Title: Are we in a housing bubble?

Sub-title: There is evidence that the selling prices of existing homes are getting a little out of line, but nothing conclusive.

 

In recent weeks good news regarding the Canadian economy keeps on coming. Job creation, inflation and interest rates are all at historically attractive levels and the country seems to be slowly crawling out of recession.

 

Canada’s housing sector has also done well. Housing starts were up again last month. Existing home sales also shot up spectacularly. But the real eye opener for housing sector stakeholders was the $337,231 average price of existing homes sold during November, which, according to the Canadian Real Estate Association rose a breath-taking 19 percent compared to the same period last year.

 

In fact if you are a Canadian homeowner, it’s almost as if the financial crisis (which experts say was the worst since the great depression) never occurred. True, within the last two years, house prices in Canada did fall by 13 percent, but then they quickly bounced back up by 21 percent, to above pre-recession levels.

 

The dramatic rise in house prices has caused numerous policy makers ranging from Bank of Canada governor Mark Carney to Finance Minister Jim Flaherty to speculate about whether recent rises have been overdone. In short: are we in a housing bubble?

 

 

Why a bubble would matter

Whether Canada’s housing sector is getting overvalued is more than an academic question. In recent weeks Flaherty has noted on several occasions that he is watching residential real estate prices closely. If he detects what he calls “irrational,” price levels, the Finance Minister has said that he would consider introducing measures to cool things off. These include toughening rules on the amount of down payments that homes buyers need to come up with. Flaherty has also suggested that he may force banks to shorten mortgage lengths, which are current capped at 35 years.

 

By two measures at least, Canada’s housing market does show characteristics of moving out of line with its long-term historical valuations. For example during the past nine years house price increases have averaged around 8.0 percent. That’s far above the rate of inflation which has hovered between 2.0 and 3.0 percent annually during much of that time.

 

Secondly, the average prices of existing homes sold here in Canada (CDN $337,231) seems way out of line with the U.S. $171,900 medium price of homes that changed hands in the U.S. during November.

 

That said Canada has several things gong for it that would justify somewhat higher local real estate prices. Unemployment here is lower than it is south of the border, and Canada’s banks, which are in far better shape than their U.S. counterparts, continue to lend money at a reasonable pace. As a result, Canadians have been spared much of the frenzied foreclosure activity that continues to push U.S. house prices down. Furthermore, Canadian families save been more of their income than U.S. families (5.5 percent compared to 4.5 percent) and are carrying less debt. That means they have more room to weather shocks such as a job loss, mortgage rate increase or a future drop in real estate valuations.

 

Bubble like characteristics?

One big problem with determining whether Canada’s housing market is entering in bubble territory lies in finding a consensus regarding just what the word is supposed to mean. One noted economics glossary doesn’t even provide a definition. Wikipedia, a pretty good barometer of current thinking, defines an economic bubble as “trade in high volumes at prices that are considerably at variance with intrinsic values.” Nowhere in the definition does it state how wide that variance must be.

 

For example when historians talk about bubbles they often refer to the stock market crash of 1929 and the Internet stock implosion earlier in the decade, both of which sent prices down by more than 75.0 percent, and were thus presumably massively overvalued before the plunges. Real estate prices in many regions of the United States, which have fallen by more than 30 percent, also demonstrated many bubble-like elements.

 

However Canada right now shows few signs of any such discrepancies. For example Benjamin Tal, an economist at CIBC World Markets figures that the current average price of a home is roughly 7.0 percent over what would be consistent with current housing market fundamentals such as interest rtes, income growth, rents and demographics.

 

True overpaying 7.0 percent for a home does work out to a lot of extra cash. But home purchases are capital transactions; you don’t make them every week. If you plan to own your home for ten years, a slight overvaluation is unlikely to be a deal-breaker. That is unless you are prepared to sit around in your apartment for much of that time, hoping that prices might come back down again.

 

Peter Diekmeyer is Bankrate.ca’s economics columnist.

 

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