The housing affordability argument: Misleading, short-sighted, and just plain stupid
OCTOBER 16, 2011
Are houses really 'affordable' in Canada?
One of the most short-sighted and misleading arguments used to justify house prices at current levels is the notion that the carrying costs of the typical house, in relation to the typical income, is nowhere near as high as was experienced prior to the last major real estate bust back in the late 80s.
While technically true, it is short sighted, dangerous, and highly misleading to suggest that this justifies house prices at current levels. Here’s why:
All affordability indices are misleading because of their erroneous assumptions:
I've explained this concept before, so I don’t want to belabour this point. The bottom line is that affordability measures, such as RBC and CMHC’s affordability indices, are highly misleading as they make massive (and clearly erroneous) assumptions regarding consumer behaviour.
The first is to assume that down payments have been stable over time, despite the fact that we know that is not the case. Even the Bank of Canada chimed in on this over the summer, confirming that the typical first time buyer makes the minimum required down payment. Yet affordability indices use a stable 25% down payment over time even though the down payment requirements have shrunk markedly since the late 80s.
Some economists have suggested that this is offset by the fact that amortization lengths are often longer than the one used in the affordability calculation. An amortization length of 25 years is typically used, despite the fact that the maximum allowable amortization is 30 years. They clearly haven’t run the numbers. I have:
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. You can see that this is clearly not offsetting.
The other major oversight is that they assume that people are buying a ‘traditional’ house. For a bungalow, this means a house with 1200 square feet. For a two-storey, this means a house with 1500 square feet. Interestingly, in 1975, the average new house being built in Canada was almost 1100 square feet and has risen steadily since then, hitting just shy of 2000 square feet in 2010. So here’s the bottom line: Consumer behaviour has gravitated towards a “bigger is better” mentality over the past two decades. These affordability indices assume a stable average house size for first time buyers when the evidence clearly shows that this is not the case.
There are more issues that you can read about here. But despite these glaring issues which mask the true affordability picture, the readings are still quite stretched by historic standards. That alone should concern us:
What do low interest rates tell us about income growth?
One of the things lost on the people who look only at affordability readings is that interest rates primarily reflect two things: 1) A risk premium to the lender, and 2) An inflation expectation.
Interest rates rise primarily when people are concerned that the borrower will not repay OR will repay in greatly inflated dollars, meaning that the lender has lost purchasing power on the money lent.
When people look at affordability readings and conclude that we are fine since we are below the heights hit in the late 80s, they are missing a massive point: Inflation was high in the 80s, meaning mortgage debt could more easily be repaid in the future in inflated dollars. The importance of this point cannot be overstated: An expectation of rising inflation is by necessity an expectation that wage growth will be relatively robust.
The reality is that interest rates at these current levels strongly suggest that we do not have the luxury of future inflation making current debt burdens easier to bear.
It shouldn’t shock us that the worst incidences of falling house prices have been during periods of exceptionally low interest rates in developed nations. While high interest rates tend to cause sharp, rapid, but relatively short corrections, low interest rates coupled with extreme debt levels are more suggestive of a long, deep, protracted decline in house prices as the US is experiencing or Japan has been experiencing since the 90s. Don’t misconstrue my message: I am NOT saying that this is our exact future. I do think we will have a long, protracted, and deep real estate correction, but not to the same extent as the US or Japan.
The key point is that low interest rates are not at all bullish for real estate in the long term as there are inflation and wage growth expectations reflected in rock-bottom interest rates, which mean the debt burden will not easily be inflated away as they were in the late 80s and early 90s.
The stupidity and short-sightedness of the argument is mind-boggling:
I hate to be harsh, but those thinking that housing will be okay as long as we keep ‘affordability’ below 1980s levels are making an incredibly stupid blunder. If, during a time of unprecedented low interest rates, we allow affordability to be stretched to levels last seen when interest rates were in the high double digits, we guarantee a massive debt crisis.
