AUGUST 25, 2011
Debunking the supposed drivers of Vancouver’s absurd real estate market
Vancouver house prices are nuts. RBC recently calculated that ownership costs associated with a standard condo in the city consumer nearly 50% of the average family income. The carrying costs of bungalows and two story homes are even more ridiculous, consuming 93% and 96% of household income respectively.
And we know what the other fundamentals look like in that city:
In trying to dismiss what is plainly obvious to anyone not living in “the best place on earth”, four narratives have developed to explain away the ‘supposed’ overvaluation issue in Vancouver. We’ve addressed three of them before. The fourth was discussed in an excellent article which I will highlight in a moment.
Let’s look at each story individually.
Story #1: House prices are not actually that unaffordable in Vancouver. The average price has been distorted by a handful of extremely expensive homes.
This story was popularized by condo
salesman expert Bob Rennie and widely reported in the mainstream media. The Globe and Mail even ran an article titled, “Busting the myth of Vancouver real estate.”
"...People who specialize in housing affordability in the region say their statistics also indicate that the perception of Vancouver’s affordability problem is distorted by high prices in some places."
"...But Mr. Rennie noted the average condo in Metro Vancouver sold for a mere $313,000 last year after the most expensive condos in the top fifth of the market were taken out. Similarly, single-family homes in the top fifth of the market average $1.72-million. But once those high-end sales are removed from the price-averaging mathematics, home buyers in the rest of the region paid an average of $632,000."
Yes, you read that correctly. Vancouver is not really expensive. It's just that many of the houses there are expensive. Once you strip out the expensive ones, it's not so expensive anymore.
Rennie is clearly a comedian. You can’t make this stuff up.
Here’s the truth. We put this story to rest in a recent post titled, “Misleading averages and bad science” where we used the Teranet index to measure the rise in house prices in Vancouver relative to other fundamentals. This index uses a paired-sale methodology to gauge house price increases in certain Canadian cities. The index methodology largely eliminates the effect of a handful of extremely high or extremely low priced transactions, which can admittedly wreak havoc on averages. Here’s what the Teranet index shows:
Consider this story busted!
Story #2: Wealthy immigrants with buckets of cash have driven the market beyond the reach of locals, and it will stay there indefinitely.
Every bubble needs a “this time it’s different” story. This is Vancouver’s. This story is often told as the Hot Asian Money (HAM) phenomenon. Let me start by saying that as it pertains to Vancouver real estate, I believe this story has had a profound impact on house prices, but not in the way most would think. Bank of Canada governor, Mark Carney, in a recent speech in Vancouver, hit the nail on the head. In addressing the ‘extreme valuations’ in Vancouver, he had this to say:
"Given such developments, one cannot totally discount the possibility that some pockets of the Canadian housing market are taking on characteristics of financial asset markets, where expectations can dominate underlying forces of supply and demand. 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."
There it is. The HAM story is far more likely to influence the Vancouver real estate market not directly through an influx of foreign capital, but indirectly by stoking the powerful human emotions of fear and greed.
Let me clarify a point here. Are there wealthy foreigners buying real estate in Vancouver? Absolutely! But is that influx of capital sufficient to explain the rise in real estate values, and will it be permanent? These are the big unknowns.
Let me make three points on topic:
i) I have yet to hear a single intelligent answer to a very simple question. If wealthy foreigners are driving the market with all-cash offers, how do we explain the fact that BC in general has the highest debt-to-income measures of anywhere in Canada? Something about high house prices being sustained by foreign cash inflows doesn’t seem to jive with massive and rising indebtedness in the region.
ii) I’ve heard all the arguments about why folks from Mainland China are looking to get their capital out of the country: Political stability, chance to own property, prohibitive government regulations against ownership, deep belief in real estate as an asset class, better education opportunities…etc. I don’t dismiss those. I simply question whether Vancouver will always be the destination of choice given the extremely attractive opportunities to own real estate in other (truly) world class cities at a fraction of the price. This would be particularly true if (when!) real estate in the Lower Mainland starts to correct. For fun, play around with google search terms involving Chinese investors and real estate. What you will immediately notice is that there are hundreds of articles about Chinese buyers of real estate in many countries…
iii) Recent developments suggest that the debate about the role that foreign money is having on real estate is now a moot point. The top financial regulators in the country recently announced that they will be looking into this exact question. On the same day, major changes were made to Canada’s immigrant investor program. With regulators now looking into the issue and making it abundantly clear that they are willing and able to curb such inflows of foreign capital, it seems that this argument is now irrelevant. If it is the driver of Vancouver’s irrational real estate market, it won’t be for long.
Story #3: There is no more land!
