Fun With Predictors

Here is a fun predictor I use to guess near-term (i.e. 4-6 months out) price movements on the Teranet HPI. The model works by finding peak correlation between price changes and months-of-inventory, the best is shown below:

I then use a simple regression fit (I'm ignoring log fit for now) and play around with the regression window length and get minimized error post-2009 with an 8-month window. Since peak cross correlation is shifted we have the ability to "predict" price changes some time into the future, in this case 3 months ahead:

This is then translated onto a year-on-year prediction:

On the graph above I get an estimate of close to -5.5% YOY change in the March Teranet HPI. I have been calling for between -6% and -4% on the Teranet HPI in February-March of 2013.

Predicting Prices in Vancouver

Below is an overview of an analytical method used to predict Vancouver prices. I have been predicting price changes on a short-term basis (looking out a few months) and this is not done through pie-in-the-sky guesswork, this is based on a defined set of steps and calculations.

Housing-analysis blog creater and owner, and financial planner, "mohican" noticed back in 2007 there was a (negative) correlation between so-called "months of inventory" (MOI), the ratio of reported for-sale inventory to monthly sales, to price changes. MOI tells us how long it will take to clear inventory at current sales rates. Other equivalent measures you may hear are months of supply, sell-list ratio (the inverse of MOI), and months to clear. This blog refers to MOI, and data can be found on REBGV news releases. (Note that Fraser Valley real estate board also published similar stats, and the correlation is good there as well; this analysis is only for REBGV data.)

Price changes are measured using the Teranet HPI, however similar correlations to MOI exist with the MLS-HPI and to a lesser extent median price changes. In order to account for month-month sales noise MOI is averaged over three months. I only have complete monthly inventory data for REBGV to 2005. There are likely data before this but I do not have access to them.

Two further innovations come by first recognizing that correlation changes depending upon the period over which price changes are measured. For example the correlation to quarter-on-quarter price changes is better than month-on-month price changes. Second the correlation becomes better if we time-shift the data (i.e. cross-correlate).

Below is a graph of the cross-correlations between price changes over different intervals and 3-month-moving-average MOI:

What this shows is that the highest correlation exists when correlating half-on-half price changes with a 3 month delay. The scatterplot showing this relationship is below:

Note MOI is displayed on as logarithmic scale. Other correlations are not as good but still not bad. Looking at year-on-year and quarter-on-quarter, both appropriately time-shifted, show the relationship is not as high but still obvious:

The most recent price weakness is shown on the QOQ graph above, indeed 2012 is behaving as previous years.

An important, and powerful, note on these graphs is that because of the time-shifted peak correlation, only MOI numbers from the past are displayed. For example the HOH graph only displays MOI to 3 months ago, the YOY graph only displays MOI to 6 months ago, and the QOQ graph only displays MOI to last month. That means that if we know MOI today (and we do thanks to Realtor Paul Boenisch posting daily sales, listings, and inventory on vancouvercondo.info)  we can use this model to predict prices some months out.

Take the HOH graph above and apply current 3 month average MOI (about 10) to the graph. That implies that we should be seeing a -5% half-on-half change in the Teranet HPI 3 months from now, in January 2013. A weaker measure is to use the YOY graph and forecast prices 6 months from now; based on that measure we should see the Teranet HPI down -4% to -6% year-on-year in April 2013.

In summary a method of forecasting Teranet HPI for Vancouver has been presented. By finding peak negative cross-correlation between months of inventory and price changes over defined periods it is possible to calculate predictions with varying degrees of strength. Further work expanding this method into other cities is possible.

Price to Rent Ratios for Vancouver

I have been loath to publish price-rent ratios for Vancouver, even though I think it's one of the primary methods by which prices are set in the long run. I went over the issues with price-rent ratios here. For a backgrounder on why this is important, read Calculated Risk's posts (like this one) and refer to the Federal Reserve Bank of San Francisco's letter from 2004 on the subject.

When looking at an area like Vancouver with increasing density one must be careful using detached dwellings when formulating price-rent ratios as the earnings are forecast to increase greater than rental inflation into the future and would carry a higher price-rent ratio. The best gauge we have for a time-insensitive price-rent ratio is by using apartment rents and prices, that is, properties that have undergone most of their density increases.

Below is Greater Vancouver's apartment price-rent ratio, measured by using the MLS-HPI for apartments and the CMHC-surveyed one bedroom apartment rents, then normalizing them to a point in time.

As of December 2011 the price-rent ratio was 100% above the nadir in 2000 and 66% above the upper level of the price-rent band going back to at least 1991 (and likely longer).

