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An Argument on why the Canadian Housing Market is not in A Bubble

An Argument on why the Canadian Housing Market is not in A Bubble

Abstract

The housing market is highly important to the economy of any nation across the globe. The real estate market however faces numerous problems because of in-elasticity of supply in the short term. In this case, Canada is not an exception but the country has worked hard to resolve its housing problems. It has been argued that the market solutions to the housing challenges are the most efficient compared to the governmental resolves (Duca, Muellbauer & Murphy, 2010). However, Canadian housing market is not a bubble owing to the involvement of the government in finding solutions, which gives the market players adequacy in terms of outcomes. Despite many years of trying to solve the housing problems, the Canadian government is yet to develop an adequate solution to these issues. The issues in the sector are exacerbated by the inelastic supply that prevents development of decent and affordable houses. The high demand for real estate has come about as a result of the fact that everyone is in need of a place to live yet the supply of housing is inadequate. In addition, price control is also essential in maintaining the affordability of housing services and also ensuring quality. The analysis shows the effects of housing inventory, migration, and employment on demand while the involvement of the government and low mortgage rates are termed as negative to future market needs. This paper evaluates the aspects of Canadian housing market and tries to prove why it is not a bubble.

 

Table of contents

Abstract          2

Introduction    4

Discussion and Arguments     5

The positivity of Mortgage markets            6

Negative Trends in Canadian Housing Sector        7

Factors That Will Influence Canadian Housing Sector In Future  7

Factors Affecting Housing Demand Negatively    9

How Housing Affordability In Influenced In Canada       10

Conclusions     11

References      13

 

An Argument on why the Canadian Housing Market is not in A Bubble

Introduction

Real estate market is highly significant to any country because of its economic elements and implications. The housing sector has many issues that come up mostly as a result of the in-elasticity of supply. The supply of houses is inelastic in the short term, and this factor causes a market imbalance. The government of Canada can be said to have contributed towards finding viable solutions to the housing sector because it operates alongside the private sector within the industry (Moody & Sunny, 2013). This is aimed at making sure that the elements such as affordability of houses, quality and supply are maintained. Even though the government may attempt to improve the sector, economists argue that market forces provide the most optimal solutions to the housing problems. The market factors in question may include current stock level, employment rate, and migration rates among others which mainly influence the demand for housing (Duca, Muellbauer & Murphy, 2010). Nevertheless, a number of risks subsist in the sector and these may include market imbalances as well as the rising household debt that can prevent many people from owning homes. The Canadian real estate sector could grow substantially if home prices are stabilized as this will allow many to afford housing at a value. In Canada, the the real estate market trends prove constancy of prices and this is evident whereby a rise in mortgage interest rate is subsequently followed by higher housing prices to accommodate income growths, hence neutralizing the effects.

In recent times, there has been a lot of speculation with regard to the recent increase in real estate prices in Canada. Several economist such as Robert Shiller have compared the rise in prices to similar rises in prices in other markets including those in the US and Spain that created a bubble which resulted in the collapse of the real estate market (Duca, Muellbauer & Murphy, 2010). This paper assesses the recent trends in the Canadian real estate, and explains the factors that affect the supply along with demand, in addition to analyzing the affordability of housing. The evaluation of the trends, supply and demand, and affordability will lead us to conclude that Canada has a resilient real estate market that might see a slight reduction in price, but not a total collapse in prices as is the case with the bursting of a bubble. The real estate can be subdivided into five types namely residential premises, business premises, industrial, agricultural and finally the specialized housing.

Discussion and Arguments

The views regarding the housing sector differ greatly from one setting and culture to the other. For example, the definition of decency is highly subjective and the Canadian government particularly sets a high value on living environment. From this perspective, the high standards set by the government could make it difficult to resolve the housing problem. In addition, affordability is another concern with the Canadian regime because the government merely assumes that housing is affordable if the cost does not exceed 20% of a person’s income (Kinsley, 2012). Recently, this figure has been raised to not more than 40% mainly because of the changing market demands. The Canadian government has tried to use diverse techniques to solve the housing issues including the housing code enforcement, which is a technique used in regulating the minimum conditions to be met in rental housing. The government has also attempted to solve the problem through enforcing tax exemption on home down payment as well as offering low interest rates on mortgages. This is, however, reserved for the poor who are unable to afford to purchase or own a home. This inefficiency has seen to it that the supply remains less in comparison to housing demand, and this affects the market prices.

