Back in 2005, as the US housing bubble started to pop, Paul Krugman wrote That Hissing Sound.
This is the way the bubble ends: not with a pop, but with a hiss.
Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23 percent in a day. In fact, prices often keep rising for a while even after a housing boom goes bust.
So the news that the U.S. housing bubble is over won’t come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay. And the process may already have started.
It appears as though the process has now started in Vancouver. From the latest monthly report from the Real Estate Board of Greater Vancouver:
- Residential property sales were 2,853 in May – a 15.5% decline compared to May 2011.
- May sales were the lowest since 2001 and 21.1% below the 10-year May sales average.
- New listings totalled 6,927 in May 2012 – a 16.8% increase compared to May 2011.
- Last month’s new listing total was 15.3% above the 10-year average for listings in May.
- At 17,835, the total number of homes listed for sale increased 21% from this time last year.
Sales have stalled and inventory is rising. To make things worse, yesterday the Canadian government made major changes to mortgage rules.
- Mortgage amortizations were reduced from 30 years to 25.
- Refinancing limit reduced from 85% of home’s value to 80%.
- Gross Debt Service ratio reduced from 44% to 39%.
- Government insured mortgages now limited to homes purchased for under $1,000,000.
- Minimum down payment of 20% for homes priced above $1,000,000.
- Cash-back and stated-income (liar) loans eliminated.
- HELOC maximum reduced from 80% to 65%.
Also, consider that these mortgage rule changes are coming at a time of record low affordability. From RBC’s latest Housing Trends and Affordability report:
Any time the government tightens mortgage rules, it can have a negative effect on home prices. Coming at the same time as the market appears to be turning and with affordability at record lows, it will probably speed up the decline and could turn that hiss into a pop.
Millions of Americans have been devastated by the bursting of the US housing bubble. Most of them are people who bought close to the peak of the market then lost their down payments and more when prices collapsed. Home values in the US are back to 2002 levels and people who bought near the top have lost over 30%.
The moral of the story is clear – when housing is significantly overvalued it’s better to rent than to buy.
But what about people who did the prudent thing and rented during the bubble? Did they also pay a price? And what about Canadians renting today waiting for the Canadian housing bubble to burst?
To answer that question, let’s look at an example of someone living in today’s bubbliest North American market – Vancouver. According to the latest Rental Market Report from CMHC, the average rent for a Vancouver condominium is $1,474. The average price of a Vancouver condo is $445,458.
Traditionally, real estate values are proportional to rents. The rule of thumb is that homes should cost about 15 times their annual rent. For example, a condo that rents for $1,000 per month ($12,000 per year) should sell for about $180,000. For the average condo in Vancouver, the current ratio of price to annual rent is 25.2 – implying (as did my earlier post) that Vancouver is due for a 40-50% correction.
So let’s compare two scenarios: renting during a bubble versus buying in a normal market.
Scenario 1 – Renting in today’s Vancouver condo market.
At today’s average monthly rent ($1,474), the annual cost of renting would be $17,688.
Scenario 2 – Buying that same condo if there were no bubble.
In a normal market, the average condo would be selling for 15 times annual rent – $265,320. Assuming condo fees of $3,000/year and property taxes of $1,750, the total annual cost of owning would be about $4,750/year (for the purposes of this discussion, let’s ignore mortgage costs). Additionally, an owner could expect that condo to appreciate. The long-term average inflation rate in Canada is 3.26%. Being conservative and using the average inflation rate, this condo could be expected to appreciate $8,650 during the first year.
The total benefit of buying over renting would be annual savings plus appreciation. In this case that number would be $17,688 – $4,750 + $8,650 = $21,588. For someone able to purchase that condo for $265,320 without a mortgage, this benefit would come out to 8.14%. That’s how housing bubbles hurt people who do the prudent thing and rent during a bubble. It deprives them of a tax free return of over 8%.
And in the event readers are wondering if a price to rent ratio of 15 is realistic, 98 out of 100 US housing markets now have a price to rent ratio less than 15!
With all the information Canadians have heard about the US housing bubble and the incredible economic damage it’s bursting has caused, it’s hard to believe they would follow the same path – and yet they have. The average price of a Canadian home currently stands at $362,899 – about 70% more than in the US.
(Note: Canadian realtors typically report average prices while American realtors report median prices. Average home prices in the US are about 20-25% higher than median prices. The current median US price is $169,500 making the average US home approximately $210,000.)
According to a recent article in The Economist, Canadian house prices are 29% overvalued relative to household incomes and a staggering 71% overvalued relative to rents.
Things are even worse in Vancouver, where the latest Demographia Housing Affordability Survey ranks Vancouver the 2nd least affordable city in the English speaking world. According to the survey, the median price of a home in Seattle was $321,500 while in Vancouver it was $602,000. In the year since that survey was published, Vancouver prices have gone up another 7.8% while Seattle has gone down 7.1% – making a home in Vancouver more than twice as expensive as a comparable home in Seattle. This is in light of the fact the two cities are similar in almost every way – including incomes.
How did things get so out of whack? Same way as they did in the US – with a debt fueled housing bubble. Lesson not learned.
How will the situation resolve itself? In all likelihood the correction will also follow the path of the US – a multi-year housing crash which ruins the lives of countless Canadians and takes down much of the economy with it.