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Canada’s Housing Bubble Defies Gravity

The market for real estate, particularly individual homes, would seem likely to display speculative booms from time to time, since the psychological salience of the price of the places we see every day and the homes we live in must be very high, and because homes are such a popular topic of conversation.

— Robert Shiller, recipient of the 2013 Nobel Prize in Economics, Sterling Professor of Economics at Yale University[1]

One of the earliest uses in recorded history of the word bubble in relation to financial speculation is the South Sea Bubble, referring to a joint-stock company (the South Sea Company) founded in England in 1711. It issued shares to the public in 1719, and in less than a year increased its stock market value ten-fold. A short time later its stock price had dropped back to close to the original listing price, a 90 percent crash. Fortunes were made and lost. After 1720, the company continued to exist, eventually taking over responsibility for the debt of the government of England. The Bubble Company, as it was known, copied another formed in 1716 in France, known as the Banque Royale, which was also organized as a joint stock company and also used to finance government debt. Both of these companies were created for the purpose of converting government debt into shares of stock in a listed company. This idea of paying off government debt with shares sounds crazy today but, at that time, it fired the public imagination and many ordinary people got caught up in the speculative greed associated with these companies. Most of the speculators would eventually lose their life savings. These two companies and other similar copy-cat companies became known as the bubble companies. The concept became so popular that the English parliament passed the “Bubble Act” to control them.

Another more famous instance of financial insanity and speculative fever was a period known as the Tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn’t referred to as a bubble, perhaps because of the difficulty for the human tongue in saying “tulip bulb bubble.” Most people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person’s life savings for one rare bulb. The fad spread to England and many other countries. Even today in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago. The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash along with widespread public involvement and fascination.

Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn’t do any better in providing explanations since bubbles don’t readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. The Canadian-born economist J.K. Galbraith, who taught at Harvard University, discussed many of the most extreme bubbles in A Short History Of Financial Euphoria. Unfortunately he, too, fails to come up with a suitable definition of the bubble phenomenon. Galbraith states that recurring episodes of collective financial insanity, fuelled by greed, are inevitable.[2] Since it’s impossible for people to detect when they are in the grips of a manic episode of excessive speculation, the only defense is to develop a healthy degree of skepticism, an attitude that comes naturally to few people. For lack of another more suitable word, and recognizing that it isn’t precise, I will refer to markets that are overvalued and in the grips of speculative fever as bubbles. The word mania could be used, having the advantage over bubble that it implies a degree of mental illness or instability that is usually associated with the phenomenon.

Jeremy Grantham, founder of the large investment firm GMO, based in Boston, Massachusetts, manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him, a slender man in his seventies, in New York City after he presented at a conference in 2003. He opened his remarks by stating, “I’ve never been wrong.” The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause he continued, “I’ve been early” and the room erupted in laughter.

Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for bubble participants who ignore the warnings. Inevitably the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction. As Grantham says in a 2014 report, “the pain will be psychological and will come from looking like an old fuddy-duddy.”[3] However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price.

Anyway, Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right when the global financial crisis hit, starting in 2006 with housing, and in 2007 with Bear Stearns and 2008 with the Lehman Brothers collapse.

Grantham describes his research into bubbles. His research showed that “all 28 major bubbles … eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed.”[4] The definition of a bubble that GMO settled on was any event that was two standard deviations from the mean, expected to occur once every forty-four years. Grantham describes the U.S. housing bubble that exceeded 3.5 standard deviations from the mean, an event that would be expected to happen only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003 and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the U.S. and the world for decades.

“All bubbles … retreated back to their original trend.”

— Jeremy Grantham

And the cycle of a U.S. housing bubble and crash had never happened before for residential housing on a nationwide basis. Before the 2000-08 bubble, all housing market bubbles were local and there have been many. Real property or real estate, in the form of raw land or housing, provides fertile ground in which to grow a bubble. Especially in North America, where the history of widespread land ownership is only about two hundred years old, the episodes of mania that have developed from time to time are legion. After all, many of the people that moved to North America from Europe came because of the opportunity to own land, something that was difficult in their country of origin.

Shiller discusses the recent worldwide real estate bubbles: “We have no shortage of recent examples of real estate booms to consider. There were sharp home price increases after 2000 in cities in Australia, Canada, China, France, Hong Kong, Ireland, Italy, New Zealand, Norway, Russia, South Africa, Spain, the United Kingdom, and the United States.”[5] If bubbles or booms are likely to be a recurring phenomenon in the history of human financial activity, then individual homes and those who own the homes are ripe to exposure to the bubble activity. Houses will be the target of widespread speculative activity since almost everyone is interested, has a view on what the proper values are, and has a lot at stake given the size of the investment.

