US Federal Reserve Indicator Shows Canadian Real Estate Is Way Overpriced

US Federal Reserve Indicator Shows Canadian Real Estate Is Way Overpriced

Canadian real estate has another indicator showing prices may have detached from fundamentals. The Federal Reserve Bank of Dallas (a.k.a. the Dallas Fed), publishes a housing index that’s little known outside of the banking world – the Exuberance Indicator. The indicator isn’t often used, because the documentation is highly technical. Today I figured I would break it down into plain English, for all of you Millennials looking to understand the market. This way you’ll have a better read than most people in the real estate industry.

“Exuberance… I Totally Know What That Word Means, But Why Don’t You Explain It”

First off, let’s talk exuberance. Exuberance sounds like a good thing, but bankers say it with caution. They’re always on the lookout for when markets become “overly exuberant.” That’s code for when buyers decide to pay a premium on a commodity, for little other reason than everyone else is doing it.

The term didn’t catch on until then US Federal Reserve Chairman Alan Greenspan said it in 1996. When making a speech, he rhetorically asked “how do we know when irrational exuberance has unduly elevated asset prices?” This was three years before the dot-com bubble. Ever since then, the banking industry doesn’t say “bubble” all that often. However, they frequently say markets are “exuberant.” When it gets really bad, a market has become “over” or “irrationally” exuberant. Way cuter and less panic inducing, right?

Measuring Exuberance

Measuring exuberance in the stock market is pretty straight forward. There’s a lot of ways to do it, but the most simple would be a stock price to earnings. For every dollar a company earns, a buyer pays several more. The thought is, the company will start earning that multiple in five or so years. Sometimes that multiple gets really, really high — to the point where it almost becomes impossible to earn that money in a reasonable amount of time. When buyers pay this premium, they’re buying on exuberance, not realistic expectations.

Inflation adjusted premium paid on S&P 500. Source: Shiller P/E.

Measuring Exuberance In Housing

In the past, it wasn’t all that important to measure exuberance in real estate, because it never had the same consequences as a stock market crash. Sure, it sucks to lose money –  but it never took out an economy. Consequently, not a lot of cutting edge research went into trying to figure this out, until after the US housing bubble. When that blew in 2008, it triggered the Great Recession. Basically, a real estate crash took out the world’s largest economy.

Since then, everyone’s been scrambling to figure out early warning indicators. Efthymios Pavlidis of Lancaster University, and the Dallas Fed teamed up to create a set of Exuberance Indicators.

Pavlidis, The Dallas Fed, and Exuberance Indicators

The exuberance indicators are a set of housing indicators published the the Dallas Fed, and Pavlidis, to measure “explosive dynamics.” Fundamental pricing is established with a few traits like real house prices, price-to-income ratios, and price-to-rent ratios (full working paper here). From there, they look for “explosive episodes” that show prices have deviated from the fundamentals. If they deviate too high, and for too long – markets are vulnerable to correction.

How To Read The Exuberance Indicator

I know, unless you’re in finance that last section was pretty eye-rolly. The most important thing to remember is it shows the detachment of home prices from fundamentals. The indicators include two sets of numbers – home prices and critical values. When home prices go above the critical values, you’re in over exuberant territory. If it stays there for five quarters, the risk for a housing correction becomes very high.

Exuberance For Canadian Real Estate

The Canadian real estate market has been pretty lucky thus far, with only 3 major spikes in exuberance. These phases are in the late 1980s, the 2000s, and today. Let’s break them down.

Source: Efthymios Pavlidis et al., The Federal Reserve Bank of Dallas.

Canadian Real Estate Exuberance In The Late 1980s
In the late 1980s we see a spike, but it doesn’t hit the critical values. That’s because prices didn’t spike across the country. If you’re from Toronto (and you’re old enough), you might remember a crash. If you’re from a city like Vancouver or Calgary, it was barely a blip on your radar. Most losses were realized in the Greater Toronto markets. This is why we see a spike, but it doesn’t rise above the critical threshold.

Canadian Real Estate Exuberance From 2003 to 2008
From 2003 to 2008, Canadian real estate hits above the critical threshold values. Despite the large levels of exuberance, prices “only” fell 7.67%. The reason the drop was relatively soft, is Canada used an “unconventional” central banking policy tool – artificially low interest rates. Interest rates went from over 4% to an all-time low of 0.25% in just over a year. Most people think this just impacts the amount you can borrow, but that’s only a small part of it.

When you set interest rates below the rate of inflation, you devalue money. Afterall, if money is being lent at a lower rate than it loses value through inflation, it’s cheaper to borrow than save. This results in a type of elevated asset inflation that is not reflected in CPI, which I wrote about just a few months ago. Basically, houses didn’t have a fundamental appreciation, so much as the value of the money used to buy them rapidly decayed.

