DECEMBER 20, 2011
I had an interesting discussion with well-known Toronto mortgage broker David Larock. It started with the following picture showing the real house price index I had created for Toronto:
This was posted on my twitter feed and subsequently reposted by Globe and Mail finance guru Rob Carrick on his facebook page (a very interesting read, by the way. He recently posted a question about whether it was a good time to buy a house, which generated nearly 100 comments). I had sent this picture to Rob with the following message:
"Anyone familiar with [economist] Robert Shiller's work will know that he is a huge believer that when real house prices rise substantially above normal levels, it's the hallmark of an overvalued market. Coupled with other valuation metrics like price/income ratios and particularly the divergence between prices and rents, it very strongly argues that Toronto has a dangerous overvaluation issue to contend with."
David responded in an email to myself and Rob Carrick. He openly discussed both his concerns for the market and alluded to the tendency we all have for confirmation bias, a point which applies as equally to me as anyone. At any rate, here is his response. Mine follows:
Ben, we’ve never met. I’m a mortgage broker but not a typical one in that a.) I am perfectly prepared to accept that housing prices are inflated, b.) I have fully supported the tightening of high-ratio mortgage insurance guidelines and c.) I am hoping that we see house prices moderate sooner rather than later.
I agree that the last several years of Canadian house price appreciation have been primarily fueled by cheaper mortgage rates and, for a time, looser high-ratio lending guidelines. I also accept that house price appreciation has historically followed the rate of inflation, and if we use an overlay of the two measures, that we clearly have an unsustainable disconnect.
But where I think we may disagree is on the question of whether or not we are actually in a housing “bubble”. I am assuming that both of you think we clearly are, but I am not as yet entirely convinced that this is the case. In the spirit of keeping a good lively debate going I offer these as my main supporting points. (Side note: while some of my points are general, I will reference the Toronto real estate market because it’s the one I know best and because I think it’s tough to make sweeping statements that generalize about all of Canada’s disparate real estate markets):
· While real estate price appreciation has been primarily fuelled by lower interest rates, I have long felt (and written at length) that mortgage rates are likely to stay low for an extended period of time. If that proves true, and if rates rise slowing when they eventually do revert to non-emergency levels, I think affordability will be impacted but not unmanageably so. This effect would trigger more of a soft landing as opposed to a bubble bursting.
· Placing too much emphasis on “record levels of overall debt” can be misleading because a lot of that debt is tied to assets that have also risen in value. To me, the more accurate gauge of whether house prices are sustainable is affordability – and while affordability measures like average TDS and GDS ratios are showing some tightening, their average overall levels are still well below the maximums that the lending community’s well-established and historically based models say are affordable. (Yes, you could argue that sharply higher rates could change that in an instant, but my views are based on the belief that that outcome is highly unlikely).
· Further to that point, and specific to the Toronto real estate market (which I most closely follow), here is the latest Teranet house price index. Many people are surprised to see that since 2005, Toronto house prices have appreciated less than almost any other Canadian city. Rob, when you showed the graphs of individual cities yesterday I kept thinking that a comparative measure would give them more context. Yes they are all sloping upwards, but the slope and magnitude of each curves is different.
· Specific to the Toronto market again, a friend sent me this slide (see attached) prepared recently by BMO’s Robert Kavcic, and I thought it was compelling and somewhat surprising. Bubbles normally undergo an acceleration in price run-up before they pop, and if I read this chart right, the rate of house price appreciation in Toronto has been fairly consistent over the last several years. If this trend holds, this is the best snapshot I have yet seen to support the argument that Toronto is not in the middle of another 1989 (at least so far!)
· Lastly, wwe are nowhere near the stage where everyone thinks that real estate is a can’t miss investment (which I think will be a clear signpost that a pop is coming). In fact, if you polled 10 random people I wouldn’t be surprised if half of them thought house prices would decline in the next five years. If the overall market psyche is balanced, I think bubble-like behaviors are unlikely to create the kind of hysteria that normally precedes a pop.
All that said, I am a mortgage broker who makes a living that is closely tied to the real estate market and I own a Toronto home that is by far my largest personal balance sheet asset, so I certainly have lots of reasons to hope against any sort of coming crash – and maybe I am guilty of confirmation bias in some of my thinking.