Shiller on the definition of a bubble, from the transcript of an NPR interview with Shiller and fellow 2013 Nobel Prize–winner Eugene Fama, hosted by David Kestenbaum.

“It’s like a mental illness.” He goes on to say: “Symptom one: Rapidly increasing prices. Symptom two: People tell each other stories that purport to justify the bubble. Symptom three: People feel envy and regret they haven’t participated. Oh, I would add one more — the news media are involved.”[6]

Canada’s house price increase since the late 1990s fits well with all four categories. Of course, there is no bubble if it doesn’t come to an end at some point, with a large decline in prices. And there is no bubble if prices don’t rise above the long-term sustainable fundamental or intrinsic value. Both of these requirements are difficult to prove in advance of the post-bubble price collapse so there is always room for debate until after the deflation period. And no one can predict when a bubble will end, making people look foolish for months and years before they are eventually proven correct. The Economist was early also in its prediction of a collapse in U.S. housing prices, but turned out to be prescient. So far Canada’s nationwide home prices defy all predictions of a collapse, as shown in Figure 1.1.[7]

If we take Grantham’s assertion at face value, Canada’s bubble (and Australia’s) could be even greater than the one in the United States, which he calculated to be 3.5standard deviations from the mean. Reversion all the way back to the original trend line in Canada means a devastating real estate crisis.

According to Shiller, while real estate cycles are as old as private ownership of land, the development of cycle peaks and valleys in several countries simultaneously is a recent development, only becoming widespread during the last two or three decades. In the 1980s, 1990s, and especially in the 2000s, bubbles formed in real estate and housing in many countries. Canada took its place front and centre with this new trend, along with Australia, which experienced even more extreme levels of elevated prices that rendered housing unaffordable.

The United States, and several other developed countries caught up in a synchronized cycle of real estate speculation, suffered a sudden collapse in housing prices. This collapse required a recapitalization of the banks in those countries that continues to this day. The bank bailouts that government authorities decided to fund in the United States, Ireland, Spain, the United Kingdom, and elsewhere created enormous debts for governments and significant political tensions that will continue for years. People resent the fact that, while people lost their homes and jobs, most bank executives were protected and continued to award themselves huge bonuses after the bailouts.

Canada’s bubble surpasses most others

We don’t fully understand why Canada escaped (so far) from the housing sector collapse that hit these other countries. We know that Canadians, and some foreign investors, continue to buy and speculate on houses and condos with borrowed money, and the housing bubble continues to grow bigger, making the situation even more dangerous than what prevailed immediately prior to the U.S. crisis that started more than eight years ago.

How did Canada get into this state of heated housing markets, excessive real estate investment, and speculative euphoria? In normal times, the primary determinants of the price level and value of residential real estate are household income (including the jobs market) and household formation, mostly young people getting married, starting a family, and buying into housing for the first time. In Canada the working population has enjoyed superior gains in income relative to other countries mostly due to the Canadian economy’s exposure to the commodity super cycle that started around 1998. As well, the good fortune of being in close proximity to the largest consumer market in the world — the United States — made wealth and incomes grow more rapidly than many other developed countries. Especially in the last twenty years, Canadians have seen large gains in income related to mineral exploitation, conventional oil and gas production, and increasing oil output from the oil sands. In fact, according to BCA Research,[8] commodity prices have doubled on average since 1998 (crude oil is up seven fold) and Canadian exports of commodities (mostly to the United States) had grown to about 40 percent of total exports in 2012, up from just 17 percent in the late nineties.

Canada enjoyed outsized gains in income compared to the United States, with unit labour costs soaring by 80 percent versus the U.S. since 2000. Hourly compensation in Canada doubled compared to only a 50 percent increase in the U.S. Unfortunately Canadian productivity lagged far behind our southern neighbour, according to the BCA report.

