Housing bubble could deflate slowly

Thomas Holloway, Special to The Vancouver Sun 

Housing bubble could deflate slowly

The chart above plots changes in the ratio of house prices to income.

Vancouver Sun graphic / PNG

In the 1964 Bond movie Goldfinger, “M” asks the hero: “What do you know about gold?” Bond replies with a wry smile, “I know it when I see it.”

What do we know about a housing bubble? Do we know it when we see it? Typically, households will over-own, developers will over-build, banks will over-lend, government will be over-involved, and the economy will be over-dependent. Parts of the Canadian housing market display each of these aspects.

As value investors, Leith Wheeler Investment Counsel Ltd. is on the look out for overvaluation. Why the real estate market? Because it is an important factor in the economy and can have a large, indirect effect on other asset prices.

Leith Wheeler looked at 40 years of housing fundamentals in 21 OECD countries to see how house prices interacted with inflation, household incomes and rents. Between 1970 and 2012, prices rose most of the time, just as your dad and your realtor always told you they would. However, in the long run, prices rose because incomes and rents rose, mostly due to inflation. Looking at the ratios of house prices-to-rent or house prices-to-income highlights the cyclical nature of real estate.

To help make sense of all the data, we identified 48 distinct peaks in national price-to-income ratios in countries such as 1978 Norway, 1989 Britain, and 2005 United States, where house prices kept rising for awhile, but price-to-income ratios peaked at the end of 2005.

Instead of concentrating only on the recent U.S. debacle, however, we looked at more history and more countries. The accompanying chart shows the results.

The chart plots changes in the ratio of house prices to income. The bold line is the average price-to-income ratio over all 48 cycles. On average, the starting point of the cycle was 20 per cent below the peak and the valuation then fell back the same amount. The dashed bold line is Canadian price-to-income ratio aligned to December 2011. The starting point was about 30 per cent lower. We don’t know that December 2011 will be the peak because this method doesn’t necessarily help with timing.

If we look at rents instead of incomes, the picture is the same, except that for the current Canadian cycle, the house price-to-rent ratio started 35 per cent lower. Historically, the market cycles that went up more tended to fall more. The valuation ‘tents’ are roughly symmetric. For comparison, we highlighted both the FHFA (Federal Housing and Finance Agency) and Case-Shiller versions of the U.S. 2005 cycle (dots and dashes, Case-Shiller includes more “inexpensive properties with alternative financing”). FHFA and Case-Shiller (put out by S&P) are widely watched indexes of national house prices. Note that both follow the script (the black solid line).

Using a combination of price-to-rent and price-to-income ratios, the simplistic conclusion is that Canadian housing needs to unwind by about 30 per cent from the current valuation ratios. That’s not the same thing as prices crashing by 30 per cent!

That’s because if rents and incomes continue to go up, prices may not need to drop that much. Annual growth in income and rents of three per cent would deflate half of the valuation bubble over seven years. It is also conceivable that we don’t revert all the way back down.

A modest price decline coupled with gains in rents and incomes is called a soft landing. That’s what B.C. Assessment appeared to signal this past week as homeowners received their property assessments and saw values down slightly in many regions for the first time in years. It’s also what the central bank and federal government is aiming for. However, watch out for weaker inflation or income gains, particularly as the economy adjusts to weaker housing activity.

It is possible that the market will force some price reductions in the short-term.

Similarly, if inflation and incomes don’t grow, the soft-landing idea stops working. This is what happened in the U.S. The U.S. price-to-income charts fit the model, but it got there with more price drops and less wage inflation.

We use this framework to think about different scenarios and the implications for the economy and security valuations.

A housing bubble is hard to define, but like James Bond, we know it when we see it.

We see it in Canada right now. But this doesn’t have to mean financial disaster is next. In fact, this research indicates that housing is almost always either inflating or deflating. It sure does matter for the economy, but for personal context, back to the Goldfinger movie. Bond turns to Moneypenny, asking, “What do you know about gold?” “The only gold I know about is the kind you wear … you know, on the third finger of your left hand,” she replies, suggestively. Moneypenny understands, as do most Canadian homeowners: the gold on their fingers isn’t a retirement strategy and price changes needn’t make any difference at all.

Thomas Holloway, CFA, is a fixed-income analyst at Leith Wheeler Investment Counsel Ltd. in Vancouver. This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.

