JULY 24, 2011
Revisiting the driver of real estate growth in Canada:
It's no surprise to any reader of this blog that house prices in Canada over the past decade have significantly outpaced the traditional fundamental drivers of rental growth, income growth, GDP growth, and inflation. I don't want to kick a dead horse, but I also don't want new visitors to miss this key point.
On a national basis, the evidence is clear: We are significantly overvalued.
Yes, this has been pulled higher by exceptionally irrational behaviour in BC, but that glosses over the fact that fundamentals are also ugly in many other provinces and cities. We've discussed this at length:
GDP growth: Provinces
We've seen that interest rates have had a significant role in this process, but that interest rates alone cannot explain the pronounced dislocation between house prices and fundamentals (check out the discussion at the end of this article).
Finally, we recently addressed the suggestion, which is gaining increasing media traction, that house prices in Canada are actually not that expensive....the average has been pulled higher by transactions in the $ million range. Interesting suggestion, but once again, the stats have something else to say. When we analyzed the Teranet index, an index that largely controls for the influence of 'average' house prices, we still found that house prices had significantly outpaced fundamentals.
So that leaves us focusing on graphs like this:
Yes, ladies and gentlemen, this is one housing market plumped by abundant credit coupled with willing borrowers...particularly over the past decade. It's the sort of mix that makes for a wild party, but leaves a heck of a hangover.
Indeed, the expansion in mortgage debt relative to GDP has been what has had the strongest relationship with real house price increases over the past decade. So let's take another look at it and see if it can possibly give us some hints on what comes next.
This first graph shows the year-over-year change in real (inflation adjusted) house prices over the past decade, compared to the year-over-year change in mortgage debt as a percentage of GDP. The relationship is clear.
It makes sense. We know from the work of Robert Shiller that house prices over long time horizons tend to pace inflation, meaning that the real return on housing is roughly zero. Other researchers have suggested that rental growth, per capita GDP growth, and income growth are also important variables that should drive house prices. The extent to which each variable is emphasized varies by researcher, but when house prices signifcantly outpace ALL of them, there is cause for concern.
With regards to inflation, it makes sense that real house prices should move higher primarily when mortgage debt as a percentage of GDP expands. House prices should roughly pace inflation. As inflation pushes up the costs of labour, land, and building supplies, the replacement costs rise, and so to do existing houses. But to rise significantly above inflationary pressures requires that people take on greater debt burdens relative to their incomes. And since GDP is just a measure of our collective income, as mortgage debt rises relative to GDP, it's just another way of saying that people are taking on more mortgage debt relative to their income. It's quite difficult to have sustained real house price increases that are not also associated with an underlying expansion in mortgage debt relative to incomes. That has clearly been the case in Canada.
While it appears that house prices lead the change in mortgage debt, I'll suggest that this is likely not the case. Sales are reported to CREA as soon as they happen. Any sale becomes part of the data set as soon as the papers are signed. However, mortgage debt is counted only after the deal closes, which often entails a gap of several months.
That being the case, we might expect that times where mortgage debt as a percentage of GDP is decelerating on a year-over-year basis, and especially when it is negative, it will exert downward price pressure on real house prices. On the flip side, as mortgage debt relative to GDP is accelerating and strongly positive on a year-over-year basis, we might expect house prices to experience upwards price pressure. Has this been the case? Generally it has.
Historically, the year-over-year change in mortgage debt as a percentage of GDP has been a fairly good, though not perfect, indicator of short term price movements in the Canadian real estate market. I believe this will be especially true going forward. The reality is that house prices cannot be sustained at current levels without a stable supply of new buyers with ample new credit able and willing to take the plunge. With ownership rates already stretched, and with prices at such high levels relative to incomes, it overwhelmingly argues that the deluge of first time buyers who have taken the plunge in the past few years, armed with ample mortgage debt courtesy of CMHC's accommodative policies, will NOT be around in sufficient numbers and have access to sufficient credit to keep the party going.
Of note, the year-over-year change in mortgage debt as a percentage of GDP has been exceptionally weak over the past two quarters...the weakest pace of expansion since 2000. With non-mortgage consumer credit already cooling rapidly, one can't help but wonder if the great Canadian consumer is ready to tap out. If so, this metric may give us an early warning. We'll revisit this one periodically.