In the 1980s and 1990s, the North American Free Trade Agreement (NAFTA), signed by Prime Minister Brian Mulroney and President H.W. Bush in 1992, and its predecessor, the Canada–United States Automotive Products Agreement (1965), allowed southern Ontario — actually all of Canada — access to the United States for many exports, including autos and auto parts. Hydroelectric power exports from Quebec and British Columbia —fuelled income gains. Up until 2005, the housing-construction boom in the United States heightened demand for lumber and other wood products. In the last ten years the Canadian dollar appreciated from a low of about 63 cents to a peak of about five cents above par against the greenback. In late 2014, the Canadian dollar stood around 90 cents U.S., making Canadians feel much wealthier than they had in 2002. Happy days returned for snowbirds and other travelers with Canadian dollars. Canada enjoys unique good fortune compared to other G7 countries (United States, France, Germany, Italy, Great Britain, and Japan) when it comes to resources and commodities. According to the Department of Finance and recounted in a 2008 speech by the late Finance Minister Jim Flaherty, Canada has the second-largest known reserves of petroleum resources in the world (mostly oil sands) and is the largest exporter of oil to the United States. Canada is first in the world in hydroelectric power generation. It is the largest producer of potash and high-grade uranium in the world, the third largest producer of nickel and aluminum, and the world’s largest producer of forest products. None of the other countries (Brazil, Australia, Indonesia, Russia) that are large producers of these minerals or resources are located next to the United States, except for Mexico, a country that has managed its resources poorly compared to Canada (although that is changing).[9]

A major side effect of these unusual gains in wealth due to resource revenue and commodity pricing is the effect on house prices. Canadians, with their improving incomes have found the cash and the borrowing power to bid up the cost of housing.

Severely or Seriously Unaffordable

While Canadian incomes were rising more rapidly than elsewhere, housing prices grew even faster. According to an eleven-city index of single-family homes, called the Teranet-National Bank National Composite House Price IndexTM, between 2000 and August 2014 prices surged from an index level of 68 to 167 — a gain of 2.45 times.[10] This increase means that house prices grew much faster than household incomes.

One of the best measures of housing affordability is the ratio of median house prices to median household income — and this ratio indicates that a bubble has formed that is even more extended than the one that preceded the housing collapse in the United States. Median household income means that half of the households have lower incomes and half have higher incomes.

According to Demographia, in their annual report, Canada’s six major markets — Toronto, Montreal, Vancouver, Edmonton, Calgary, and Ottawa — are all moderately unaffordable, seriously unaffordable, or severely unaffordable.[11] The report showed that the ratio of median house prices to median household income in Canada’s six major markets was 4.5, or seriously unaffordable. The cut off for what is deemed affordable, according to their methodology, is 3.0. The major markets rated as being severely unaffordable (5.1 and higher) are headed by Vancouver at 10.3 (second in the world only to Hong Kong 14.9), and Toronto at 6.2; Montreal is rated as seriously unaffordable at 4.7 . Since those three markets make up about 68 percent of the total weighted value of the eleven-city index, the ranking of severely or seriously unaffordable applies to most of the homes in the largest Canadian cities.

Two more major markets in Canada — Edmonton and Ottawa — ranked as moderately unaffordable (3.1 to 4.0) partly because of unusually high median incomes. Calgary was seriously unaffordable (4.1 to 5.0), at 4.2 times which shows how stretched housing has become there considering that Calgary has the highest median income in the country at $100,000. Since the ratio measures house prices against household incomes any market with very high incomes like Calgary that ranks in the 4.0to 5.0category must have very high house prices to be seriously unaffordable. Calgary’s household income compares favourably to Vancouver ($65,000) — at 50 percent higher. If Vancouver had Calgary incomes, its ratio of 10.3 would come down to 7.2 , only a bit higher than Toronto. On the other hand, if Calgary had Vancouver’s much more modest incomes, Calgary’s ratio would soar to 6.0, putting it well into the severely unaffordable category. Both Edmonton and Ottawa with affordability measures in the moderately unaffordable category have elevated incomes, much above average, $87,200 and $79,400 respectively, so that their moderately unaffordable rating depends on them continuing to earn higher than average incomes. There have been booms and busts in the past, especially in resource-rich Alberta, so there are no guarantees that high incomes will last forever.

The affordability survey also points out that Canada’s housing markets showed the fastest deterioration in affordability of all the countries that it follows during the last ten years, going from affordable to unaffordable in all major markets. The report claims that in other parts of the world like Hong Kong the biggest factor in house price escalation is the lack of raw land. A lack of raw land in most Canadian cities, except Vancouver, is not likely to be a long term issue.

Other measures of house prices, such as the trend in increased prices over time, show that Canada has one of the most expensive housing markets in the world. Figure 1.2 [12] confirms the view that such rapid home-price growth outpacing income growth is extreme when compared to other real estate bubbles in the past and in other countries.

