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Tuesday, July 26, 2011

How vulnerable are Canadian housing prices?

Economic Outlook

How vulnerable are Canadian housing prices?

By Benjamin Tal
Digging deeper into housing numbers reveals an adjustment of prices is more likely than a crash
So is it a bubble? Glancing at popular metrics such as the price-to-income ratio or the price-to-rent ratio, it is tempting to conclude that the housing market is already in clear bubble territory and a huge crash is inevitable. Tempting, but probably wrong. When it comes to the Canadian real estate market at this stage of the cycle, any statement based on average numbers can be hugely misleading. The truth is buried in the details — and there the picture is still not pretty, but much less alarming.
House Prices — Beware of the Average
The average house price is still rising by 8.6% on a year-over-year basis. However, take Vancouver out of the picture and this rate slows to 5.6%. Exclude both Vancouver and Toronto and the price increase is only 3.7%.
Zooming in on the high profile Vancouver market, we see that the gap between average and median prices is approaching an all-time high—indicating a highly skewed market. In fact, removing properties that are above the $1 million mark reveals a much more moderate price appreciation and reduces the average sale price by $220,000 to just over $590,000. So what makes Vancouver abnormal is the high end of its property market.

Looking beyond the average price numbers reveals a highly segmented and multi-dimensional market that is probably influenced by different forces. But even a multi-dimensional market can overshoot — and the likelihood is that prices in the Canadian market and its sub-segments are higher than what can be explained by factors such as income growth, rent and household formation.
Given that, the housing market will eventually correct. The only question is what will be the mechanism of that correction. A crash is, of course, the shortest route to equilibrium. But for such a scenario to materialize we need two pre-conditions: 1) a significant and quick rise in interest rates akin to the one that led to the 1991 recession and housing market correction, and/or 2) a high-risk mortgage market that is highly sensitive to any changes in economic realities, including hikes in interest rates.
Pre-conditions for a Crash in the Canadian Context
In Canada, a sharp and brisk tightening cycle is unlikely. The market expects a gradual increase in short-term rates in the coming years. The rising number of mortgage holders that carry a variable rate mortgage will be the first to feel the pain, but if history is any guide, they will return quickly to the comfort of a five-year fixed rate the minute the Bank of Canada starts hiking.
What about the risk profile of the Canadian mortgage space? We zoom in on two sub-segments of the mortgage market that traditionally accounted for most defaults: mortgage holders that carry a debt-service ratio of more than 40% and those with less than 20% equity on their house.
Just over 6% of households have a debt service ratio of more than 40%—a number that has risen by a full percentage point since 2008. Note, however, that this ratio is still well below the ratio seen in 2003, when the effective interest rate on debt was more than a full percentage point higher, and no correction in house prices ensued. All other things being equal, even a 300-basis-point rate hike by the Bank of Canada would take this ratio to only just over 8%.
Moving on to the equity position, roughly 20% of the Canadian residential real estate pool is in properties with less than a 20% equity position. Note that this number has been relatively stable over the past few years, and Vancouver and Toronto lead the way.
Digging deeper and looking at the households with both low equity positions and high debt-service ratios, we found that this fragile segment of the market accounts for only 3.2% of total mortgages. Shock the system with a 300-basis-point rate hike and that number would rise to a still-tempered 4.5%. Historically, even in that group, the default rate has been well below 1%. Thus, short of a huge macro shock, there does not appear to be the risk of large scale forced selling that would typically be the trigger for a precipitous plunge in the national average house price.
As a result, while house prices are likely to adjust as interest rates eventually climb, the national pace of any correction is likely to be gradual. That could still entail a period in which housing underperforms other assets as an investment class, until rising incomes and a tame price trajectory brings the market back to equilibrium.

Benjamin Tal is deputy chief economist at CIBC