Our real estate market continues to over perform relative to the rest of the world and, over the past several months, we have been bombarded with predictions about the future of house prices for Canada in general and Toronto in particular. The range of these predictions is really quite staggering, considering that they are all coming from well-informed economists: from a bubble-bursting drop of 25% at one extreme to a continued rapid rate of price appreciation at the other. Let’s examine where these predictions are coming from & see if we can glean what is most likely in store for us over the next year or so.
All of the predictions have something to say about affordability as a key issue. This is only common sense: clearly there needs to be some correspondence between prices and households’ ability to make the monthly payments. The problem is in the definition of affordability.
Earlier this year, Capital Economics, a British economic research consultancy with a Canadian branch in Toronto, made headlines by predicting that a market correction was imminent because Canadian house prices were overvalued by 25%. This conclusion was based upon the fact that the ratio of house prices to household incomes has increased dramatically and is now about 25% above the historical norm. This klaxon warning was recently reiterated in an article in Britain’s venerable The Economist magazine. At first blush, this rationale seems to make sense, until you realize that the reason prices have risen faster than incomes is that interest rates have fallen well below historical norms, and so the higher prices have remained affordable. The price/income ratio is just too simplistic a measure of affordability.
Even more recently, a report from Bank of America Merrill Lynch economists has predicted that Canadian house prices will fall by about 10% in 2012, based on a “fair value” model for average house prices that somehow takes into account disposable income and interest rates to determine what households can actually afford from a cash flow perspective. I don’t know the details of their calculation of “fair value” but I do know that, when it comes to house prices, just as William Munny observed in Unforgiven (right before he shot Little Bill), “fair’s got nuthin’ to do with it”.
TD Economics has also made a prediction for next year. In a report published on December 22, they said that they “believe that the average Canadian home price is overpriced by roughly 10%” and that “metrics like price to income, price to rent, and affordability all support this conclusion”. Another country heard from .
In a more positive vein, the Toronto Real Estate Board (TREB) has developed an “affordability indicator” that makes a lot of intuitive sense. It defines the indicator as the ratio of average housing costs (mortgage payments, taxes and utilities) to average household income, where the housing costs are based on average house price, 20% down payment, 25 year amortization and the average 5 year fixed mortgage rate. A graph showing the trend for this indicator over the past 25 years is shown below. It shows that affordability was way out of whack, not surprisingly, after the speculative bubble in the late 1980’s, but has remained within a relatively narrow range during the past 15 years, corresponding to the boom we have experienced since the mid 1990’s. It’s interesting that the indicator has remained close to lenders’ rule of thumb of 32% for maximum housing costs as a proportion of gross income – a hint that this indicator is on the right track to understanding affordability.
Based on the TREB indicator, it would seem that affordability is still well under control, although we may be approaching a limit. Given that interest rates are expected to remain flat through 2012 and that household income is expected to rise by 2-3%, this suggests that prices will continue to rise in 2012, but at a somewhat slower rate. TREB is forecasting a 2012 increase in average Toronto area prices in the 4-5% range, as compared to the 8-10% that we have seen over the past couple of years. Beyond 2012, as interest rates increase, we should see a gradual leveling off of prices, and perhaps a bit of a downturn depending on how much and how fast rates move upward. This seems to be more or less the consensus forecast right now.
Another perspective on the whole affordability issue is provided by Will Dunning in a recent report prepared for the Residential Construction Council of Ontario. In this report, he identifies that there has been “affordability space” in the Canadian market that has allowed prices to appreciate, but he says that affordability is more of an enabler than a cause of house price changes. In other words, the affordability space makes it possible for prices to increase, but other factors, primarily the supply/demand balance, are responsible for driving price changes. He says that Toronto area prices have increased mainly because there has been an inadequate of supply of new housing, coupled with strong job creation (due at least in part to the “wealth effect” of rising house prices), and that this isn’t going to change any time soon. He agrees that rising interest rates will ultimately cause prices to level off and perhaps even fall, but says that there is often a significant lag in this effect. In fact, he argues that it is quite possible that prices will continue to rise at a brisk pace for another 2-3 years.
All of this, of course, assumes that we will not experience any major economic upheavals, for example a renewed global recession triggered by the European sovereign debt mess, over the next year or two. I think this is a pretty safe bet; the Europeans will most likely find a way to muddle through somehow.
The bottom line, in my view, is that the outlook for 2012 is at least as positive as TREB’s forecast of a 4-5% price increase. The market is finally starting to slow down a bit, with prices easing in December as they always do (see the chart below), but this year’s fall market has nevertheless been unusually strong. This often means a correspondingly strong spring market, so I expect that things will pick up in late January or early February pretty much where they left off in late November.