert a 0.7 percent annual drag on economic growth in Canada. The propensity for such reversions to overshoot their average means that we cannot discount a drag of 1 to 1.5 percent annually in the aftermath of a housing correction.
Cheers,
Ben
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13 Comments
I'm surprised you didn't mention China at all. New houses are directly counted under Investments (gross). And what does China do to keep their GDP high? Build brand new empty cities.
On a different note, is it possible to give use a sneak peak of your content list of your book? Pretty please?
r u serious? YOU are going to write a book?
I'll personally sign your copy Sammy boy (...or is that girl? What are you pretending to be today?).
U know what would "suck", Sams Mango? If Ben actually made money off the thing. And I know Ben is going to walk into a publisher's office with a loaded gun, point it at the guy's head and FORCE him to publish it. Then he's going down to Indigo on Yonge Street with a loaded gun and FORCE people to buy it.
Would it ruin your world view, that people make money by writing about stuff you may not agree with.
And let's be honest here. Garth can write and get published. From what I've seen Ben can easily do as good a job, but (don't take this the wrong way Ben) the bar is pretty darn low...
Good work Ben. Construction and Government employment covered up our problems temporarily. New single family home sales substantially down in the G.T.A. 40% to 60% Investor market in new Condo's based on Social Unrest. Large amounts of buyers from India, Israel and China. Condo's are viewed as safe and an exit strategy. Commercial construction not looking good for the fall. Infrastructure programs winding down. No comparisons or patterns from the past can be looked to. Government tinkering with deposit structure, amortizations, interest rates, immigration pattern, household formations,credit availabilty, wealth affect and marketing, Q1 and Q2 all worked to create quite an illusion. There is very few people left who can afford to buy. People do not buy into the market if they do not have a job. There are no more rabbits in the governments hat. Huge debts Federally and Provincially are what we have now. People in Ontario best be praying for the U.S. recovery while we still have some manufacturing left. That will be real wealth creation. At the end of the day solid employment is necessary to maintain a healthy housing market. Buying and trading houses is not healthy. New housing use to be a by-product of a healthy economy. Looking forward to your book. Guess we have to wait a little while longer for the final chapter. The elephant has been in the room for some time. Denial can be a great coping skill until it bites.
From a Calgary real estate blog
It's different this time
All the stars were in alignment for the perfect firestorm this spring. No more 40 year mortgages. No more 35-year mortgages. Minimum 5% down. Higher interest rates. Government bailouts gone. Recession here. First-time buyers have evaporated. Home ownership at an all-time high. No buyers. Panicked sellers. Bad weather.
One fear-pumper said in eager anticipation in March 2010, "come spring(2011) when it becomes painfully obvious that their is no hope of a recovery due to rising interest rates, falling sales and continual monthly price declines, the entire Ponzi shim sham scam will collapse."
We can sum it up with this line from the infamous, anonymous fear-pumper himself:
"They became stupid and got carried away making silly unsubstantiated
guesses about the future"
Here's a few more of his hallucinations:
2010
Apr 13: "Mortgage rates are rising faster than I thought, if the trend continues, the 5 year rate will be about 9% by years end" (Update: 5-yr mortgages available for less than 4%)
May 9: "Any one retarded enough to still be in stocks should seek addiction counseling immediately"(Update: TSX up 18%)
May 22: "Alberta's heading for 10% plus unemployment,its gonna get very ugly very fast" (Update: 5.9%)
May 28: "Alberta set to lose 56,000 residents"
Jun 3: "A housing price crash is now imminent."
Jun 3: "sooner or later those 1-3 million dollar homes will stop selling" (Update: Calgary luxury homes sales up 51%)
Jun 6: "Prepare to dive greedy bas _ _ _ds, prepare to dive, shes going down"
Jun 11: "its all downhill from here."
June 14: "She’s gonna blow soon "
Jun 16: "this bitch is gonna blow."
Jun 21: "Calgary average home prices will be $160,000 when all is said and done"
2009
"we are finally here. the bust will happen this year"
“The atrocities of WW2 will seem timid when compared to what lies ahead.” (I'm not making this up)
2008
"the great unwinding is virtually at hand"
“you can see and smell the sheer panic and fear in the air"
"a total and complete collapse"
“very dark and very bad”
2007
“shes all over now
shes toast
it couldnt be any plainer to see
prices wont fall to the 300,s
try $160,000 for an average sfh”
“it realy is coming to an end”
2006
"I think Calgary is going to crash, because I think people are running very high debt loads"
In Jun 2006, CMHC made zero down available, and it elicited these comments:
"this shows that (CMHC) fears the current bubble is coming to an end"
"This is the equivalent of giving morphine and cocaine to an ailing horse, in order to get a last sprint out of him before death." (This dead horse is still being flogged five years later, but the CMHC nag is still running)
This year will be different, though. And the Leafs will win the cup.
I could do the same with Ben's post...write a book on how to lose money Ben? Give me a break
Too funny. You mean since this blog began in September 2010? Outline your macro view for the Canadian economy and housing for the next 5 years. You know my perspective. Working for a "large real estate firm" as you claim, I'm sure you know that a few months is nothing but noise around a trend.
First of all, I'm not pushing any of that "worse than WWII grabage. I'm not sure what blogger you are referring to. And perhaps it is worth mentioning that Calgary is still down over the past two years. So.....I guess it was different.
and you continue to be wrong about housing in Canada
http://www.theglobeandmail.com/report-on-business/economy/housing/toront...
You may be interested in this article by Mark Carney:
http://www.group30.org/images/PDF/ReportPDFs/OP81.pdf
He notes that private credit to GDP is a "robust leading indicator" of banking crises. And what has Canada been doing?
http://www.tradingeconomics.com/canada/domestic-credit-to-private-sector...
http://www.tradingeconomics.com/canada/domestic-credit-provided-by-banki...
Can you get any updates on these numbers? It seems to me that 2009 and 2010 should be near record highs, considering how the housing market powered the recovery.
What is your opinion on this, Ben? I think a crisis will come whenever they stop the music, i.e. whenever people have to pay a normal interest rate and/or governments try to balance their budgets. Right now we're still digging a bigger hole for this country. The attitudes I see are strikingly reminiscent of the US in 2003-2006. Utter complacency about extremely high debt.
Thanks for the link rp1! Carney's statements are big. Here is what he wrote:
"The decision to turn on the [countercyclical capital] buffer should be guided by a leading indicator of financial excess. In particular, research has shown that one of the best indicators is the performance of the private sector credit-to-GDP ratio relative to its longer-run trend and one would look for deviations from that—a positive credit gap, in the terminology."
Square this with OSFI's recent stress tests on banking assets in overinflated housing markets. Again we can put two and two together and ask, is Carney actively advocating for countercyclical buffers to be instituted informally in Canada now? His statements about growing household debt and the statements in this paper stand at odds, at least from what I see publicly announced. Unless Canada starts actively reining in bank lending, even the non-high-ratio stuff, Carney will look a bit of an idiot. Dontchya think?
Hey Ben,
Don't let these guys get to you. Your posts are thorough and involve critical thinking about what the future might hold. Their posts involve seeing the future through the prism of the recent past. I'm sure you've heard the parable of the turkey, having being well fed and well treated in the recent past, seeing himself as having a pretty rosy future, until that fateful day in October...
I'll be buying your book for sure. I do have a request though... could you write a bit more about Montreal? It is the country's second biggest real estate market...if not by valuation certainly by units...
Hang in there,
Calculon