As moderate stress test we can assume that the price-rent ratio will revert to at least within its historical band of 100-120 (on the graph above) in 5 years. For different rental inflation numbers the annual nominal price drops, from December 2011, required are:

• -8.5% per annum (cumulative -35.8%) for rental growth of 1% per annum
• -7.6% per annum (cumulative -32.6%) for rental growth of 2% per annum
• -6.7% per annum (cumulative -29.2%) for rental growth of 3% per annum

For reversion to the middle of the 100-120 historical band:

• -10.1% per annum (cumulative -41.2%) for rental growth of 1% per annum
• -9.2% per annum (cumulative -38.2%) for rental growth of 2% per annum
• -8.3% per annum (cumulative -35.1%) for rental growth of 3% per annum

For reversion to the bottom of the 100-120 band:

• -11.8% per annum (cumulative -46.5%) for rental growth of 1% per annum
• -10.9% per annum (cumulative -43.8%) for rental growth of 2% per annum
• -10.0% per annum (cumulative -41.0%) for rental growth of 3% per annum

The US's experience found that most price drops occurred within several years followed by a more prolonged (and still ongoing) period of flat prices and at-inflation rental growth to fully revert price-rent ratios back to their norms.

If one believes the sanctity of price-rent ratios, those are a lot of scary negative numbers.

Teranet House Price Index and Inventory

Long-time Vancouver real estate blog readers will remember the work mohican did regarding scatter plotting months of inventory (MOI, defined as month-end for-sale inventory divided by sales of that month) with price changes. Price changes have been based on the REBGV detached benchmark, alas the benchmark was revised and historical data are not available. Nonetheless the ever-resilient Vancouver Housing Blogger (VHB) has attempted to stitch together a longer-term MLS HPI and the results can be seen here.

After a bit of refinement it's been possible to improve the price-change-to-MOI fit by looking at price changes over different periods and leading or lagging the datasets. Using Teranet, not MLS-HPI data, I have found the best fit to be as follows:

The best fit is looking at 6 month price changes, delayed by 3 months, and plotting against 3 month moving-average of REBGV months of inventory (MOI). I have plotted above on semilog only to show the effect has a geometric component. Nonetheless a linear correlation is about -0.9, or in statistical lexicon, not bad.

I would take away the following things from this graph, (and I will have much more over the coming months as monthly data become available):

• Teranet data lags months of inventory. This is for a few reasons, first that Teranet uses data based on closed transactions where MLS uses data timed on subject removals, which can be several months in advance of the closing date. Second Teranet uses some averaging to produce a more statistically significant dataset but results in a lag in reporting the data.
• Price changes have a seasonal component. Prices are usually firmer in the spring and weaker in the fall and this is part of the reason why 6 month price change correlations protrude from the data field.
• Most intriguing, and astute readers will have already figured this out, is that there is a strong predictor of the expected Teranet HPI several months in advance of it being reported, based solely on 3 month moving average MOI data.
• We have a strong indication of MOI about halfway through a month. That is, we need not wait for the REBGV reported month-end data -- with daily numbers being reported by Paul Boenisch and Larry Yatkowski we get a sneak-peak at the likely MOI value. Also check the comment section of vancouvercondo.info for some more analytical predictions of month-end inventory and sales.
• This graph validates that an MOI above 7 means prices are going to drop. Current MOI is approaching 10.

I'll have some more fun graphs in the months ahead.

Mortgage Rules Changing and Timing

News abounds of the impending changes to maximum amortization lengths for government-underwritten mortgage insurance. This announcement follows the general form of previous announcements affecting CMHC, "strengthening" the housing market, and comments by Minister of Finance Jim Flaherty on concerns particularly about overbuilding in Toronto.

What's different this time is the implementation period is, in business terms, immediate: only 13 days to complete a transaction and fill out an application for mortgage insurance under the old guidelines. This was in an effort to avoid the surge in activity witnessed last year when the rules were changed with 60 day notice. To recap the changes to all mortgages that are eligible for government-underwritten mortgage insurance are as follows:

• Maximum amortization falls from 30 years to 25 years
• Lower the maximum amount Canadians can borrow when refinancing to 80 per cent from 85 per cent of the value of their homes
• Fix the maximum gross debt service ratio at 39 per cent and the maximum total debt service ratio at 44 per cent
• Limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.

Certainly none of these moves can be considered stimulative for housing, and in total impact it's around 10% less total debt that can be withdrawn based on the 30-25 year move, even more for top-prime borrowers, and completely snuffed for loans above $1MM, though it's unclear how many loans are insured above this level. There has been some good commentary on the moves and the implications in the short term.

What I wanted to concentrate on are two things, first the implications at the high end of the market in the event of a significant bout of weakness, (houses in higher-end areas of Vancouver are seeing months of inventory well above 10, which all but guarantees subsequent price drops) second the timing of the announcement.

