Bears have been calling a real estate bubble in Canada for 20 years, and we’re totally wrong. That’s a comment I keep receiving, about an alleged call I made 20 years ago. First of all, I don’t think I spoke to you 20 years ago about housing. Second, if you took advice from a high school kid on home prices, that’s on you. This did get me thinking though — why do so many people think this call is two decades old?
Taking a quick dive into who called the Canadian real estate bubble a decade ago, it wasn’t high school kids. These were some of Canada’s most notable people in finance. It was also supported by the country’s central bank, warning of massive overvaluation. How did they get it so wrong?
Well, they didn’t. It turns out they were correct in the assumptions about real estate prices. Many markets did meet the technical definition of a bubble by several measures. What changed is the Canadian perspective on affordability. By changing the way Canadians viewed real estate prices, they supported the 2008 bubble. They nurtured it, and grew a regional issue into the massive national issue it is today.
What Is A Property Bubble?
There’s a few ways to define a property bubble, but almost all are ways of identifying exuberant behavior. This is when buyers are making emotional decisions, not supported by fundamentals. If this happens, there’s a rapid acceleration of price growth not supported by wages. Buyers aren’t buying because the economy is great, and they hope to capitalize on rising rents.
They’re buying because of the sole expectation someone else will pay more. In finance, this is called Greater Fool theory. Buyers hope the next person will pay more, with little reason other than they’re not as savvy as you. Often the seller bought it from someone who thought the same. Just because they are lower on the chain doesn’t mean they can’t make money. In fact, it’s often lucrative for everyone except the greatest fool. You don’t have to be the smartest, you just need to be smarter than the last person.
Measuring Exuberant Real Estate Markets
The US Federal Reserve developed an exuberance model that identifies these periods. When buyers have become exuberant, the index produces a value above the threshold. If the threshold is breached for 5 quarters, the whole market is exuberant. An exuberant market is better known as a bubble. The Fed believes these require a correction, but when the correction occurs, is still a mystery.
Canadian Real Estate Exuberance IndexThe US Federal Reserve Exuberance Index for Canada, and critical value threshold. A market that is is above the threshold for 5 consecutive quarters is considered to be exuberant. Source: US Federal Reserve, Better Dwelling.
The above Fed model only identifies two national real estate bubbles for Canada. The first is around the Great Recession, often seen as a “wrong” call. While this period was frothy, it wasn’t until ~2013 that people said prices were overvalued. The second period is during the current round of exuberance, which began in 2016. Let’s unpack what happened, and why both of these periods are correct.
The Canadian Property Bubble Around The Great Recession
The Great Recession saw home prices around the world rise at a very rapid rate due to credit expansion. Canada obviously wasn’t an exception. As Carolyn Wilkins, yes that one, pointed out in 2004 — real estate bubbles reflect excessively easy domestic credit conditions. Those conditions are “largely determined in global markets.”
In other words, since global markets price debt, the credit slack is out of local control for the most part. Excess credit allows people to absorb home prices much more easily. This often means home prices can become inefficient due to global credit markets. In many cases, bubbles have nothing to do with local conditions. They can be a reflection of global credit conditions.
Those who warned about home prices from 2000 to 2015 were notable people in Canadian finance. There were bubble warnings everywhere, cranking up to an 11 after the Great Recession. In 2013, Mark Carney warned markets “are already severely unaffordable.” He went on to say, Vancouver real estate prices were 11x local incomes, partly due to “Asian” investors.
In 2013, the current BoC governor was the number two at the central bank. He had warned that year, affordability had stretched far beyond normal. Canada devoted way too much GDP to real estate, he argued. Less than a decade later, he argues the country needs the price growth.
In 2013, the most hated shark, Kevin O’Leary called Canadian housing a bubble. He even went on to warn people against buying, saying “… I would not buy a home today… when rates go back up, which they will over the years, you’re going to lose 20… 30% of the value of that house.” Technically he’s still not wrong, since rates didn’t really rise. Canada adopted a semi-permanent, recession level of credit easing for over a decade.
The next year, the Bank of Canada seemed to have backed that statement. In their 2014 report, they say housing is “overvalued by more than 10 per cent since at least 2007.” They estimate at the time of publication, home prices may be overvalued by as much as 30%, but saw a soft landing. Using low rates, they would slowly bring home prices down, and restore affordability.
Banks were in on it too. In a now deleted report, BMO had forecast Toronto and Vancouver real estate prices would fall. Toronto prices “are at risk of declining moderately when interest rates normalize.” In Vancouver, “expect detached house prices to decline moderately in the medium term.” Obviously, these are a lot of smart people, plus Kevin O’Leary. They all couldn’t possibly have imagined the whole situation. Let’s see what they were talking about.
Real Toronto Real Estate Prices Hadn’t Recovered From 1989
First, let’s start with everyone’s favorite city — Toronto. Before the Great Recession, the previous peak for the average sale price was $273,698 in 1989. In 2013, the average sale price reached $522,958, just almost double after 24 years of recovery. Big gains, but not exactly the frothy gains people expect today. Right now I hear people say expect prices to double every 6 years.
Note: That would make your million dollar condo worth $1 billion by the end of this century. Why start the next Amazon, when you can just leave your kids a few condos?
