Bubble In Canadian Housing Market?

Speculative Bubbles in Housing Markets
The phenomenon of a rapid and unsustainable rise in the price of real properties locally or globally, that is incoherent with other economic indicators such as real income level and other affordability indicators, following a substantial drop in their values are referred to as property or housing bubble.
The purpose of this paper is to study the general phenomenon of housing bubble by looking at its economic preconditions as well as economic impacts. Further we will use some economic indicators of the past property and housing bubbles in an attempt to possibly identifying their occurrences in the future housing markets.
Whether or not real estate bubbles can be identified or should be prevented is a subject of debate between different schools of economic thoughts around the world. However the global economic recession of 2007-2010 is believed to be greatly linked to the burst of housing bubble mainly in the United States. Some argue that economic indicators can be used in identifying bubbles while they are being inflated, and central banks should take steps to prevent their course. Others argue that it is a natural course of markets which eventually leads to a redistribution of wealth and central banks role should be only to clean up their aftermath.
In this paper we will go through relevant topics in the following order:
• Housing market indicators
• Macroeconomic and market Preconditions
• Past &present real estate bubbles
• Analysis of the current housing market data in Canada
• Assessments and conclusion
Housing Market indicators
In identifying a bubble, one can make an educated guess using relevant financial ratios as well as observe economic indicators to compare current market trends with those in previous bubble occurrences. These financial ratios and indicators mainly compare valuation and debt level in different periods to determine the surge in housing prices with respect to the average income (affordability) and to determining people’s level of debt (leverage) as well as lending institution’s exposure as a result of providing mortgages to home buyers.
Valuation & Debt Measures
First proxy indicator of a bubble is when house prices grow faster than the incomes or if prices are running ahead of incomes. This condition can be caused either by inability of housing supply to match the rise in demand or, that with respect to rise in income, the extent that demand for housing rises is too high.
Several measures are used in testing the valuation and debt component of real estates, of which the most common are the followings:
1. Price to income ratio
2. Price to rent ratio
3. Housing debt to income ratio
4. Housing debt to equity ratio


Price to Income Ratio
Price to income ratio is a measure of affordability which is obtained by dividing median incomes by median house prices. In other words it is the ratio of median house prices to median household disposable income. In addition of it being an overall affordability measure, it is used by lending institutions to determine the degree of affordability of loans to mortgage applicants. In Toronto area based on the data released by real estate boards this ratio on average was 5.1 in 2010 and 5.5 in 2011. This chart shows how price to income ratio for existing properties changed in Canada between 1988 and 2010.

Price to Rent Ratio
Price to rent ratio is the average cost of ownership divided by the received rent income or estimated rent that would be paid if renting. It measures how much the buyer is paying for each dollar of received rent income. Given that rent is similar to corporate and personal incomes, in additions to government rent control provisions it is bound by supply and demand mechanisms and is unlikely to be unsustainable, a rapid rise in house price combined with flat renting market can be an indication of a bubble. This chart shows an overall raise in price to rent ratio in Canada from 1980 to 2008.

Housing debt to income ratio
Housing debt to income ratio or debt-service ratio is the ratio of mortgage payments to after tax or disposable income. When this ratio gets too high, households become increasingly dependent leveraging on their growing house prices. Using this ratio, it is also possible to determine total cost of home ownership when including utilities and property taxes. This chart shows in overall how Canadian household’s savings been fluctuating from 1929 to 2009.