We can see that Japan peaked on house prices to income in 1989, at about 30 percent above the long-term average, and has been trending down ever since. The 1989 peak in Japan was not quite as stretched as the peak reached in the United States in 2005 and the current peak in Canada, both of which topped out at close to 40 percent above the trend line. This chart provides concrete evidence that Canada’s current bubble is truly egregious, not only compared to past housing price peaks in Canada but also compared to the housing bubbles that have appeared elsewhere. In other countries, when prices reached extreme levels such as Canada has now, a real estate crash followed, as can be seen in Germany (peak in 1980), Japan (peak in 1989), and the United States (peak in 2005).

House prices in Canada as measured by a major annual survey are more than 40 percent overvalued.

To get back to normal levels, a correction is needed that takes the house price/median household income ratio from above 5.0to below 3.0, which is approximately the same magnitude as the correction that happened in the United States. And a correction that big is called a crash, not a correction and definitely not a soft landing.

But we know that Canadians are reluctant to believe that the real estate market is going to crash. We also notice that the media love to present various scenarios that would justify Canada’s current extreme house prices as within the range of normality because of unique circumstances that apply in Canada but not in the United States. So let’s try to find a factor or factors in the Canadian situation that make Canada a special case and could justify the current high prices for houses.

One frequent argument that is used by those who wish to deny a housing bubble is the current state of interest rates. The assertion is: “as long as interest rates stay low, house prices cannot decline.” It is definitely true that extremely low interest rates in Canada contributed to the housing bubble. But any attempt to argue that low interest rates guarantee a permanent bubble does not work. Look at Figure 1.2 and examine closely the line that shows Japan’s house prices since 1989. House prices are 60 percent lower today than they were at the peak of Japan’s bubble. And for almost the entire twenty five years since ’89 Japan’s interest rates have been much lower than interest rates are today in Canada. In fact, the ten year Japanese government bond yielded less than two percent for the entire sixteen year period since 1998 and house prices continued to decline.

Immigration and Foreign Investors to the Rescue

Anyone who’s ever discussed house prices with someone from Toronto or Vancouver knows that residents of those major cities will respond immediately (if they own property themselves) by mentioning immigration or its close cousin, the foreign investor, to justify unusually high prices or signs of overbuilding as dozens of new condo towers dot the skyline. These homeowners justify high prices by pointing to the positive influence of non-Canadians and recent immigrants and their allegedly very deep pockets combined with their strong passion for owning Canadian real estate. As with most widely held views, there is some truth to the belief. Immigration is a key swing factor in household formation, as population growth without immigration would be much lower in Canada — closer, in fact, to the slower pace that exists in most other developed countries.

According to Statistics Canada, the growth in Canada’s total population has been rapid compared to that of most other developed countries, varying between 0.8 percent and 1.2 percent annually for decades.[13] The rate of growth of the total population for Canada exceeds all other countries in the G7 , especially countries like Japan and France, because Canada has a relatively high rate of net in-migration. But since 1992 the annual rate of growth has never exceeded 1.2 percent, hardly enough to cause a housing boom. Australia, New Zealand, and Switzerland grew at faster rates, all above 1.2 percent annually.

Our population growth surpasses that of the United States (0.7 percent), which had the second-highest rate of population growth among G7 countries and also had net immigration. Two-thirds of Canada’s recent population growth has been realized through immigration. This immigration flow is cited often as a key factor in the housing boom in Toronto, as that city attracts the largest percentage of immigrants to Canada. However, Canada’s rate of growth due to immigration is only slightly more rapid than that of the United States, and that country recently had a housing bubble and a crash. This deflates the argument pushed by Toronto condominium salespeople who love to talk about immigrants moving there and buying their product.

There are other reasons to doubt the “immigration justification” argument for high prices. For example, the immigration explanation doesn’t hold up when we notice that cities like Winnipeg, Regina, and Saskatoon had even faster house-price increases in the last five years — places that attract very few immigrants compared to Toronto and Vancouver.

Toronto is the preferred Canadian destination for immigrants. According to statistics published by the City of Toronto, it attracted fully one-quarter of all immigrants that came to Canada during 2001 to 2006, or about 267,000 people. Of course, the Greater Toronto Area (GTA) would have absorbed even more people. Toronto is home to 30 percent of all recent immigrants in Canada but only 8 percent of Canada’s population. But any cursory look at Toronto’s skyline (and indeed that of the GTA) shows that there is no shortage of recently-constructed units to fill that need. Immigration could only provoke a permanent housing shortage and a long-term plateau of elevated housing prices if somehow there were no new construction. But exactly the opposite is the case. Housing and residential construction in Canada is one of the biggest segments of the economy. Unless all those construction workers are building either the wrong kind of housing or in the wrong place for the people who want to buy, there is little chance that a booming flood of immigrants could push up house prices over the long-term.