Canadian Real Estate Exuberance Today
That brings us to the current cycle. In the first quarter of 2015, the exuberance indicator goes beyond the critical threshold, and continues to today. Over this period cities like Vancouver saw prices rise 59%. Toronto rose to a peak of 55%, before falling to 43% today. Even with the slight pullback, the country’s whole real estate market remains detached from fundamentals according to these indicators, Pavlidis and the Dallas Fed. This would require a massive surge in income, or a decline in prices to correct.

The Federal Reserve Bank of Dallas let the world know that Canada was at risk using this tweet. Yes, it only has 8 favorites, and was likely seen by just a few Canadians. What? You don’t follow central bank branches on Twitter? You really should.

Preserving real estate prices using further unconventional policies is still an option, but much more dangerous at this point. Interest rates are only 1%, so a 3% cut is probably out of the cards. Even if it was an option, consumer debt levels are so high, increasing them would be a further drag on the economy. Afterall, more money devoted to servicing debt, is less money that can be spent consuming goods and services. Economies need you to consume goods and services to continue to grow. That’s how jobs get created.

None of this means there is a real estate crash in the picture soon. Isolating just this indicator shows us nothing more than national prices are greatly detached from fundamentals. Markets can stay irrational for a very long time, and the value of your cash can be reduced very quickly. However, the price increases we’ve been seeing are not rooted in a fundamental increase of value. This was just confirmed by one of the most influential banks in the world.

Note: Before a well intentioned Canadian questions the quality of data coming from the Dallas Fed, you should probably know they are the go to for housing information. Even white papers produced by the Bank of Canada and the Government of Canada use their housing data. Yes, a foreign government has the best quality data on Canadian real estate.

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Photo via flickr.



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  • Trader Jim 7 years ago

    Sweet Jesus. To put this in context, the Federal Reserve typically understates risk, since that Greenspan speech let to a huge drop in the market. So them saying “at risk” is 10000% it will happen. Hope people smarten up, because the higher it goes, the worse the fall.

    • Mike 7 years ago

      This data is from Q1 2017, since then, the market went down by 5-20% so this information is useless…

      • MH 7 years ago

        Well, don’t use it then, Mr. Financial Genius. For everyone else they posted the update of the same analysis on Oct 17th. Find the differences:

      • Ahmed 7 years ago

        You see that the chart continues higher into 2017 Q2, right? You can always tell when a Realtor makes their “discreet” comment. It’s funny to think that Realtors think the debt problems solved themselves over a summer. The drop we saw was a panic induced drop, not a return to fundamentals. There has to be a long-term down cycle, that shows a “healthy” return to the baseline.

        What’s “useless” is when people like you perpetuate this BS. Unfortunately that weekend at Realtor school didn’t teach you what deleveraging is, and how it works.

        I am a homeowner that’s been very lucky to see the value of my home rise. I don’t think it’s worth double since I bought it just a few years ago however. A 30-50% drop will still give me way more than I paid for it, and allow the country to resume healthy growth. A country is for productivity of people, not the earning power of stationary land.

      • Paul Q 7 years ago

        In Toronto, perhaps. Vancouver is still very exuberant. Terribly so. Frustratingly so. It’s not that I wish to purchase a property, it’s that I don’t want to see my stubborn friends in financial straits.

      • Ham 7 years ago

        You really need to have an objective look at your biases. It seems you suffer from a severe case of confirmation bias.

        Toronto is still seeing huge YoY gain even after the drop earlier this year. If you look at the graph more closely, you will see that even with the small decline, we are still deep into the over critical region today.

        • bluetheimpala 7 years ago

          Wait for Q3 and then Q4 numbers. Huge gain by year end? Gains probably but Huge…hmmmm….

          YoY is too simplistic as we saw big increases in the front end of the year. 40% for H1 and -20% H2 still results in a 20% YoY…but that’s not the story.

          What is more important is the delta has flipped and all that is happening is the gains are being wiped out.

          All you need is to look at August-October.

  • bluetheimpala 7 years ago

    Purely anecdotal (i’m not a researcher but follow real estate)…

    Price are dropping in the GTA a lot quicker than I expected (I really thought we’d see an uptick after the slight downturn). Example: Oakville house (3br, detached, 2pc ensuite, good neighbourhood rank), comparable2 months ago SOLD for $890-920. 9% decrease. They closed around $810 and personally I believe they are lucky and it will be in the mid-$700s come December; the only reason they got $810 is because the other comparables were overpriced and SHOCKER…are not selling.