As it stands, there is a 100% chance that interest rates will rise faster than incomes over the next decade. I happen to think interest rates will remain very low for a long period of time, but the overnight rate from the Bank of Canada is 1% meaning that a 5 year variable rate mortgage can be had for a hair over 2%; Meanwhile the 5 year bond is yielding 1.6%, meaning a 5 year fixed rate mortgage can be had for a sliver over 3%. For a perspective on just how low this is relative to the average...
If variable rate mortgages again touch 4% and fixed rates touch 7%, which they will in time, it means interest rates have doubled from current levels, despite the fact that even these higher figures are well below the long-term average.
This will almost certainly happen within a decade. Do we really believe that incomes will double over that time? Do we really want to run debt burdens up to levels last seen in the 80s with interest rates roughly 1/6 the level they were then? Do we really want to ratchet up debt burdens when all it would take to double interest payments at current levels is to move the fixed and variable rates to 4% and 7% respectively? Do we really not see why that would be exceptionally bad if that were to happen?
If you understand this, you see why low interest rates are not the saviour of the housing market. If not, there’s still time to buy before you’re priced out forever.
-Ben
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57 Comments
Just as an aside, Ben, the "discount" from bank prime being offered by mortgage lenders these days is getting very small -- I would wager that it would actually be pretty hard these days to get a VRM for a "hair over 2%" -- the actual number would be closer to 2.6-2.7%. At least for now.
Actually I think even if rates stay low prices will fall because cash flows are flat in inflation-adjusted terms. Low inflation means low revenue and income growth. You don't need to make the argument that rates will increase "eventually" to make your point, though if rates do go up it's particularly hard for those who were expecting low rates ad infinitum.
100% agree. Thought I made that clear. Perhaps not. House prices will fall even with uber low interest rates. I mentioned rising interest rates (which will happen eventually) ust highlighting the ridiculous thinking surrounding the 'affordability' question.
@Ben, but you also stated that you think incomes are going to outpace interest rates. IF this is true, wouldn't debt burdens be eased quickly by reducing DSRs to manageable levels and allowing for principal repayments?
I think you misread.
"..there is a 100% chance that interest rates will rise faster than incomes over the next decade."
oops. I don't know if that's necessarily true, though. Wages have historically outpaced inflation, well for some of us anyways. See Occupy (your city).
Yup...agreed. My point is that strong wage growth would be associated with rising interest rates. With rates so low, those taking out mortgages today will be renewing at a higher rate at some point. The rise in rates will very likely mean that their mortgage payment as a percent of their income will rise at renewal, even with rising wages.
Yes I agree with you general thesis, after re-reading it. I think, though, wage growth will be uneven for some time. If we look at hourly earnings they are progressing at a fair clip. If it's true that wage growth is suppressed in aggregate, some people must be really taking it up the wazoo, or there is going to be significant unrest over the next decade when it comes to resolving income distribution. The OWS movements have put a bug in the public conscience. If it's a recurring bug, it starts becoming a meme. Something to watch.
Speaking of interest rates, here is Michael Pettis with another interesting take on savings rates and interest rates in China: http://mpettis.com/2011/10/lower-interest-rates-higher-savings/ . It may be that some of these concepts of saving may be translating to Canada in some way, making normal monetary policy responses less obvious.
Great read. Pettis is the man.
I agree with everything you write Ben, which leaves those wanting to buy a home (like myself) in a conundrum. If we buy now, we will likely be financially strapped in 5 years at renewal time if interest rates double, however, if we don't buy, it could be a decade or more before housing prices become "affordable" based on fundamentals.
If the BOC slowly raises rates over the next 5-10 years (so as not to shock the economy) and housing prices slowly decline with these increases, then monthly carrying costs will likely be the same, so there really would be no point in putting off buying now. -That is only if the government can pull of a soft landing. This is the reasoning one of my friends is using to justify buying now in Vancouver.
The only way it would make sense not to buy now is if you believe the market is going to crash and prices decline more than 30% over the next 5 years. I used to think a crash was inevitable in Vancouver, but now after 3 long years of waiting, I am starting to believe that the government will do anything to keep this housing party going, or at least try to cushion and prolong the fall-out.
