CANADIAN HOUSING: FIRST IN, FIRST OUT, BUT WHERE TO FROM HERE?
Existing home sales and prices, as provided by the Canadian Real Estate Association (CREA), went through a sharp downturn last year, falling by 40% and 12% respectively from their peak of late 2007. Just as quickly and sharply, a phenomenal rebound kicked off early this year and was still going strong early in the fourth quarter. From their trough sales had surged by 74% as of October, while the average price was 20% higher. In this extremely sharp two-year cycle, the housing market has undeniably held up to its ‘fi rst-in, fi rst out’ (FIFO) historical billing. The downturn in existing home sales and prices (Q1/2008) preceded the start of the technical recession (dated Q4/2008) by three quarters. On the flip side, the strong recovery in existing home sales and prices that started in earnest in Q1/2009 led the end of the technical recession (dated Q3/2009) and the start of the overall economic recovery by at least two quarters.
Furthermore, the Canadian resale housing market downturn and recovery was as V-shaped as can be. The length of each leg of this cycle was also nearly symmetric with the downturn lasting roughly all of 2008 and the ensuing recovery spanning all of this year. While in the thick of a recession, the strongest countervailing force that set the stage for the mother of all rebounds, apart from lower prices, was lower interest rates. Recall that the Bank of Canada began easing its monetary policy back in late 2007, when it was becoming clear that the U.S. economy was tilting into recession and would surely drag Canada along with it. By the time the recession officially hit in Canada a full year later, the overnight rate had already been slashed from 4.50% to 2.25%, more than halfway en route to its all-time low of 0.25% by April 2009.
All said, the housing market has gone beyond retracing its steps and fully recovering from the end of 2007 – which had marked the peak of a half-decade long boom, concentrated in Western Canada. As of October 2009, national sales were running at a blistering 550K annual pace and the average price was $340K.
Seasonally-adjusted monthly sales hit all-time record volumes for 3 of the last 4 months, and are on track to continue this record-setting pace over the next few months. As of October, both sales and the average price stood 5% higher than their respective 2007 peak. Extrapolating this trend echoes Buzz Lightyear’s mantra “to infinity, and beyond!”.
Back here on earth, however, this latest housing cycle raises a number of concerns. For one, was the whole two year cycle just a blip? A second, related question would be: is the recovery sustainable or was it all too much, too fast in the midst of a recession and early stages of recovery? Digging into the pace and magnitude of the rebound, more technical questions arise, such as: how much of the rebound was simply the unleashing of pent-up demand? Alternatively, how many of the current sales are simply being brought forward on the expectation that interest rates must eventually rise, in effect stealing from future demand? Last but not least, is a bubble brewing in Canadian housing just a blip?
The ‘blip’ story goes something like this. The downturn in 2008 was that of a housing market being just an innocent by-stander getting unfairly sideswiped by fears of a U.S.- style downturn and rock bottom consumer confidence in the midst of an extreme financial crisis. As these fears abated and the worst of the financial crisis passed, the doom and gloom headlines became more nuanced and some modicum of confidence was restored, whereas little existed before. As a consequence, the housing market navigated rough waters and made it through the storm relatively unscathed. This narrative is not wrong per se, but its implicit conclusion is that all is back to ‘normal’, whatever that may be. It also suggests that it will be smooth sailing from now on. In other words, the volatility in sales and prices has shaken out, and the expectation from here onward is a steady uptrend.
As a result, we see two problems with calling this cycle a blip. Both arise from near-sightedness. First, it fails to think about where the market stood pre-downturn. Second, it neglects the fact that the current uptrend is too steep and that the resulting erosion in affordability will come back to bite into future demand. To expand, the first problem is that the ‘blip’ notion fails to take a longer-term perspective on home values. If the Canadian housing boom (roughly 2002-2007) resulted in modestly overvalued residential real estate, which we estimate was roughly 10% on a national scale at the 2007 peak, the downturn had just about set things right from a value perspective, with a peak-to-tough price adjustment of -12%. For a number of reasons, we never forecasted a U.S.-style crash in Canadian housing. On the other hand, the adjustment that took place in 2008 looked warranted from a fundamental value perspective. The resulting improvement in affordability that came from more modest prices was encouraging and sustainable from a macro-financial perspective. From their trough, the most sustainable path for Canadian home prices would have been a gradual and modest uptrend aligned with nominal income growth. But now that home values are already past their previous peak in such short order, we estimate that the typical home remains overvalued by 12% at the national level. Unfortunately, sheer momentum suggests that this overvaluation is likely to increase over the course of the next few quarters, peaking at 13-15% in H1/2010
The misalignment of home prices with their fundamental drivers, such as demographics and income, cannot last. That much is known. What is less clear is the exact timing of when and precise channel by which the two will eventually realign. Because a necessary realignment has been erased so quickly without support from income growth, another adjustment must take place – although it could take many forms. As of our writing this note, early signs of market cooling are emerging and our analysis still suggests the most likely outcome is a soft landing and relative stagnation of home values in real-terms along with a resumption of stronger income growth over the 2011-13 time frame.
The second problem with the ‘blip’ characterization is that fails to look forward to the eventual resetting of interest rates – what happens when the sturdy trampoline of rockbottom policy interest rate that continues to fuel the sharp market rebound is taken away? Changes in affordability that rest solely on lower interest rates are inherently cyclical in nature, as opposed to those that arise from household income or homes prices.
Call this housing cycle a blip if you like. But we feel that is misleading, especially because of what this suggests for the future. While the market looks remarkably unperturbed from start to end of this sharp cycle, existing home sales and prices cannot sustainably stay on their current path. Markets are currently very tight and favour sellers, as evidenced by multiple competing offers and bidding wars, but we expect them to rebalance over the course of 2010. As the central bank begins to hint at a tightening monetary policy cycle in the second half of next year, sales could well see a last gasp of strength. Moreover, by that time, the availability of units on the supply side should provide a relief valve helping to cool price growth. And, by 2011, while the overall economy will have improved significantly, housing markets will be losing momentum. Repaying the past, stealing from the future.
On the issue of pent-up demand, we had calculated that, on a nationwide basis, at most 53,000 existing home sales that would normally have occurred in Q4/2008 and Q1/2009 did not occur because of the crisis of confidence resulting from the financial market turmoil. This figure is established on the basis of a continuation of the pre-recession downtrend in sales, which actual sales undershot significantly. Since Q2/2009, however, sales have overshot that trend by a wide margin. We calculate that 75-100% of this pent-up demand would have been absorbed by October. Sales have been tracking our near-term expectations well and we continue to judge that any remaining pent-up demand will have likely been exhausted by November. At the very latest, by year-end this source of demand will have completely dried up.
The full absorption of pent-up demand by itself should help to slow overall sales in the first half of 2010 compared to their recent pace, which has already begun to cool on a 3-month trend basis. Over the course of Q2/2009 and Q3/2009, up to one in five sales (monthly seasonally-adjusted units) could reasonably have been attributed to those that had previously been delayed