Mon, Aug 22, 2011
Submitted by Ben Rabidoux of The Economic Analyst
More insights into mass psychology and Canada’s real estate obsession:
Perhaps the most defining features of an asset bubble is a marked and persistent deviation from the underlying metrics that once determined fundamental value. We know how real estate in Canada stacks up when compared to GDP, personal disposable income (cities and provinces), rents (cities and provinces), and inflation. It’s not pretty. As with any real estate bubble, the overvaluation is most extreme in a handful of cities. The regional data can be seen in the highlighted links. Certainly not all areas of the country have experienced a massive divergence from underlying fundamentals, but it is extensive enough to concern us.
And with the reliance of the Canadian economy on construction and consumer spending to support employment and GDP growth, a housing correction from current levels would almost certainly be associated with a nasty recession complete with anemic economic growth and persistently high unemployment for several years, a topic I addressed yesterday when we looked at some lessons from Texas, and previously when we looked at how housing supports Canadian GDP.
A second key component to the development of any asset bubble is a new and widespread belief about the ‘investment worthiness’ of a particular asset. It’s one of the key ingredients we discussed in an earlier post about the necessary components of an asset bubble. This shift in perception often occurs slowly at first, then builds under its own momentum as increasing participation in the bubble also serves to drive prices higher in a self-fulfilling loop. Yet this change in perception is often very difficult to measure. It’s reported that Robert Shiller became convinced of a US real estate bubble after conducting years of surveys examining people perception of housing and watching respondents’ perception of real estate become wildly bullish in the years leading up to the crash. I’ve explained why overwhelming majorities are contrarian indicators in a previous article.
Unfortunately, such data does not exist in pure form here in Canada. We can gather some insight from reports from CAAMP and RBC, both of which publish survey results, but the necessary historical data is not there from which to compare.
I don’t think I need to argue too hard to convince most people that there is wide-spread bullish sentiment towards real estate and an equally pervasive view of real estate as inherently ‘safe’ and the easiest path to prosperity. However, the goal here is to quantify data in a way that avoids these anecdotes.
The best we can do is to explore data that should have a relatively stable long-term trend, and see if it instead shows a marked deviation from that trend around the same time that the bubble begins, which I would put some time around 2003 when prices began to experience a marked deviation from underlying fundamentals.
Today, Stats Canada released data showing investment in new housing construction, which, as Stats Canada indicates, shows “investment in new housing construction represent(ing) the spending value for individuals, enterprises and governments in the construction of new residential dwellings.” This does not include construction investment for cottages, mobile homes, conversions, and renovations. If we compare this to a stable metric like GDP, we might expect that during boom times, demand for new housing would increase as participation in any bubble would have to be widespread. So what does it show?
Unfortunately, the data only extends back to 1994. Nevertheless, the trend is clear. The implications seem to be that either there are more people per capita building new homes, which seems a fairly sure guess given our rising home ownership rates across all demographics (see below), OR the values of the homes being built is increasing relative to GDP. Neither of these are sustainable, particularly rising values relative to GDP as it implies an erosion in underlying incomes necessary to support house prices and very likely is associated with rising house size and the emergence of housing as a predominant form of conspicuous consumption, a trend I argued would likely reverse course as it has in the US.
We can add this data to several other data sets that also suggest that shifting consumer perceptions and widespread participation seem to be a hallmark of the current real estate market:
Do these findings represent a new and stable norm in the Canadian real estate landscape, or is a mean reversion back to more stable long-term averages more likely? Unless we are willing to embrace the mantra that ‘it’s different this time’, it’s time to start wrestling with the implications…
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