I am hopeful that May was the peak for housing in Vancouver and we will start to see the slide this winter and into next year. We have decided to give Vancouver one more year to see how this all plays out.
All true, except incomes don't nearly need to double to support double interest rates - mortgage payments are not 100% of incomes and interest payments are just a fraction of mortgage payments.
True....and I understand this. I specifically said that the interest payment (not mortgage payment) will double if interest rates rose for exactly that reason.
Can you elaborate on the part of the article where you say: "As it stands, there is a 100% chance that interest rates will rise faster than incomes over the next decade"?
What's the reasoning behind that? I've given up hope that interest rates will rise at all for the next two years, and given a variety of macroeconomic conditions, I'm fairly pessimistic about interest rates rising at all within the next five years.
Private sector incomes may not rise over the next five years, but the public sector is ~40% of GDP and most of those salaries are indexed to inflation. Even assuming private sector income increases of zero, I'd guess aggregate income increases will be ~2% over the next five years, so net salaries will probably be ~10.4% higher.
Even if rates finally start rising five years out, the'd have to rise rather quickly for mortgage costs within a decade to outpace income increases, no? I'm just curious what your thinking is.
Hi Chris
I agree with everything you've said here. I think interest rates will be exceptionally low for the next few years. The point is that at some point rates will start rising, meaning those buying today will be renewing at higher rates.
Let me use an example. Let's say that someone took out a mortgage for $300K at 3% amortized over 30 years. Their monthly payment is $1261.
At renewal time in 5 years, you would have 267K left on the mortgage. If the interest rate on a fixed rate mortgage has risen to 6%, your monthly payment would have risen to over $1700, or 35% higher than the original payment.
Unless wages have risen by 35% in 5 years, this now eats into your income. That's my point. If wage growth is strong, inflation would also have to be rising, which makes it exceptionally unlikely that rates would stay at rock bottom levels, particularly for the fixed rate mortgages which are set in the bond market.
So you see the conundrum. If wages begin rising, so too will interest rates. But with interest rates so low, even a minor rise translates into a substantial jump in payments, which will very likely outpace whatever wage growth there is.
Does that make sense?
Housing affordability is determined on a case by case methodology based on the ability of the purchaser to qualify using standard debt-service ratios that all banks adhere to.
And you can spare me the diatribes about Canadian "sub-prime" mortgage lending (virtually non-existant), or the supposed popularity of cash-back mortgages, which are not only more difficult to qualify for, but have nasty claw-back penalties if you ever decide to break the mortgage or sell before the end of the term.
Many first-timers only qualify to purchase a 500 square-foot condo in Toronto, so that is what they purchase.
Averages tend to skew market perceptions to the high side, both in sale price and square footage.
As far as "justifying" house prices are concerned - a free and open marketplace determines the price. Nobody is holding a gun to anybody's head to make them buy.
Off the mark entirely with this comment. The discussion pertains to the RBC and CMHC affordability indices, which show affordability well below the highs of the 80s, but make some questionable assumptions with their data.
Subprime lending? Already covered:
http://www.theeconomicanalyst.com/content/subprime-lending-canada-wading...
Try to keep up.
As far as "justifying" house prices are concerned - a free and open marketplace determines the price.
Thanks for the chuckle. The Canadian mortgage insurance market is utterly dominated by a single government-owned insurer that imposes particular down-payment and amortization requirements on the mortgages it insures. 90+% of first-time buyers choose to go right to the edge of these requirements, which are ultimately dictated by the Minister of Finance. But yeah, I guess the marketplace really is "free and open".
To cc - I am sort of in the same boat as you - we moved to Canmore 2 years ago, choosing to rent while the Calgary properties sold. It has been painful trying to keep tabs on the market to see if our decision was right. We are paying $2500 a month to rent a newly built decent place that was on the market at one time for around $1.4M. (the landlord pays all taxes and maintenance so they probably realize about $2000 per month or $24,000 per year). My best estimate from talking to realtors and doing my own comparisons is this place would list for around $950k now. In this town of 25,000 - about half permanent and half weekenders, there are now 483 listings and prices appear to be crumbling.