Ah yes, the land constraint argument. Thanks to commenter 'Makaya' for reminding me of this one. It's true that once you move too far east or west of the city, you encounter rather rugged or rather wet building sites. The real story here suggests that construction has been unable to satiate demand due to land constraints from restrictive policy or just a shortage of building sites. Interesting argument, but again, let's let the data speak for itself. I discussed this at length in two recent posts:
Here in Canada, the average house size is estimated to be roughly 2.4-2.5 individuals. Note the last definitive reading was in 2006. But also note the rather obvious trend:
Accounting for some new construction that replaces existing dwellings, and some construction for second homes, we might estimate that one new unit for every 2.3 new people added to a population would most certainly satiate demand.
So how has Vancouver fared in this regard? See for yourself:
You'll notice that over the past 10 years, during a time when house prices have risen over 150% in the city, there was one house built for every 2.24 new people added to the population. This level of construction is entirely able to satiate demographic demand. Note also that from 2002 to 2007, a full six year period, there was one housing start for, on average, every 1.48 new people added to the population. And this was during a time when house prices doubled! There’s absolutely no way that building constraints were any factor in the price gains seen during this period, particularly in 2004 when housing starts exceeded the total increase in population! The notion that house prices are driven by the inability of the construction industry to satiate demand due to land constraints, is completely and totally ridiculous.
Story #4: The underground drug economy is boosting house prices
I’ve had some commenters on this site adamantly insist that the drug industry is what is pushing house prices higher in Vancouver. Interesting argument. There’s little doubt that BC is Canada’s drug central, but is this the reason for Vancouver’s stratospheric house prices?
An interesting article by Frances Bula has looked at this very question. It’s well worth the read in its entirety, but I will highlight only a few key quotes:
“There are dozens of ways to launder money in real estate, from paying cash for down payments or renovations to buying houses in the names of dummy owners to establishing elaborate mortgage-repayment schemes that convert bags of dirty cash into legitimate-seeming transactions. Has the practice become so common in Vancouver it’s helping to drive up real-estate prices?”
“Does B.C.’s drug industry even produce enough wealthy people to manipulate the market? First, you’d have to know how big the drug industry really is in the province. The most thorough study of the marijuana industry, done by Stephen Easton at the Fraser Institute in 2004, estimated that our grow ops, numbering around 17,500, generate close to $2 billion in export value per year at wholesale prices; at retail, estimate $7 billion. Assuming (optimistically) Canadian middlemen get all the markup, that makes the marijuana industry about the same size as the forest industry. The $4-billion figure commonly cited seems more likely.”
“Then there are the drugs brought into B.C., like heroin and cocaine. One 2000 U.S. government estimate of total American spending on illegal drugs besides marijuana was $54 billion. Assuming that grew by 20 percent over the next decade, it would be $60 billion today. If Canada’s number is one-tenth—the general rule for economic stats—that’s $6 billion. B.C. usually accounts for at least one-tenth of national statistics, but with the heavy drug use here, assume we make up 20 percent of the market. That’s $1.2 billion in local sales (less wholesale costs and shipping). This is all tax-free, of course, which boosts buying power.
So let’s say the illegal drug market has the equivalent clout of double its retail sales: $16.4 billion. That’s still just a fraction of our economy (B.C.’s GDP is estimated at $196 billion this year).”
“…Tsur Somerville, the lanky, outspoken UBC professor who scrutinizes local real estate, thinks they do impact the market, but no more than any other growth sector. “It’s just another industry with wealth,” Somerville says. “The fact that it’s drug money makes it no different from the mining industry or any other.”
“…There’s a simpler explanation of what drives Vancouver housing prices up. Drug profits allow some buyers—just as it allows wealthy forest executives and Chinese immigrants—to participate in the collective activity of driving prices up. Housing prices in all cities go up when they experience demand shock. A big new business opens; local sales increase; wages follow. Developers gradually respond to that demand shock by building more housing. But it doesn’t work the same way in every city. Places that have market elasticity—where it’s easy for developers to build—gradually see prices return to a level in line with local incomes. As local incomes rise and fall, housing prices follow the same path.”
“But in cities that are less elastic—where there’s little developable land, or the regulatory process is onerous—housing prices rise long past the original demand shock. Speculators enter the game. Some are investors, betting the market will keep overheating. Many are simply people who buy beyond their income level, believing the housing market is worth betting on. Prices keep going up because they’ve all become part of a Ponzi scheme, betting that the next set of buyers will make the same calculation they did in deciding to get into the game. It doesn’t take drug money to drive up housing prices. It just takes buyers who act like they’ve been smoking too many funny little cigarettes.”
Well said! The Vancouver real estate market is a classic bubble, fueled by excessive expectations of market return and access to cheap and readily available credit. No one can predict exactly when this bubble will meet its untimely end, but for anyone willing to take an unbiased look at the data, the outcome should not be in question. For those interested in predicting future direction of house prices, I've suggested one metric worth keeping an eye on.