    Just buzz through Toronto and there are a lot of listings fyi…the pain is coming quicker than most expected. Too much debt(initial or extracted). No one wants to be underwater. Mom and Pop need to retire somehow. A lot of inventory will be on the market over the next 6 months I suspect.

    Demand for Condos in Toronto proper is still strong with units selling over asking, albeit not the 30% over asking we saw at the height. It all depends on the unit and the location (location, location, location!).

    Suburbs are in for some pain with the rural-burbs probably burning to the ground…no one should be paying $700 for a cookie cutter semi in Aurora.

    This could be a very positive event as ‘new money’ will be able to get into the market.

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  • Anne Hamilton 7 years ago

    Would be really interesting to see charts of Vancouver or Toronto in isolation – in the same way that looking at a car crash is interesting.

    • bluetheimpala 7 years ago

      Looking at these two driver/core markets is like looking at the last car in a multi-car pile up with an 18 wheeler. Sure it looks bad for the guy at the back but they got the least of the pain. There is a a family of four burning to death in their dodge grand caravan at the front (should’ve got a Sienna) because they didn’t get out quick enough, a couple CUVs rolled over and bodies everywhere because they had no safety belts/nets in place and then just a pile of gnarled metal with the jaws of life being used to pull out whatever remains there are…money contracts inwards to the source of economic activity, you can figure out the analogy on your own.

      I like a good car crash but if anyone believes Tor or Van will take the brunt of this, they are sorely mistaken. The insanity in TO should’ve been stopped before it permeated outward.

      When you start hearing about London, Waterloo, Cambridge, Sudbury and Lindsey being ‘feeder/bedroom communities’ to Toronto, you know pricing is out of whack.

      Suburbs will burn.

  • Who knows what comes next 7 years ago

    Very interesting read. Comments also seem diverse enough to express everyone’s take on this issue. Bottom line is: who knows what’s going to happen next? We all chip in our two cents, but ultimately, no one has any idea how exactly things will play out.

    I’m obviously not a fan of a market without fundamentals at all – I detest it and blame less discerning buyers for falling prey and contributing to this mess. That being said, I’ve been hearing noise of a crash for so long that I’m starting to think some are just using it to play the market. Though it remains to be seen whether that prediction truly happens. We’re all going to be impacted one way or another, but maybe a correction will create some awareness.

    • Mathmagician 7 years ago

      Everyone is saying they’ve been hearing a crash for so long, but this chart shows that real estate was only overvalued starting in 2015. As the author explained, it’s only after 5 quarters that it becomes likely to correct. That would put us in Q2 of 2016, aka last summer. That’s exactly when Toronto real estate starting to take off.

      If you crashed in the last Toronto market, you didn’t break even until 2007 after inflation, excluding interest. If it was only breaking even, there was no chance that it was overvalued at that point.

  • Justin Thyme 7 years ago

    The Canadian government, read The Bank of Canada. is facing something very dangerous.

    I call it retroactive inflation.

    That is when the price of PAST purchases goes up.

    When goods are bought on credit, the interest is part of the purchase price. When interest on this loan goes up, the price of the goods goes up. AFTER the purchase. Retroactive inflation.

    If the Bank of Canada raises interest rates faster than wages go up, there is nothing to counter this retroactive inflation. No increased wealth to cover PAST purchase price increases.

    With Canadian debt at all-time record levels, this retroactive inflation (which does NOT show up in regular inflation figures) could be far worse than the effects of inflation that effect only present and future prices.

    Debt that is most vulnerable would be line-of-credit loans, which are normally not constrained by long-term rates. Home equity loans would fall into this category. The next most vulnerable would be credit card interest. When credit card interest goes up, it goes up on PAST purchases as well – ALL current debt. The third most vulnerable would be mortgage interest on terms that are due within two years.

    Thus, the Canadian government is in a conundrum – the economy demands interest rates increase, to promote an overall increased rate of return on investments, but doing so causes a double whammy of inflation – higher current and future prices, and higher retroactive prices.

  • mike 7 years ago

    does anyone have data on registered realtors in metro vancouver by year going back 20 years just curious

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  • Peter 7 years ago

    Assuming land has been acquired, it costs $200/sqare foot to build a house with very nice finishes. If you scrimp on finishes you are looking at $150/square foot.

    So do the math on the cookie cutter semi in Aurora for $700k. Assume 1800 square feet, that’s $270k to build. How much is the land value of the semi? $300k? At that very low land cost it would be a $570k cost to build.

    Point is, if prices are out of whack, how low coukd prices possibly go given houses are so expensive to build.

    • Paul 7 years ago

      Peter, the land is the thing that crashes the most. And that’s coming from a land owner.

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