On an inflation adjusted basis, things look a little more interesting for prices. The 1989 peak in 2013 dollars, shows prices were still 12.47% below that year. The average price growth between 2009 and 2013 was 6.65%, far in excess of wages. It would appear the acceleration was enough to bring up concerns. Shortly afterwards, this period would be declared a “generational buying opportunity.”
The sudden shift has to do with the official narrative on affordability changing. Traditionally, home prices growing faster than income has always been an issue. This is due to the fact it means the rest of the economy is shrinking. If you’re spending money on housing, you aren’t spending it elsewhere. The general economy takes a hit.
Around 2015, Canadians did something the rest of the world would find insane. Prices no longer mattered, but the payments were the determining factor. In 2008, less than 40% of people paid more than 20% of their disposable income on shelter. Today, anything where the payments are less than 35% of income is affordable. Also, only those with a minimum of upper middle incomes should be able to buy. If you can pay $50 for a candy bar, does that make $50 an affordable candy bar? Not exactly, but that’s the logic adopted.
Canada And The US Were Equally Dependent On Real Estate
Sadly, changing the way people think about affordability doesn’t change inefficiencies. In 2006, the US had devoted a peak 6.7% of residential real estate investment as a percent of GDP. It was considered absurd. Canada was a much more reserved, *checks notes*, just a little lower at 6.6% of GDP. The US crashed, but Canada kept extending the inefficiency.
Canadian Residential Investment % of GDPCanada’s residential investment, expressed as a percent of GDP. Source: Stat Can, Better Dwelling.
By 2013, Canada had breached the US peak, and was still right up there as the economy stabilized. The country’s residential investment reached 6.8% of GDP. That kept pushing until the most recent number, which was 9.27% of GDP in Q4 2020. Canada is now more than 30% more dependent on real estate than the US at the peak of their bubble. As you might have guessed, this can lead to a lot of market inefficiencies. We’ll circle back to this point.
Canadian Real Estate’s 2016 Bubble Phase
Fast forward to 2016, and people have begun saying real estate prices are in a bubble… again? Some, like portfolio manager Hilliard Macbeth, argue prices have never been corrected. The inefficiencies have just extended, and are flowing into new areas. Essentially, it’s the same bubble, it’s just turning from a regional one into a national bubble.
The behavior of Toronto real estate buyers is really something worth noting. Today we’re no longer discussing multiples of household incomes. That ship sailed. Now we’re looking at the widespread adoption of speculative behavior. In 2018, almost half of Toronto condo investors took possession of negative cap units.
Toronto Real Estate and The Rise of Speculords
Being a landlord is fairly straightforward, at a high level. You buy a place, and rent it to a tenant for more than your payments. After deducting costs, the profit is your yield. It’s almost like a dividend, and maintaining yields is the objective of the biz. OG professional landlords, especially in commercial, pour over spreadsheets for yield. Not negative cap landlords.
As the name implies, these buyers are willing to accept negative cap rates. Every month, since rent is set at market, these speculords will top up their tenant’s rent. They paid so much for the property, the people renting it are essentially paid to use it. The speculord hopes the value of the property rises faster than their costs. After all, some sucker is going to want to pay more, as soon as the bank gives them enough debt. This is the definition of greater fool theory in action.
When policy is used to backstop the market, no inefficiencies are resolved. Instead, they get worse and spill out into other areas of the market. In 2020, when the pandemic hit, Toronto and Vancouver had become so unaffordable, not even a crash could fix it. That’s when home prices around the country began absorbing excess credit slack.
The pandemic’s acceleration of work-from-home policies allowed people to move further out. Already easy credit policy made easier, allowed home buyers to absorb rising prices. Now the fastest rising home prices are in rural areas, and small towns. The justification? It’s cheaper than Toronto, so the correct price is whatever you can pay.
Canadian Real Estate 12-Month Price ChangeThe 12-month change in price for a benchmark home in Canadian dollars in February 2021. Source: CREA, Better Dwelling.
Both periods are technically bubbles, so both camps are right. The argument is more so if this is a different bubble, or the same bubble as MacBeth argues. In the period around the Great Recession, home prices increased mostly due to credit. This isn’t debated, but acknowledged by the country’s central bank.
Rather than letting a few real estate markets correct, they hid the inefficiency. They shifted the narrative, and all of a sudden a lot of smart people were wrong. It no longer mattered how much home prices were, as long as people paid less than 35% of income for the debt. An odd take, considering most of the country is paid a similar level. Even more odd when you realize Toronto wages are lower than many regions, but home prices are higher.
By ignoring, and supporting, the inefficiencies, the issue has spread into more regions. A region with falling wages? Those people will be replaced with higher wage migrants, so prices should rise now. Negative population growth? That’s just temporary, and people will move to St. John’s eventually — higher prices. Young adults can’t afford the region? They’ll want to commute 3 hours to serve early bird dinners to homeowners, so prices should rise.
Everyone in the country now thinks everyone else is the greater fool, waiting to pay more. Some have even convinced themselves immigrants will keep coming to drive up prices. Basically believing in greater fool visas. In 2013, people were warning about a real estate bubble. Today, Canada is looking at a cultural real estate bubble, where everyone in the world just wants to buy its real estate.
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