Regardless, I enjoy the debate and respect both of your opinions so I thought I’d offer you my perspective on the ever raging debate about the sustainability of today’s house prices (at least in Toronto!)
Certainly a reasoned response. Again I admire Dave's willingness to acknowledge that the gains we've seen in the Toronto real estate market are exceptionally unlikely to persist, a welcome change from the "buy now or be priced out forever" mantra that less honest members of real estate professions often push. Here's my response:
Thanks for dropping me a line. Let me address your points one at a time:
1) Low interest rates tend to accompany the greatest housing corrections for precisely the reason that they reflect a future of lower inflation/income growth and tend to be a central banker last resort to keep a consumer spending-driven economy from stalling. Japan and the US are two extreme examples of this dynamic, and I am not suggesting that this is our future, but the point that low interest rates and housing busts are incompatible has been proven incorrect. While I agree that low rates will be here for quite some time, I think it's indicative of tremendous deflationary pressures and rising prospects of global economic shocks that are as of yet being discounted by the general population. Low rates are an absolute necessity to induce a soft landing at this point, but the second necessity is for consumers to undergo an active and widespread deleveraging where consumer debt and mortgage debt are paid down. How that can be done painlessly in an economy that is driven 65% by consumer spending without adversely affecting labour market and GDP growth is a bit of a mystery to me.
2) I agree that the only thing keeping the market intact at the moment is the mercifully low TDS and CDS ratios. The problem with placing too much faith in these ratios is that it misses the incredibly important role that a credit boom has in boosting the economy and labour market both directly and indirectly, a topic I have delved into at length on my site. The point is that our economic growth, particularly in Ontario, has largely been propelled by the very credit bubble we are discussing. The attached charts should freak us all out....and keep in mind that this only measures the direct impact of credit on key industries and does not account for the rise in retail sales, vehicle sales, etc that have driven to a large degree by consumer credit. Again, this is fabulous for the economy and labour market in the short term, but those TDS and CDS ratios look awfully burdensome when employment and GDP growth reflect the organic strength of the underlying economy absent an unsustainable run-up in credit.
3) I agree that Toronto has not experienced a ridiculous rise in nominal terms, but keep in mind that if you compare the rise in TO house prices to the rise in the Case-Shiller in many US cities prior to the bust that have since experienced significant declines, you'll note that TO has outpaced a number of them. The key metric is not how much house prices are rising in nominal terms, but rather how much they are rising relative to fundamentals like income growth, GDP growth, rents, and inflation. In this sense, the rise in TO house prices is far from benign. Think of it this way: Is a housing market that is rising a lowly 2% a year sustainable if incomes are falling by 1% each year? How long do you have to have that sort of disconnect before you run into a significant overvaluation issue? House prices must ultimately be constrained by aggregate wealth within an economy. When they rise well beyond this, it's unsustainable and dangerous regardless of how prices have changed in nominal terms.
4) I looked at the chart you attached and am totally puzzled. Which housing index is being used? I can't find a single index that shows a 40% total rise in TO house prices between 2000 and now....with the exception of perhaps the NHPI. If that's what's being referenced, we'll have to have a different discussion on why the NHPI is a ridiculous proxy for the real estate market. I think the graph is completely wrong, but the point is taken that house prices have not experienced nearly the same run-up in prices. But despite that, I see offsetting factors that have me far more concerned today: We wont have the luxury of double-digit wage growth and inflation to make debt repayment less burdensome...consumer debt burdens are more than double what they were at the prior peak....the TO economy is far less diversified and far more reliant on finance, insurance, real estate, and construction (the "housing-related industries") than it was then which is yet another concern (i,e, Toronto's economy is increasingly reliant on the housing boom itself...see attached graph).
5) Not sure I agree with you on this one. With 60% of all new condos in the GTA going to "investors" (who apparently relish 3% cap rates and negative cash flows) and with that proportion rising to 80% in the city....and with 25% of all of those being "flippers" with no intention of renting out the unit, I think we can safely say that speculation is rampant in at least one market segment. Beyond that is anyone's guess, but I would point you to an article I wrote that addressed the change in mass psychology as it relates to Canadian real estate. Without a doubt there is a love affair with real estate in Canada. While it's difficult to quantify entirely, these graphs (in the article) speak for themselves.