Canada has been cited as having very low interest rates over short periods, and this influences the level of investment and results in the inefficient asset prices (Kinsley, 2012). Nonetheless, it is believed that the housing sector in the country will not turn into a bubble unless the external forces come into play. This means the sector will not face price variations over a period because of the strong economic conditions that promise more job opportunities that translate into improved living standards. As a result, housing in the long run will become affordable especially in terms of decency.

The Positivity of Mortgage Markets

The real estate market updates could be said to offer positive market reactions that are bullish for the Canadian housing sector and this could be discussed more specifically in relation to the mortgage markets. The Canadian mortgage market features relatively high levels of equity, with the average equity in housing peaking at 66%, and more than 72% of borrowers having more than 25% equity in their mortgages (Masson, 2013). Economists usually worry about borrowers defaulting especially if they lack a large portion of the equity in their homes. In Canada, this section equals to 9% of mortgages that have less than 10% equity, and this has reduced the chances of defaulting.

A further positive trend that is evident in the mortgage market is the extremely low number of mortgages that are in three or more months of arrears. The financial obligation of three months or more are at 0.3%, which is a reduction from 0.4% in 2009 (Masson, 2013). This is good for the sector because it shows better market performance especially as far as the settlement of mortgage loans is concerned. Another bullish factor linked to mortgages is that in comparison to mortgage originators in other countries such as those in the US, the originators in Canada are more likely keep the mortgages they originate on their books. This helps to make sure that the follow up costs incurred after mortgaging are kept at minimum and thus enhances the Canadian economic situations (Boivin, Lane, Meh & Economic, 2010). Since they restrict the use of the originate-to-sell model, the mortgage originators have a vested interest in getting their mortgages repaid, and as a result, the Canadian originators have a bigger incentive to ascertain that the credit quality of their consumers is strong so that the originator avoids losing money in the case of default. Therefore, in order to maintain good relations with the buyers, quality is key to the terms of contract and this thus improves the value of housing.

Additional recent trends that promote the housing sector relate to the Canadian supply and demand and one measure used in evaluating the supply and demand balance is the sales-to-new-listings ratio. The ratio complied by the Canadian Mortgage Housing Corporation (CMHC) rates the market as a buyers’ market in case the ratio is below 40% and the same market is regarded as a seller’s market where the ratio is over 55%. At the national level the ratio falls slightly below 55%, and this is a sign of healthy market relations as well as strong demand for housing, especially considering that 11 of the 31 major metropolitan centers in Canada are in a sellers’ market. An indirect measure of supply as well as demand for real estate is carried out by assessing the rental market. The national vacancy rate is at 2.5% in 2012, and this was a downward revision from 2.9% in the year 2011 (Masson, 2013).

Negative Trends in Canadian Housing Sector

There are diverse bearish trends in the Canadian housing sector and one of the most worrying of these is the steady rise of the rates of home ownership from 60% in 1971 to 68.4% in 2006. When home ownership increases to high levels, the demand for housing will naturally reduce because 2/3rd s of the population already own their homes. In which case, the supply could surpass the demand for housing in the long run thereby affecting the economy negatively. A second worrying trend is the increased leverage of the Canadian households to over 160% in 2012 which has raised concerns amongst economists who feel that the Canadian households are becoming increasingly over leveraged (Moody & Sunny, 2013). Household debt is also split into credit card, student, automotive, and the mortgage debt. Lately the amounts of credit card and automotive debt have significantly reduced therefore indicating that an increasing portion of household debt originates from housing debt. This not only concentrates the risk but also makes households more sensitive towards housing debt and such a situation makes the owning of houses more expensive to low-income earners because of unpleasant terms of mortgage.

Factors That Will Influence Canadian Housing Sector In Future

The real estate sector in Canada is growing into a vital element that is considered in arriving at the country’s economic decisions. The housing sector faces a myriad of demand and supply components that either promise better performance or otherwise and among the factors that affect these sector are employment rate, migration, and housing inventory as well as the mortgage rates and government involvement in the housing sector. These factors greatly determine the future housing demands and the supply of houses (Moody & Sunny, 2013). However, it is necessary to review the positive aspects of these factors in relation to the demand impacts and also consider the impacts they have on supply. In the same light, an analysis of the negative impacts will demonstrate whether much effort is required to improve on each component in order to balance the Canadian housing market needs.