The foreign investor argument is equally problematic in explaining an excess of demand over supply, which might force prices higher. The facts on the ground are difficult to determine. Statistics are as elusive as the mythical foreign buyers who seem to be a major (unpaid) ally for every sales campaign for luxury condos in Toronto.

We can’t track foreign investors as easily as immigrants since there is no record that identifies a house or condo buyer by occupation or country of residence or even type of buyer such as family, individual, or corporate. Most foreign investors in the Toronto and Vancouver areas, which are the areas with the most significant amount of foreign investment purchases, concentrate on the condominium market probably because there is little need for on-site supervision. Based on anecdotal evidence only, many condos in Vancouver and Toronto sit empty as investors choose to leave them unoccupied, at least in the short-term, because perhaps the plan is to flip the unit for a quick profit. This type of investment is really speculation, not investment if it is left empty because there is no income associated with owning the condo, only expense. Of course if it is rented it could be an investment, but a poor one since expenses normally exceed income in Canada’s condo market. The strategy that would yield a profit for the speculator is a sale that depends on finding a buyer willing to pay a higher price than the speculator. Of course, taxes and condo fees continue to eat away at the potential profit the longer the unit is held prior to flipping. It’s hard to imagine that foreign investor demand will be anything more than a temporary lift to the condo markets. It could go on for a few years but eventually foreign investors will move on to the next hot property market or they will sour on the Canadian economy or they will notice that their favourite speculation, the condo, is no longer rising in price and therefore not likely to yield any quick profits.

But there is a more substantial, domestic and permanent source of demand for housing that might be a factor in the bubble, and that is young people who reach the age when they want to get married and move out of their parents’ home to live independently. This is known in the economic world as family formation.

Family Formation and the Bubble

Economists that examined the bubble and collapse in the United States noted that a substantial drop in household formation after the financial crisis of 2009 hurt the demand for housing and contributed to the housing crash there. Analysts estimate that as much as one-third of the U.S. male population between the ages of eighteen and thirty-five lives at home with parents, highlighting the dramatic drop in family formation. Perhaps that’s why sales of the computer-based game Grand Theft Auto have never been better.

So what has happened with young people born in Canada who have reached adulthood over the last decade? As you would expect, their experience is very similar to that of their contemporaries in the United States. In Canada, these young people, known as Generation Y (or millennials), are very slow to leave home and establish independent living quarters, especially compared to previous generations.

Forty-eight percent of the so-called late baby boomers (those born between 1957 and 1966) were married during their twenties, compared to only 33 percent of millennials born between 1981 and 1990 (who were twenty-five to thirty-four years old in 2015). This represents a huge drop in the rate of family formation, with more than 67 percent of millennials remaining single. Although single people might be homeowners and couples might live together but not get married, they are much less likely to buy a home than are their married cohorts.

An even more important trend regarding these young people as potential home buyers is this: a remarkable 51 percent of those aged 20 to 29 live at home with their parents (based on 2010 data), compared to just 28 percent of the late boomers at a similar stage in their lives.

Obviously two well-paying jobs are a prerequisite to buying a house and moving out of the parents’ basement. But as was shown at the beginning of the chapter, Canadian income growth and employment surpassed that of the United States by a wide margin, primarily because of commodity demand and prices. So it’s a puzzle why so few young Canadians have taken the leap to move out on their own. Perhaps the high cost of housing is making it impossible for these young people to get started on the homeownership ladder, even when their parents might like to give them a push.

In fact, under closer examination, we see that while median income growth has been good, it has been relatively poor for the millennials who would normally be forming families and buying entry-level housing. While gains for the top 1.0 percent have been spectacular, for the rest of the population (the 99 percent who make less than $200,000 per annum), income increases have been very modest in Canada even with resource wealth, and especially after adjusting for inflation. This trend goes back several decades. For millennials, that job as a Starbucks barista isn’t providing enough income to rent an apartment much less buy a home or condo.

According a study by the U.S.-based Pew Research Center, millennials are the first generation in the modern era to have “higher levels of student loan debt, poverty and unemployment, and lower levels of wealth and personal income than their two immediate predecessor generations ... at the same stage of their life cycles.”[14]

We can conclude that factors such as household formation, immigration, foreign investors, and income growth, even when taken together, cannot explain the amazing surge in house prices. This lack of support for house prices makes the appearance of this bubble even more unusual — and much more precarious. We now turn our attention to the one major contributor that did drive the bubble’s formation and housing price increases; one that will play the leading role in the ensuing crash in Canadian real estate.