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.