It is somewhat easier for me to quantify the drift downwards in price in Canmore than it is to quantify in Calgary. I am quite sure that anyone who bought in Calgary since early 2007, or maybe 2006 would not come out ahead if they were to sell, pay realtor fees plus money they have spent fixing and decorating.
I am so happy now that we did not buy because it looks as though another move is in the cards, and we would be trapped with a loss of about $300,000 and probably not wanting to sell and crystalize the loss.
I am not willing to wait 5 years to buy or build a new home either, but I am going to watch what happens through 2012 before I dive in.
I wonder when the market sentiment switch is going to be tripped. I think it will happen sooner rather than later and I will not wait for the last drop of blood to be rung out of the market to buy.
Shhhhhh. It's the one chart the government doesn't want you to see or understand.
http://greshams-law.com/wp-content/uploads/2011/10/Canada-Real-Interest-...
The mindboggling blunder from our policy makers is assuming that the Cdn $ is a reserve currency. Should their be a collapse in crude, I know just completely impossible since there have been no technological advances since the stone age, our country might get shunned from capital markets and see yields rise.
It could be some other calamity, but its highly dangerous to have so many people leveraged the way they are, with no savings and a big debt overhang. There are way too many homeowners who couldn't last a month without a paycheque. A nasty recession and there goes the housing market.
Can you name a policy maker who assumes the C$ is a reserve currency? A citation would be nice.
I am a Real Estate Broker and have been selling Real Estate in Ontario since 1981.
In my entire career selling hundreds of homes to Clients, none have had difficulties
financially carrying their homes. I find most if not all the Clients I deal with are prudent.
Everyone knows Real Estate is a long term investment, and a person should buy within their
means, and the Really Smart Buyers use their NET INCOME to calculate GDSR/TDSR, unless
you are a Speculator.
And like every RE agent and home buyer who is prudent, they forget to calculate for future inflation and assume they'll keep getting a salary raise.
Hi Rita. Interesting perspective. Some food for thought for you:
According to a stress test scenario by the Bank of Canada, it would take only a 0.5% increase in interest rates for 1.1 million Canadian households to become at risk of defaulting on their consumer credit or mortgage-related debt.
Either the Bank of Canada has the wrong numbers, or your experience is not typical.
Yes Ben but like always, I hear RE agents say that their customers are well off and manage their risk well. It's unfortunate that what matters now is not the ability of a homeowner to pay the mortgage, rather if the rest of the street, or person down the hall can afford the mortgage. In the US there were many doctors, lawyers and 100k+ professionals whose properties went underwater all because of foreclosures in their area.
This is one of the many risks a homeowner must be aware of.
Very interesting.
Would you know total number of Residential homes in Canada?
Even if you haven't seen difficulties, you have also witnessed at least one other property cycle.
Sure, the people I know who bought houses in 1988/1989 Toronto didn't go bankrupt or get foreclosed on, but that doesn't mean their lives weren't impacted by the bubble. Housing getting ~30% more expensive meant about 10% less money to go around in the household budget. And 10% is pretty substantial: about how much many rules of thumb say we should save, or spend on cars & vacations. Those who bought in '86 or '93 were substantially better off than those who got caught up in the peak.
Rita, do your clients typically keep you posted about their ability to financially carry their homes, after the sale is complete? E.g. if you help a buyer purchase a home -- and then a year later he loses his job or is saddled with a large outside financial obligation that makes it difficult for him to make his mortgage payments -- does he typically call you to tell you about it?
If not, how can you say that none of your clients have had difficulties financially carrying their homes? Or did you just mean "at the time of purchase"?