Housing Debt to Equity Ratio
Housing debt to equity ratio or loan to value ratio is an expression of ratio of the mortgage debt to the value of the underlying property. In other words this ratio is also referred as financial leverage. A debt to equity ratio of 1 indicates 100% financing and ratios of higher than 1 means a mortgage amount greater than the value of the underlying property. Following a bubble burst and properties losing their value, given that mortgage obligations are intact, debt to equity ratios higher than 1 are often observable.
Macroeconomic and Market Preconditions
Although Housing market dynamics similar to other commodities react to supply and demand forces, it also has some unique characteristics. Given that houses are fixed in location, their markets are shaped by local housing markets and an aggregate study could be less reflective of the reality in smaller local markets. Based on a simple supply and demand model and under perfect market conditions, a rise in demand would have to signal to the supply side to supply more housing stocks. But, given that houses relatively take a long time to build, we consider the short run supply of housing stocks to be fixed. Therefore a small shift in the demand for housing, depending on the elasticity of demand, can raise the housing prices substantially.
In reality supply and demand for housing are affected in addition to the market forces, also by macroeconomic conditions as well as government policies. Taking to consideration that house purchases are mainly financed by financial intermediaries, and given the household’s budget constraint, a change in lending rates by the central bank can substantially affect both demand and medium and long term supply of housing.
In addition to interest rates, overall condition of the stock markets and economy can also be an important factor in the demand for the housing. Purchasing a house above all is an investment decision. If there are more opportunities for capital gain in other sectors, it is more likely that the flow of investment be directed to a different direction than housing. On the other hand if other markets remain stagnant, and there is a trend in rise in house prices, it is more likely that the flow of investment be directed towards housing and cause a boom in the housing sector.
Apart from signs and indicators for housing bubbles, there are different economic schools of thoughts who explain bubble phenomenon in a different ways. Keynesians argue that housing market like any other market is derived by a psychology of fear and expectations. When prices are rising and people experience capital gains, they become overconfident and inject more capital into the housing market in expectation of higher capital gain. As people increase their demand, they also drive the prices higher and at the same time growing their risk exposure. Paul Krugman, who is an economics professor at Princeton University, also a writer for the New York Times, makes a parallel between housing bubbles in the US with previous market meltdowns:
In parts of the country there’s a speculative fever among people who
shouldn’t be speculators that seem all too familiar from past bubbles—the
shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints
showing CNBC, not ESPN, on the TV sets in the 1990s. (New York Times, 5.27.05)
Further, similar to stock market bubble of 1990’s Krugman identifies the expectation of capital gain as the main reason for housing bubbles:
So when people become willing to spend more on houses, say because of a
fall in mortgage rates, some houses get built, but the prices of existing
houses also go up. And if people think prices will continue to rise, they
become willing to spend even more, driving prices still higher, and so
on…prices will keep rising rapidly, generating big capital gains. That’s
pretty much the definition of a bubble.(New York Times, 8.8.05)
On the other hand, Austrian economic school of thoughts takes the supply side view and blames government’s monetary policy as a cause for oversupply in the housing market. It argues that the application of monetary policy and lowering of interest rates by government and central banks that are intended to boost the economy and increase the capital expenditure in order to stimulate consumption and output, makes it too easy for households to enter the housing market. Based on this theory, as a result of monetary policy, commercial banks due to their increased reserves are able to provide more mortgages on easier terms. As more funds are directed towards the housing market, too many houses are built which results in too many recourses being wasted in building unneeded buildings. In this school of thought housing bubbles are seen as an example of credit bubble, since property owners generally use borrowed money to purchase property. Bursting housing bubble in addition to loss of property value causes unemployment in the construction sector as well as other related service industries. This chart illustrates how employment in construction sector has been affected during past recessions in U.S.

The post Keynesian theory on the other hand takes the demand side view and argues that with the rise of real estate prices, property owners feel richer and are more likely to borrow against their homes for consumption or to speculate further in the property market with borrowed money. After the bubble bursts, property values declines while their level of debt remains intact. The aggregate effect of the inability of borrowers to meet their obligations creates pressure on lending institution and the whole economy. Therefore one indication of a housing bubble being created is a surge in household’s liabilities or debt to income ratio. Below is an illustration of the trend of debt level in U.S.

Past & Present Real Estate Bubbles
According to an IMF report published in January 0f 2002 on 1990’s Asian housing crisis, which sent shock waves to financial markets around the world, liberalization of financial institutions and ease of flow of credit has been identified as main causes for creation of financial cycles which in turn have contributed to inflation in housing markets leading up to bubble creations:


The 7th Annual Demographia International Housing Affordability Survey which was published in 2011, has rated housing affordability in major metropolitan areas in Australia, Canada, Ireland, New Zealand, United Kingdom, United States and China (Hong Kong). Based on affordability measures, it is believed that at the present time there are perhaps several housing bubbles in the making. By a quick review of the data provided in this bulletin, it is not difficult to observe a decline in affordability indices as a result of disproportional and constant hike in real estate prices in some of these metropolitan areas. This report places Vancouver BC only after Hong Kong as the most unaffordable cities and also Toronto and Montreal among the severely unaffordable markets.


