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.