I agree with Rita, over 30 years as a builder, never seen a bad outcome, not one. People have raised families in homes, up and downs, but a home has always been stable. Paying rent and speculating on when and how much interest rates will go up or down is harder then simply buying and holding. No one has a clue when rates will go up, by then you could have spent 5-10 years renting and have nothing to show. Good Luck with that angle. Focus on your job, you feel you have good savings, buy within reason. You will be fine. Banks will let you reach for the starts, no one ever operates on the margin in Canada, you are dreaming if this country is like anything you see in the US. Apples and Oranges. Housing demand, employment is very very strong right now in Canada, you are fighting a losing battle. Anyone can say, "hey at some point rates will go up" no need to have a blog and be a prophet of doom for that. Show people a Canada where you have people with no jobs and weak incomes getting approved, you might have something.
my advice, buy within your means. This rates are too low to miss.
Now you know why I don't have a blog Ben. It breaks my heart to see it coming.
what do you see coming? Keep worrying about whatever you seems to keep you up at night.
Awww you gave it away Appraiser. Too many intentional big cap/small cap typos.
"never seen a bad outcome, not one. "
Either you are being disingenuous or you didn't live in Vancouver in 1982-2. This isn't about "outcomes" in my view, it's about earnings and on that front real estate earnings aren't that good right now.
If you look at the Bank of Canada, they are all googly-eyed on household debt levels and seem to have blown the all-clear when it comes to how debt has been accumulated. I think you'll find the Bank of Canada cares very little for those who have saved, through bank deposits, FI, equity purchases, real estate holdings, beanie babies, or whatever, as long as you don't have too much debt.
landlord - buying and holding the overvalued property on a top of a housing bubble is harder (and very risky) than renting - people often pay more to own than to rent.
On the other hand lets see your "buy within your means" idea - to buy a 500K condo with the 20% down/25 years/3.5% rate - "the Household Income Required is $ 140,387" - good luck finding enough new buyers with an income like this to keep the market going (and even expect the growth).
"never seen a bad outcome, not one"
Of course not. You're long gone with the money! Also, how likely are you to ever admit that people simply paid too much, or that you had any role in it whatsoever?
That's not how it works, in fact, we take the largest risk by buying the land and paying to get it up - we don't make more money, our spreads are the same as 15 years ago. The numbers are just higher. The people honestly making money are the true risk takers who buy these units at pre-construction. Risk/Reward is always true, even in this biz. I am pretty much fixed to a pre-sale amount, then I will dig a hole. Otherwise, we don't. But the money has been made by the guys who get in early and buy from plans, in 2-3 years when its ready by our team, they have made more money then us a group frankly.
Speaking of inflation, it looks to me like the cost of living in Canada is about to go up.
Bank of Canada to get marching orders to look beyond inflation targeting
As I read it, the cost of living is about to go down. Carney is suggesting he may raise interest rates, driving inflation below 2% in order to curb borrowing.
While I see how this can be effective on a national level, there are some international currency implications. You see how volatile the Aussie is relative to the US$ due to their high interest rates.
Great posts Rita and landlord:
Funny how people with no actual real world experience profess to know more than those with decades spent in the trenches.
Ben seems delighted that the stock market is only down 3% year to date and completely glosses over the fact that real estate is up, yet again.
The latest TREB numbers have the real estate market up 10% in price year over year - yet Ben stated last year that the market would go down 10%. That's a 20% miscalculation. A nearly unrecoverable blunder for those who were scared out of the market by such predictions.
Talk about being off the mark.
a nearly unrecoverable blunder for those who were scared out of the market by such predictions
Thanks for that, it'd been too long since we heard the "buy now or be priced out forever" argument.
Why did you delete my comment Ben?
It was moronic. You misrepresented my position entirely. Attack what I said, not what you want to believe I said. If you lie about something I supposedly said, it will be deleted. Pretty simple.
I am sorry that you called the market off by over 20%, that is very clear from anyone reading this blog. Housing in Canada just printed record average highs again today. Don't shoot me for that.
Your post says, rates will eventually go up - what do you think inflation and housing will do, nothing?
How is that misrep of anything?
