MAY 16, 2011
This will be the last post examining the fundamentals that underpin real estate across Canada. Later this week, I hope to compile all the data we've examined thus far into a sort of comprehensive overview of the Canadian housing market....an über primer if you will.
As a refresher, here is some of the data we've examined thus far:
House prices and population growth.
House prices and rents.
Today we turn our attention to house prices and inflation.
Why inflation matters
It was bubble guru and Yale economist Robert Shiller who famously calculated that house prices in the US have done little more than pace inflation over the past century.
In fact, the most extensive historic housing data set in the entire world verifies this finding. Price data for the Herengracht Canal in Amsterdam extends all the way back to the early 1600s. Remarkably, real (inflation-adjusted) house prices have moved around a long-term trend line over the past 350 years. That is to say that houses essentially pace inflation over time. Source: Piet Eichholtz as cited by Steve Keen
Note that periods of under performance relative to inflation were eventually corrected with rapid moves to the upside, while periods of over performance relative to inflation resulted in an eventual correction to the down side. Note however that this can happen via a reduction in house prices or a stagnation in house prices while inflation catches up (the 'soft landing' thesis, if you will). Finally, note that periods of outperformance and underperformance in house prices can be stable over periods of decades before finally finding their long-term equilibrium.
The degree to which house prices are influenced by inflation is debated among economists. While the very long-term trends show a stable relationship, the divergence between the two variables can be long-lasting and significant, leading some to question whether inflation is a worthwhile predictor of house price movements. However, it should be evident that as materials, land, and labour costs rise, new house prices will rise accordingly, raising the comparable value of all homes as replacement costs rise. Conversely, outsized gains in real estate values relative to inflation may indicate that house prices have gotten ahead of themselves. So while the growth in inflation and house prices may or may not be an indicator of near-term movements in house prices, we would be remiss to not at least explore the long-term performance of the two variables in Canada.
Here in Canada, inflation is often measured using the Consumer Price Index which tracks changes in a basket of consumer goods. For those not familiar with the Consumer Price Index, here's a brief overview courtesy of Stats Canada:
The Consumer Price Index (CPI) is an indicator of changes in consumer prices experienced by Canadians. It is obtained by comparing through time, the cost of a fixed basket of commodities purchased by consumers. Since the basket contains commodities of unchanging or equivalent quantity and quality, the index reflects only pure price change.
...The CPI is widely used as an indicator of the change in the general level of consumer prices or the rate of inflation. Since the purchasing power of money is affected by changes in prices, the CPI is useful to virtually all Canadians. Consumers can compare movements in the CPI to changes in their personal income to monitor and evaluate changes in their financial situation.
CPI is calculated on the national level, as well as provincially. It's the provincial data we'll be examining today. The data source is Stats Canada (CANSIM table 326-0020) and CREA. Both indexes have been set to 100 in Q1 1980 and have been adjusted quarterly.
Of note, the Teranet Index is the superior index in examining house prices and inflation as it strips away the influences of changing consumer preferences (i.e. larger houses). The Teranet index uses a paired-sales methodology whereby house price increases are determined by examining the changes in the sale price of the same house over time. CREA data does not account for this. However, since Teranet data only goes back to the early 90s and is based on Canadian cities rather than provinces, the CREA data will have to suffice, as imperfect as it is.
As with many other fundamentals that we've examined, most provinces except BC and Ontario track inflation closely until the early or mid 2000s at which point they abruptly depart from the trend. To believe that the divergence between house prices and rents/incomes/inflation/GDP will not at least narrow is to embrace the dangerous mantra that 'this time it's different', a mantra that has cost many dearly.
While some may argue that the inflation statistics have been massaged lower over time, there is a multi billion dollar Canadian bond market that strongly disagrees. For reference, the bond market is over ten times the size of the stock market, dwarfing it in capitalization.
So the question remains: Is it really different this time, and if so, why?