Sales and prices may be soaring, but is it a housing bubble?

Canada’s housing market is strong. Sales are up and so are prices. But is it a housing bubble?

A bubble is an appreciation in an asset at prices that differ considerably from the intrinsic value of that asset. Further, bubbles tend to be driven in large part from speculation – that is, buying or selling an asset with the sole aim of making a quick profit, frankly, a scenario that is just not very prevalent in Canada.

Despite this, prices are moving up. According to the Canadian Real Estate Association, the average price of a residence in Canada in January 2010 was $328,537, representing an increase of 19.6% in one year. Sales were up 58% from January 2009, when home sales volumes, that is, the number of houses sold, had slumped to their lowest level in a decade.

However, this increase, despite being large, is coming off a very depressed base.

How and why does this happen – what is driving the surge in the housing market? Bubbles of any kind are typically predicated on false assumptions – in this case, the assumption that the housing market can do nothing but continue to appreciate in value, while ignoring the fact there is cyclicality in any asset class, including the housing sector. This means that over time and dependent on the economic backdrop, prices will both rise and fall.

This was a situation exacerbated in the U.S. by loose lending standards.

The market in Canada does present some concerns–particularly in light of the devastating U.S. housing bubble–and–burst scenario during the recent economic crisis that sent house prices down by 30% from their peak. Foreclosures surged as overstretched homeowners failed to meet mortgage payments. Parts of Europe, notably Ireland and Spain, also endured house price crashes.

Meanwhile, the Canadian housing market emerged relatively unscathed by the economic crisis, with prices falling only 10% before staging a surprisingly strong recovery.

A tale of two housing markets: Canada and the U.S.

The real issue may be why the situation in Canada so different than that in the U.S.?

The housing boom in the U.S. was driven in large part by aggressive and unregulated lending practices which led to rampant borrowing and speculating.

In fact, the availability of cheap credit, combined with loose lending standards and misguided or absent policies all collided to create a situation that allowed these high risk mortgages to be packaged up and sold as complicated securities to companies who largely did not understand the underlying risks and which led to the rippling and global impact of the crisis. For example, the NINJA loans in the U.S. (that is, No Income, No Job or Assets needed), that allowed individuals to purchase homes who did not have the means to do so.

This absence of policy created the conditions that ultimately led to the crash in the U.S. housing market, and on closer examination it is precisely the presence of those types of policies in Canada that have led to the consensus there is no bubble here at home.

In a recent Wall Street Journal editorial Why Canada Avoided a Mortgage Meltdown, scholar Alex J. Pollock points out that mortgage lending is much more conservative and creditor friendly in Canada than in the U.S.

“Canadian mortgage lenders have full recourse to the mortgage borrower’s other assets and income, in addition to having a house as collateral. This means there is little incentive for borrowers to walk away from their mortgage.”

He also points to Canada as having “high home ownership rates but fewer housing subsidies.” In fact, despite mortgage deductibility and other incentives in the U.S., housing ownership rates are roughly the same in both the U.S. and Canada at between 67% and 68%. But because of the more conservative nature of Canadian lending practices, Canadian and U.S. households do not have the same level of debt.

Canada’s prudent approach protects the housing market

In fact, Canada’s financial and regulatory system, which earned a world leading reputation during the global financial crisis has specifically helped protect our housing market through:

A more conservative approach. Canadian mortgage lending practices are more conservative than in the U.S. As a result, loan defaults are far fewer. Our banks have not engaged in widespread subprime lending (mortgages offered at interest rates above prime to customers with below-average credit ratings) that sparked the U.S. housing market and financial crisis.

More prudent regulation. Our financial system is more prudently regulated. For example, mortgage lenders are not allowed to offer mortgages with loan to value ratios above 80% unless the mortgages are insured.

Insurance against defaults. Canada’s national mortgage insurer, Canada Mortgage and Housing Corp. (CMHC) offers mortgage loan insurance and protects lending institutions from defaults. Further, CMHC sets minimum standards for the mortgages it insures.

No tax incentives for housing debt. Canada does not provide income tax breaks for mortgages. Mortgage interest deductibility in the U.S. has been cited as a factor in the housing crisis there. The more debt homeowners take on the larger the tax break.

Continued vigilance: The federal government has recently taken new steps to help ensure that buyers of Canadian homes don’t find themselves in a U.S. – style jam. In February Ottawa announced changes to mortgage lending rules:

• All borrowers must meet qualification criteria for a five–year fixed mortgage, even if they are seeking shorter–term lower–rate financing.
• Purchases of non–owner occupied properties will require a minimum 20% down payment.
• A reduction to 90% from 95% of the value of homes that Canadians can withdraw when refinancing.

These changes, effective April 19, are intended to prevent homebuyers from going too deeply into debt and to curb poorly financed speculation.

Further, over the longer term Canadian prices haven’t risen nearly as much as those in other parts of the world. Here’s how the Organisation for Economic Co-operation and Development sees Canada fitting in. (From a January 2010 report, A Bird’s Eye View of OECD Housing Markets).

“Between 1995 and their latest cyclical peak…real house prices had nearly tripled in Ireland, had been multiplied by about two and a half in the United Kingdom and had approximately doubled in nine other countries in the sample, including many European countries, as well as Australia and New Zealand. Price increases had been smaller, but still considerable in Canada, Italy and the United States.”

And here’s another plus. Canada didn’t suffer from negative economic forces to the same degree as economies where house prices were hit hardest. A more severe recession and tepid recoveries elsewhere have contributed greater housing woes outside Canada.

So now much of the focus is on the remarkable recovery in Canada’s housing sector and what will prevent it from turning into a bubble.

Supply and demand are key

The answer may lie in plain old supply and demand.

Our hot housing market has been fuelled in part by immigration and population growth but primarily by low mortgage rates, with buyers rushing to purchase before rates start rising. Further, demand has been supported by low apartment vacancy, moving many of these individuals to seek out housing. As a result, demand outpaces supply in many parts of the country.

When supply and demand are better balanced, prices should moderate. Rising interest rates – widely expected to begin after mid–2010 – will also temper demand. More housing is also coming on stream, with new residential construction recently at its highest levels since late 2008.

When rates rise, homeowners will face increased mortgage costs. But rate hikes should be moderate. And as the economic recovery progresses, incomes should rise, helping households cover rising financing expenses.

Even the Bank of Canada believes supply and demand are behind price increases. A January speech made on behalf of central bank Deputy Governor Timothy Lane said:

“In the Bank of Canada’s view, it is premature to talk about a bubble in Canadian housing markets. Recent house price increases do not appear to be out of line with the underlying supply/demand fundamentals.”

The central bank noted it is likely “that a significant part of the surge in housing sector activity is associated with temporary factors – notably the historically low borrowing costs, as well as pent-up and pulled forward demand – which cannot continue to drive increases in house prices and activity.”

It’s not a perfect picture. And although risks remain – particularly if housing prices don’t slow, for now, it’s no bubble.