The Margin of Safety and Turning Points in House Prices: Great study in the Financial Analysts Journal
JULY 29, 2011
I have to highlight a great paper published in May/June 2011 edition of the Financial Analyst Journal. The paper was authored by Mitsuru Mizuno and Isaac Tabner and is titled "The Margin of Safety and Turning Points in House Prices: Observations from Three Developed Markets".
Hat tip to TC for alerting me to this article.
In the article, the authors essentially examined how closely house prices have historically tracked measures of fundamental value such as income, GDP, rents, and inflation in the US, UK, and Japan. Interestingly, these are the very fundamentals we have examined here with respect to the Canadian market. You can follow the hyperlinks in this article to read all about them.
The authors were also examining how likely it is that when house prices deviate from these fundamentals, that they will revert back to them with time. The data analysis section is a very heavy read, but I would highlight some of the excellent discussion in the introduction and conclusion:
On the importance of housing to the broader economy:
...A procyclical relationship between house prices and bank lending and between house prices and the wider economy has been documented...The reason is that rising house prices increase households’ borrowing capacity, thereby stimulating nonhousing consumption and growth in the economy.... The effect, in turn, stimulates income growth, which enables further house price appreciation. Eventually, it becomes increasingly difficult for production in the nonhousing economy to support the circulation of money in the housing debt cycle. Consequently, expansions in house prices tend to be followed by contractions and deleveraging
This procyclical relationship (ie feedback loop) has been discussed at length on this site. Consider some of these articles:
Arguably, imbalances between housing and the wider economy arise periodically because housing returns exhibit a high degree of autocorrelation. This characteristic enables econometric models to produce appealingly accurate forecasts in the short to medium term, thus fueling the innate human bias known as “representativeness” or “extrapolation.”
This bias may have resulted in the discounting of long-term macroeconomic imbalances by the application of an “it’s different this time” rationale.
The argument that "it's different this time" is about the only 'rebuttal' you're likely to hear when housing bulls are forced to face the reality of the extreme dislocation between house prices and fundamentals. Sorry.....it's never different. The same factors that have worked to drive and limit house price appreciation are still at work today, though they can be muted for a time by low interest rates, an artificial abundance of credit, and a new and temporary willingness on the part of consumers to embrace irrational debt levels.
Neglect of imbalances between housing and the wider economy by key decision makers has contributed to repeated unsustainable expansions followed by rapid contractions and financial crisis. Specifically, in many circles, widespread denial often exists, even by those who have a responsibility to know better, of the fact that the price of an asset can rise only to the extent that sufficient real wealth is available to pay for it.
Increasing the supply of affordable housing is often stated as an objective in political party manifestos. Encouraging house prices to fall, however, at least in nominal terms, is widely regarded as political suicide. Various governments have attempted to resolve this paradox either by promoting policies that make mortgage finance widely available or by trying to engineer a faster rise in disposable income than any concurrent rise in house prices. Success in achieving these objectives has been limited. The cause may be partly the complex procyclical relationship between house prices and the wider economy and partly the fact that many members of the political elite have personal as well as political motivations for promoting rising house prices—motivations that potentially override their rhetoric about affordability.
Yup.....This is where CMHC's mission statement is entirely self-defeating.
The indispensability of housing services means that prices are unlikely to fall to zero relative to aggregate wealth; similarly, financing constraints impose boundaries on the extent to which price rises can outpace long-term increases in aggregate wealth. Temporary evidence of bubbles and crashes occurs either (1) when home purchasers forget or ignore this rule or (2) when prices react in anticipation of shocks to aggregate wealth. Thus, in the long run, house prices are bounded by the supply of wealth in the economy, so if prices temporarily rise faster than GDP, this imbalance will eventually have to be corrected by an acceleration in the rate of GDP growth, a slowing in the rate of house price growth, or both.
Apart from being an elementary principle of economics, the idea that price expansions are limited by available wealth is evident from an examination of the time-series data presented here. These data, when detrended, reveal long-term mean-reverting relationships between house prices and other macroeconomic variables—in particular, GDP per capita.
And with that, let me remind you exactly what the growth in house prices and GDP per capita has looked like in Canada:
And for what it looks like on a provincial basis, check out the following posts:
The empirical data continues to suggest that house prices are in fact bound by the fundamentals so often discussed here. It is not population growth, immigration, lack of land, etc that drive house prices. And it hasn't been the traditional drivers of house price growth that has led to the unprecedented rise in real estate values over the past decade. But deviations from these fundamentals can persist only as long as the source of this deviation is similarly at work: Falling interest rates, abundance of credit, ability/willingness of people to assume massive debt obligations. These are not sustainable. It's not different this time. But don't take my word for it. Heed the wisdom of the authors:
In fact, despite prolonged cyclical pushes away from the mean, we present evidence indicating a powerful deterministic relationship between
detrended house prices and the macroeconomic variables examined. Hence, when prices deviate from the mean, the question is not if they will revert but when.