Dissecting The Golden Horseshoe’s Housing Bubble

Housing market bubbles are a relatively new phenomenon. In the early 20th century, intrinsic property values were dwarfed by the cost of construction. The price of housing was tied inextricably to the cost of building a house, and real returns on houses did not exist. The price of houses decoupled from construction costs in the 1960s, around the same time as the events preceding the Nixon shock. With increasing real wage stagnation moving in lock step, one can speculate that households may have sought to remove exposure to now intangible currency through investment in real estate. The widespread securitization of mortgages around the same time period may also have played a role. Another popular theory is that modern land-use regulations have been hindering upwards supply elasticity. Whatever the cause, real estate bubbles, and subsequent fall out, seem here to stay.

Speculative bubbles may cause otherwise rational people to assume magical thought about the nature of their investments. The Golden Horseshoe’s bubble, with properties averaging double digit increases in valuation each year, is no different. It can help to lay out the commonly trumpeted enthusiasm and comb over its impossibilities.

Myth #1: Foreign investment will yield sustainable growth in global real estate.

As mentioned, real estate never incurred bubble-like speculation until the modern era. Hence, tracking of real estate markets, cash inflows and outflows, and accurate sales data about the nature of foreign investment doesn’t exist. Many governments are seeking to implement this. If the major hypothesis, that China is fueling the real estate bubble and speculation in urban Canada, is true, it is unlikely that this inflow will remain perpetual. China is in the midst of its own serious debt bubble, likely to burst. As noted by Chicago economist Amir Sufi, the long term economic outlook of China has become bleak.

Myth #2: Immigration and population growth are fueling the surge in house prices.

This was a common theme to people arguing for the 80’s Toronto housing bubble, sustained until its crash in 1989. Unfortunately, even with a large inflow of immigrants, Canada’s population growth is slowing. At approximately 1% per annum, the rate is just one third and one half of its peak in the early and mid-20th century, periods devoid of speculative housing booms. From 1955 to 1960, the yearly rate of population increase averaged an approximate 2.6%, yet the value of housing in Toronto flatlined. The population of Toronto from 1951–1961 ballooned 45%, so a large amount of that growth made it to the city. In olden times, the notion of a housing bubble relative to population size increases didn’t make sense. If supply was low, it could readily be inflated by simply building more houses or condominiums. The more demand, the more urban sprawl increased. Troubling is that, as North America’s large aging population of baby boomers becomes deceased, housing supply will inevitably increase. Coupled with the fact that, as of 2015, Canada was building two new houses per new person entering working age, we can see that in a state of collapsing demand we will be left with a massive oversupply of housing. Housing supply, of course, is tremendously inelastic in the downwards direction. One can assume this would create dramatic housing devaluation in the event of a housing downturn. This is what we are observing right now in Alberta.

Myth #3: Canadian households are both financially strong and immune to the greed observed in the United States bubble.

The US housing bubble was sustained by fraudulent mortgages that were bound to default. Young persons and immigrants, thrilled by the prospect of owning a home, took mortgages well above what their income allowed. Verification of income sources faltered. It should make Canadians uneasy that, as of 2015, detected fraud rates were measured on applications as being up to 10%. By 2016, fraud increases were sharply on the rise. The government, wary of the dangers of a housing bubble, has passed numerous regulations in an attempt to deflate. Unfortunately, lenders from both major institutions and shadow banks quickly found novel methods to circumvent them. Greed finds a way. Finally, Canadians are more leveraged than ever before. In fact, a mere 1% increase in interest rates means that 1 million Canadians may find themselves unable to pay their bills. This is bad news as the US moves to increase interest rates, which will surely move discount rates in Canada upwards. With real wages stagnant, it’s hard to see how Canadians will be able to support their extravagant mortgage debt in the face of higher rates.

Myth #4: Speculation doesn’t play a role. Instead, the recent boom represents a ‘new paradigm’ in the value of housing.

It’s clear that speculation plays a significant role in major Canadian urban areas, as evidenced by rapid turnover and high sales volume in properties with the greatest values. As with the 80’s Toronto boom, when the speculators’ music stops we expect to see a precipitous decline in price followed by a major downturn in subsequent growth rates.

Myth #5: Canadian banks are poorly exposed to housing and a downturn would not affect the economy at large.

Housing, financial services relating to housing, and construction represent the major underpinning of the Canadian economy. Some banks appear dangerously leveraged in the housing market, while securities such as covered bonds based around uninsured mortgages are selling like hotcakes. In mid-2016, the Bank of Canada had its financial review. It identified four major risks to the Canadian economy: a housing bust, a sharp increase in interest rates, instability in China and emerging markets, and prolonged weakness in commodities markets. As one can surmise, the first three are all potentially related. If these strike at the same time, Canadians might find themselves in the midst of a perfect storm.

A matter of if, or when?

From 2010 to the present, calls of outrage about housing price increases in the media have been audible. In time, the sentiment has been rising. As with any speculative market, it’s impossible to tell if or when a collapse will occur. As with the US rise in prices from 1998 to 2007, we have witnessed well known pundits calling for imminent collapse within months over the entire time period. Of course, we haven’t observed this. Canadian mortgages are generally on 5-year fixed terms, meaning that, compared to the US collapse with adjustable rates, there may be a long delay before we see weaknesses in the market. The events that will lead to instability — weak emerging markets, higher interest rates, or mass unemployment — have yet to rear their heads. Still, it’s easy to see that the current system is a house of cards situated in an increasingly breezy atmosphere. With most of its regional housing markets appearing to enter decline, Canadians should rest uneasy.