Tuesday, July 03, 2007

Meaty Reading - Bank of Canada Paper on Housing

I recently read an interesting working paper published by the Bank of Canada on the correlation between the US and Canadian housing markets. Here is the summary (emphasis added):

The brief synopsis (no surpises here):
  • Real estate is cyclical (it goes up and goes down)
  • Real estate prices across North America are highly correlated
  • Real estate prices are more volatile in Canada (this is a little surprising)

"Housing cycles in the U.S. and Canada are quite similar overall, but Canadian housing market cycles are more volatile than those in the U.S. Most notably, Canadian housing market contractions are somewhat shorter and sharper than those in U.S. cities. An average expansion lasts from five to six years in both countries and is characterized by an average increase in real prices of about 32%, although the median expansion is larger in Canadian cities (26% versus 18% growth) in our sample. In both countries, real house prices decline by 10% to 11% during an average contraction. This price decline however, occurs more rapidly in Canada since the average contraction lasts only 3.5 years in Canadian cities compared to 4.4 years in the U.S. cities.

Real house price growth rates in the two countries are quite strongly correlated at the national level and among the largest cities in both countries. Canadian cities are in the same housing cycle phase as that of the U.S. 70% of the time. Future work could examine the possibility that there is a common housing cycle in Canada and the U.S. or in broad North American regions. This would be of interest since our findings suggest a clear link between the housing markets of the two countries, yet housing is a non-tradable product.

Real policy rates and the growth of income per capita appear to have strong effects on the transition probabilities of housing market expansions and contractions. After controlling for these fundamental variables and decade-specific time effects, we still find considerable positive duration dependence in expansions, but little evidence of duration dependence in contractions. These findings suggest that fundamental factors do a fairly good job of explaining the transition of housing markets out of contractions phases.

Therefore, to the extent that policy-makers influence real income growth and real interest rates, they are likely to have a substantial effect on the duration of housing market contractions. However, the existence of significant positive duration dependence in expansion phases probably means that there are other factors such as speculation, overbuilding and surplus inventories that drive the transition of housing markets out of expansion and into contraction.

Furthermore, the duration dependence result in expansion cycles could also prove to be a useful tool for policy makers simply because it may help predict housing market turning points. So, while rising incomes and lower interest rates almost certainly played a role in the continuation of the long housing expansion that most cities in the U.S. and Canada recently experienced, these factors alone cannot fully explain its extraordinary duration."

Another interesting piece of research I read recently is by John Burns Consulting.

Yet another interesting piece of research by Robert Shiller. He examines historical house price booms and their turning points.

Have a look and let us know what you think.

12 comments:

mohican said...

From the Shiller piece:

"Analysis of past booms seems to indicate that investors in both the stock market and the housing market seem often not to understand the supply response to price increases. These are normal intelligent people, why would they repeatedly make the same mistake again and again? There seems to be what I will call a uniqueness bias, a tendency for investors to overestimate how unique an investment they favor is, failing to take account of the inevitable supply response to high prices. The uniqueness bias is reflected
in quite a number of anomalies of human judgment that psychologists have documented, including the “representativeness heuristic,” “overconfidence,” “wishful-thinking bias,” “spotlight effect” and “self-esteem bias.”

This describes the market in Vancouver to a tee!

HADENOUGH said...

Also Victoria. Clearly these are the two cities in Canada that are most certainly in a bubble. And others of course.

My RE agent in Toronto is certain the market is going to collapse or correct there. She has been in the business a very long time. She is not trying to sell us anything as wel don't live there anymore.

freako said...

"Real estate prices are more volatile in Canada (this is a little surprising)"

I'd expect are economy as a whole to be more volatile because we are less diversified than the U.S. I'd also expect our housing prices to follow suit.

I'd also expect price volatility to be extreme where local business climate diverges from interest rate policy. For example, if our resources are doing well while eastern manufacturing is floundering, we will get low rates in a hot economy. And vice versa. That doesn't explain national aggregate volatility, but definitely the regionals.

"Analysis of past booms seems to indicate that investors in both the stock market and the housing market seem often not to understand the supply response to price increases. "

Amen to that. Furthermore, buyers/investors fail to understand the fickle nature of the DEMAND response to rising prices. Borrowed time.

freako said...

OT The Victoria numbers are in, and they are up, up and away. Having similar incomes, they are not up against the affordability wall the way we are, but I think that they are probably more overvalued than Vancouver. It is notable that sales were higher than last year.

What does this foretell for GV?

aetakeo said...

More from Shiller:
"The uniqueness bias has its effect in the housing market when people imagine that the city they live in is unusually attractive, and increasingly so. They fail to understand that new such cities can be constructed in what are today cornfields or forests. In their
1990 paper, “The Baby Boom, The Baby Bust and the Housing Market,” N. Gregory Mankiw and David Weil argued that the housing market would soon crash as the baby
boomers retired, neglecting to consider how supply would adjust to any such change in demand."

Oh my! Someone speaking sense!

aetakeo said...

Also interesting from Shiller - he's saying that in the last boom, there was a 3 year time-spread from east coast to west coast. The east coast soared and dipped earlier. That seems to be playing out again.

RentingSucks said...

"...argued that the housing market would soon crash as the baby
boomers retired, neglecting to consider how supply would adjust to any such change in demand."


There's still at least 10 years I think before the boomers start retiring in droves. Also with health advances it might be possible that they will stay in there own homes longer than previous generations.

So this isn't much help if your in your late 30's. Not too bad news if you are in your late 20's. Bad news for someone who bought during this boom and are counting on their house for retirement.

JMK said...

The uniqueness bias has its effect in the housing market when people imagine that the city they live in is unusually attractive, and increasingly so. They fail to understand that new such cities can be constructed in what are today cornfields or forests.

This is great! Does anyone have any suggestions which cornfield or forest on the NA west coast will host the next San Francisco or Vancouver? I'd like to buy in early...

freako said...

"This is great! Does anyone have any suggestions which cornfield or forest on the NA west coast will host the next San Francisco or Vancouver?"

You are absolutely right. Forest on the West Coast? Not a tree in sight.

aetakeo said...

freako, I thought of you while reading the Shiller piece, because he says that it appears housing hasn't been following a random walk. You might be interested - and derive more - from the whole thing than I did.

jesse said...

" The east coast soared and dipped earlier. That seems to be playing out again."

Actually, according to the article the maximum price drops occurred at the same time on the east and west coasts during the previous RE downturn in the early '90s. Don't know if that meant prices on east coast stagnated then fell fast or deflated slowly. Either way the west coast exhibited a more violent downturn.

jesse said...

"Real estate prices are more volatile in Canada"

The nature of the dependancy of resources makes the Canadian market more volatile which would in part explain higher volatility in house prices.

Another possible source is some structural differences in the market. Foreclosure proceedings are faster in Canada. Also lowball prices in the US are uncommon (people typically pay sticker price or more) and that could lead to more stickiness Stateside on the way down, at least at first.

In the end, if you can't make your payments it doesn't matter on what side of the border you live. It will be interesting to see what "maximum price declines" coincide this time around.