Analysis of the current housing market data in Canada
By a brief analysis of the available data in the Canadian housing market, especially in the larger metropolitan areas, base on price indices, affordability measures as well as a broader look at macroeconomic conditions, it is possible to come to the following conclusions:
o Prices of housing stocks have been rising disproportionate to the overall inflation rates.
o Price to income ratio of housing stock has been on the rise since 2001, except for a short decline from 2008 to2009, it has been increasing again since 2009.
o Price to rent ratio in major Canadian metropolitan cities with the exception of the period from 2008 to 2009, have steadily been rising since 2001 to the present time and now stand at a record level of close to 5.5.
o A report recently released in the media revealed that the level of household debt in Canada which has been rising since 1999 now stands at its record level. According to this report, debt to income ratio in Canada on average has now risen to close to150% in 2011.

o Housing debt to equity ratio in Canada have risen mainly due to favorable interest rates and the steady rise of property prices:
"There is understandable concern about the rapid rise in borrowing, and the buoyant housing market in particular, that has pushed Canadian household debt leverage to new records," said Warren Jestin, Chief Economist, Scotiabank

o Bank of Canada in risk to the outlook section of its 2011 Monetary Policy Report emphasizes on the risk of consumer’s over spending and that a reduction in real estate prices can negatively affect the Canadian economic growth:

“With household expenditures in Canada significantly above their historical
average as a share of GDP, growth in household spending might
decelerate more rapidly than is currently anticipated. Relatedly, if there
were a sudden weakening in the Canadian housing sector, it could have
sizable spillover effects on other areas of the economy, such as consumption,
given the high debt loads of some Canadians.”
Assessments and conclusion
According to CHMC 2010 reports, one fifth of the 2009 total Canadian GDP was comprised of housing sector and its related trades. Bank of Canada through its monetary policy has been effectively involved in Canadian economy for most of the recent history. An expansionary monetary policy by the Bank of Canada intended to boost the economy and to cap unemployment makes plenty of credit available at low cost. Availability of low cost credit encourages potential home buyers to enter the market. This increases the demand for housing which will push the prices up. In addition to a boost in housing market it also creates a boost in construction jobs and employment in related industries. Low interest rates combined with expectations for capital gain in the absence of alternative profitable investment options draw more households as well as speculators in to the housing market and drive the housing prices up irrationally. Low interest rates also encourage existing home owners to borrow against their home equities to spend on consumption goods or to further invest in lucrative housing markets. While interest rates are kept low, we may see slight economic growth and a decline in unemployment rates due to a rallying housing sector. Incomparable capital gain opportunities combined with preferable tax treatment by the government on capital gain on the real estate attract further recourses from less profitable industries and causes further unemployment and loss of productivity as well as further inflation (state of inflated housing bubble). At this stage a slight increase in interest rates or some bad market news can potentially cool the housing market off and bring the prices down or so called burst the housing bubble. As a result, high leveraged households faced with a negative debt to equity ratio are unable or unwilling to meet their obligations. In addition to a rapid rise in unemployment in housing related service industries, the aggregate effect of mortgage defaults creates further problems for the banks and can lead to an overall economic slowdown. A condition when due to reduction in output, inflation and unemployment occur at the same time.
Whether or not a housing bubble is forming in major Canada’s metropolitan areas is perhaps subject to a more thorough investigation. One thing however is clear that all primary preconditions for a housing bubble are currently present in Canadian housing markets. This, further suggests that if timely and proper measures are not taken by the Bank of Canada, it could burst in a foreseeable future.





List of sources
Bank of Canada Monetary Policy Report January 2011
IMF working paper, Lending Booms, housing bubbles and Asian crisis January 2002C
New York Times 5.27.2005, 8.8.2005
http://en.wikipedia.org/wiki/Economic_bubble
http://www.cmhc-schl.gc.ca
http://canadabubble.com/charts/
http://www.demographia.com/
http://www.scotiacapital.com/
http://www.statcan.gc.ca/
http://www.jeffreyteam.com/blog