The first positive factor is employment as the foremost basis of revenue for most individuals, a factor that makes the level of employment critical in driving the demand for housing. Canada’s employment figures have been improving at a steady rate ever since the financial crisis, and as at 2012, the unemployment rates stood at 7.2%, which was a decrease from 8.7% in the end of 2009 (Canada Unemployment Rate, 2013). It is expected that this positive trend in employment will continue and will hence have a positive effect on disposable income as well as purchasing power. The second and equally important factor that drives the housing demand is the rate of net migration into Canada. Population growth in Canada stands at 1.2%, which is quite high when compared to Europe’s 0.2%. Accordingly, 60% of the growth in population is attributed to net migration. The essence of immigrants is that they creates a ready market for real estate as they are either searching for places to live in temporarily in the form of rental housing, or places to settle down permanently, which can be found by buying a house. The inventory of unsold homes is the final factor that could determine the future balance between supply and demand in the housing market. An increase in the inventory of unsold homes shows either a lack of demand, or excess supply, both of which can negatively affect the price of real estate (Moody & Sunny, 2013). Unsold inventory has risen in Canada, yet this increase in unsold inventory has failed to keep pace with the population growth in the country, and as such the unsold inventory per capita has reduced.

Factors Affecting Housing Demand Negatively

A number of factors can have a devastating impact on the real estate demand in future. These include the low mortgage interest rate as well as the involvement of the state in the real estate market. An essential demand catalyst for housing is the mortgage rate and it is common for home purchasers in the Canadian housing sector to combine their savings with a mortgage in order to afford a home. As such, the mortgage rates are important in determining home affordability and the purchasers buying power, with lower rates increasing the purchaser’s ability to decrease the debt service burden. The Bank of Canada, which is the central bank in the country, plays a vital role in determining and setting the interests rates, which form the basis for mortgage lending rate. In response to the financial crisis, the Bank of Canada lowered the interest rates to historically low levels, and has continued to uphold this at a relatively low level of 1%. The bank is expected to increase these rates in the future and this is bound to cause a problem for both potential home buyers, and the people who already have mortgages (Moody & Sunny, 2013). If the bank raises the mortgage interest rate, buyers will have to pay more to finance home ownership and this will ultimately reduce the level of investment. This will definitely extend to the employment aspect because less job opportunities will be created thereby negating the chief goal of enhancing the housing affordability rates. When interest rates are raised, it will become more expensive to finance a home, and this will deter the potential home buyers. The effect of this raise on the home owners who have mortgages is also negative because the home owners who chose the variable mortgage rate, that is 26% of mortgage holders, will see an immediate increase in their debt payments. On the other hand, the majority 74% who opted for the fixed rate mortgages will find that when the tenure of their fixed mortgage is up, which typically stands at five years, their mortgages will be reset to the higher rates.

The final factor that can negatively affect the future housing supply and demand is the role of the government in the sector. The federal government plays an indirect role in the housing market because of their interventions which are made by the CMHC. The CMHC plays a critical role in the market because it issues mortgage insurance, and recently adopted the issuance of the securitization or mortgage-backed securities. Owing to the fears of the real estate market bubble, the CMHC attempted to stem the increase in house prices by raising their requirements for mortgage insurance (Masson, 2013). One way through which it tightened the scopes is by demanding a 20% down payment, in 2012, up from zero down payment many years back. Another rule that was introduced to make sure that mortgage payments would not cause financial strain on the borrower was to cap mortgage payments and related expenses to 39% of an individual’s income by instating a maximum 39% gross debt service ratio.

How Housing Affordability In Influenced In Canada

Affordability is defined as the degree at which persons are able to pay for a product without experiencing financial distress. The affordability aspect can be discussed in relation to many factors that are taken into consideration to give a conclusive view. This section analyzes the Canadian housing market demands based on the affordability measures established by the government. According to The Economist magazine, the Canadian housing sector is overvalued in terms of the rents and income, with the overvaluation being estimated at 74% and 30% respectively (Masson, 2013). The rent affordability measure is based on the rent relative to home prices and this measure is slightly flawed considering that the government intervention in the rental market has put a limit on the ability of homeowners to raise the house rent on tenants.