Timing is always the difficult part. Ask Steve Keen from Australia about predicting when bubbles pop. In the scope of his friendly bet, he lost and had to do some sort of light-hearted public penance/humiliation. However, Keen is correct about Australia's housing bubble.
I wonder, do the 'official' TREB numbers incorporate actual sale prices, or list prices? How would we know? Why aren't the raw data made available? Are the reports audited by a third party?
It may be an interesting time to hear what you have to say, Ben, about the course of rents relative to changes in supply & demand/housing prices. With inflation eventually -- eventually! -- coming to some degree after this deflationary period, how might rents be affected, especially if home ownership rates decline, more people convert their houses into rentals (due to slow sales, wanting to "ride it out," etc.), more young people rent instead of buy etc. What would cause rate increases? What would cause rate decreases? Will there be changes at all, or are potential changes in housing costs mostly attached to home prices? Would landlords be more likely to offer long-term rentals? Stay with short term? So many variables. Would love to see what you have to give us as a short primer. Thanks.
Rents are dictated by the amount of cash one has in his pocket. Roughly speaking.
My suggestion to Rita,landlord, Appraiser is to buy more RE til your hearts content. None of us are interested in how RE has appreciated 10 years ago because that is really insignificant.
For me, I love the flexibility of renting, being mobile and taking job opportunities outside Canada.
Wow, CBC News Now has had a couple of segments on a possible housing correction in Canada. I rarely see this story in mainstream media, but happy they've been covering it. Maybe Ben should be on there to spread the word
Just for the three folks mentioned above, here's a good vid to know what's happening in Canada's economy: http://www.theglobeandmail.com/report-on-business/video/video-g20-and-th...
I was oblivious (like many others) to all this at the start of 2011 then this website opened my eyes. In the video, they talk about the CDN housing market at 3:30. I don't know why people think a housing correction is impossible... I'd say it's a guarantee, just don't know WHEN it's going to happen.
you can still do all that as an owner. Look at the past 100 years petr, its always gone up. I happy to have more folks in the rental market who cannot afford to buy or are waiting. It's a great sweet spot. I can find a renter in less then five days in Toronto at my asking price + THEY pay the 65% monthly charges. Many owners in this market being this strong are able to pass some of the monthly costs down. Some places have meters, so it's great that they care about the usage, otherwise they are very wasteful.
Appraiser?
Renting is my sweet spot
You're wrong. It has not ALWAYS gone up. There have been many periods when it has gone down. Is it higher today than it was 100 years ago? Yes, but that's not the same as "always going up". Most people's finances are always tested by what happens over the near and medium term, and very few people stay in the same house for 100 years. For the record you can say that the stock market has ALWAYS gone up too, but we all know it's had several crashes along the way.
You're using flawed logic to say, well it's gone up at record rates for the last 10 years so the next 10 years it should do the same. It went up due to lowered interest rates, increasing debt loads and loosened mortgage policies. All of those are starting to unwind as we speak. So it should come as no surprise that at very least housing prices will at very least slow down to the rate of inflation (and that's being extremely generous).
You misconstrue the message. The message here is to avoid taking on too much debt to buy a house (especially with the assumption that it will go up in value). The numbers are out there for anyone to see - Canadians are more in debt now than they ever have been ... kind of shoots you anicdotal evidence in the foot. That's sort of like me saying the just about everyone I know has a university education ... so that must mean that most people have a university education. Of course the numbers wouldn't back that up, it's just means many of my friends are people I met through university or work.
I dont know if you have already looked at this one but Canada's debt/person is only exceeded by Iceland, Ireland and Japan. We all know whats happening there.
Here goes the interactive chart
http://www.economist.com/content/global_debt_clock
@Jimmy: That data in that link doesn't seem very accurate. It says Canada's public debt is 1.25T and that of the US is under 9T. Those numbers are way off.
Total Canadian net debt estimates http://www.cfib-fcei.ca/debt-clock-en.html
Have a pension? Forget about it.
Pension - what dark, morbid world are you living in - now you are calling for a CPP default? Get some rest Greg or if you feel so strongly, leave Canada before 2012