In Canada homeowners are not permitted to increase rent more than 3% annually without going through a tedious process, and as such rents are artificially lowered (Masson, 2013). This differs greatly from the case of increasing house prices, which have been raised at an average of about 10% annually with a rise from 189,900 in 2002 to 363,100 in 2012. The gap of about 7% has widened on an annual basis yet this gap ought to decrease as rents are raised and home prices increase at a slower pace than 10%. As seen, before the rental market is strong and vacancy rates stand at 2.5% every year hence creating a potential for rental prices to increase, while home prices have already been raised substantially. In terms of housing prices being overvalued based on the price-income, the overvaluation should reduce with time especially considering that the rise in housing prices has slowed down to 2.3% in 2012, which is down from an average of 7% in the last few years. The decrease in price increases is a good signal because it gives room for income growth to catch up with the rise in housing prices. Housing price growth is only healthy if it grows at the same pace as economic growth and the recent rapid increase in house prices can be linked to the strong growth in the Canadian economy together with the historically low interest rates (Moody & Sunny, 2013). An increase in the interest rates will lower the ability to finance a mortgage hence slowing down the increase in prices and giving room for income growth to catch up with the rise in house prices.

Based on the evaluation of the trends, the factors affecting supply and demand, and the affordability measure of the Canadian real estate market it is more evident that the market might be overpriced, yet the fundamentals in the market are existent to support these high prices. Although a decrease in real estate prices is probable, a crash as happens after the bursting of an asset bubble is highly unlikely. For example, in case the interest rates rise, less people would own homes and this would increase the supply of housing. If this were characterized by increased house prices, the market would stagnate in the event that the level of income remains constant (Kinsley, 2012). However, if the economic conditions in Canada improve and subsequently support the rising prices of housing, the market will not feel the effects and therefore no bubble impact will be experienced. High interest rates implies less affordability of housing services apart from huge debts for homeowners through mortgage plans and to ease this situation, prices may be increased to foster economic growth and prevent market fluctuations.

Conclusions

Canadian real estate market is influenced by several components such as the mortgage rate and economic conditions. The level of employment also affects the demand for the housing services in the sense that the level of disposable income available for an individual is central to their owning of a home. One of motivating factors to home ownership is the current low mortgage rate which encourages individuals to commit their willingness to repay the principal amount together with interest if they are granted support to owning the home. The Canadian mortgage market is characterized by relatively high levels of equity, and the average equity in housing has peaked at 66%, with more than 72% of borrowers owning more than 25% equity in their mortgages. This has resulted in many economists raising concerns of borrowers defaulting payments in case they do not have a large portion of equity in their homes but mortgage originators in Canada and other countries such as the US maintain mortgage records in their books hence absorbing related risks like costs or default (Kinsley, 2012). Immigration supports the real estate sector through a captive market with immigrants searching for temporary or permanent places of residence. Furthermore, an increase in home inventory exhibits lack of demand if not excess supply, and these are aspects that affect the price of real estate. Nonetheless, Canada can be said to be economically stable enough to prevent price deterioration in a manner that would severely affect housing market. Given this analysis, it is therefore prudent to claim that Canadian real estate sector is not a bubble.

 

 

References

Boivin, J., Lane, T., Meh, C., & Economic, C. (2010). Should Monetary Policy Be Used to Counteract Financial Imbalances?. Bank of Canada Review, 2010(Summer), 23-36. Retrieved from http://www.bankofcanada.ca/wp-content/uploads/2010/09/boivin_summer10.pdf

Canada Unemployment Rate. (2013). Retrieved from http://www.tradingeconomics.com/canada/unemployment-rate

Duca, J. V., Muellbauer, J., & Murphy, A. (2010). Housing markets and the financial crisis of 2007–2009: lessons for the future. Journal of Financial Stability6(4), 203-217.

Kinsley, K., (2012). Canadian housing Observer. Retrieved from http://www.cmhc-schl.gc.ca/odpub/pdf/67708.pdf

Masson, P. R. (2013). The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now. CD Howe Institute Commentary, (381). Retrieved from <http://www.cdhowe.org/pdf/Commentary_381.pdf>

Moody, M., & Sunny, S. (2013). Is the new central-bank governor’s optimism warranted?

Retrieved from <http://www.economist.com/news/finance-and-economics/21586837-new-central-bank-governors-optimism-warranted-moody-mark-sunny-stephen>

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