1) If prices do become weak, many borrowers will find their equity has been compromised and banks, due to upcoming guideline changes to how it must account for mortgages, will be loath to carry these loans and require mortgage insurance as a hedge. If the property is valued above $1MM that leaves fewer options for the borrower and rates will increase, in some cases significantly. It's hard to tell by how much, but if current weakness extends through the remainder of the year -- which is no sure thing -- the high end of the market will suffer from another solid blow to the midsection.

2) The timing of this announcement caught me off-guard. It was issued subsequent to the G20 meeting in Mexico and at a time where rumours of a renewed bout of stimuli and recapitalizations occurring in the Eurozone, the United States, and China. My guess is that discussions regarding coordinated and large stimulus efforts were discussed at this meeting, ahead of the EU summit occurring this weekend. If a renewed bout of stimulus is put forward, this can flow, and in the past has flowed, into speculative assets, further deteriorating earnings ratios. The changes to CMHC's rules, designed to dam against further increasing household debt, by themselves could destroy a housing market in the face of slowing jobs and wage growth in the normally slower second half of the year for housing transactions. But if paired with a significant global stimulus, the effects may be muted.

(It may also be that this was the last opportunity for the Department of Finance to shoot off a policy directive before the vacation season kicks off, so the timing may be one of practicality more than any global machinations.)

The changes directed at the high-end and high-quality borrowers are interesting in the context of a potential renewed bout of global stimulus coupled with what looks like an unsustainable investment boom in other parts of the world, particularly China. Given the Bank of Canada has hinted in the past about the relatively high level of foreign investment in Canada's property markets, I wouldn't be surprised if they are attempting to both divert capital inflows and ensure another foray of borrowing by Canadian residents is impossible.

Vancouver Teranet HPI Trendline Analysis

The Teranet House Price Index provides a reasonable indication of market movements by tracking same property sales pairs, a technique first used by Case and Shiller formulating an index for US residential housing markets. I have plotted the Teranet HPI for Vancouver below and included four appreciation scenarios as follows:

• "New Normal" - prices of the last 8 years are indicative of future gains. This is about 9% per annum.
• "Trendline" - Appreciation follows a trendline based on data from 1990 to current (5.27% pa)
• "Old Normal" - prices from about 2004 are considered extraneous and past trends from 1990 to 2003 are used to determine long-term growth trajectory. (3.0% pa based on trendline 1990-2004 inclusive)
• "Old Normal Bottom" - same as "Old Normal" but shifting the trend to be based on price troughs and not middle. This would be the "bearish" scenario.

The results can be summarised, for what they are worth, as follows, assuming one purchases a $500,000 property at today's prices (170), looking at scenarios in 2015 and 2020 where prices re-align with the respective trendlines

• "New Normal" price will appreciate to $670,000 (10.6% CAGR) in 2015 and $1,030,000 (9.5%) in 2020
• "Trendline" price will appreciate to $508,000 (0.9%) in 2015 and $655,000 (3.6%) in 2020
• "Old Normal" price will depreciate to $341,000 (-11.7%) in 2015 and $394,000 (-2.8%) in 2020
• "Old Normal Bottom" price will depreciate to $302,000 (-15.0%) in 2015 and $350,000 (-4.2%) in 2020

If one believes the long-term appreciation in Vancouver real estate looking at the trendline from the past 20 years, there should be no rush to buy in the next few years. If one believes the last decade was one that mirrored experience in the US, where prices have reverted in real terms to those of the mid-1990s, this is not what I would characterise as a good time for purchasing residential real estate in Vancouver.

Canada and Fiscal Stimulus Update November 2011

Back in a post in September I remarked it was relatively obvious that Europe was going to head into recession and that the Government of Canada was less likely to meet its "balanced budget in 2014" pledge; now Mark Carney is calling for a near certainty of a Eurozone recession and it looks like Canada will suffer lower GDP growth as a result. Recall my predictions of potential areas of stimulus should Canadian GDP growth falter:

Highly probable

• Accelerating capital cost allowance for businesses

• Slowing of public sector layoffs

• Lower corporate taxes

• Employment insurance hiring incentives

• R&D tax credits

• Extending employment insurance benefits

• Targeted but piecemeal government spending programs, geared towards non-residential infrastructure.

Somewhat probable

• A second "Canadian Action Plan"

• Energy efficiency upgrades

• Reducing Bank of Canada's overnight lending rate

Unlikely

• Reducing CMHC requirements for loans

Now today a fiscal update from the Department of Finance indicates more stimulus will be needed:

Flaherty also announced Tuesday the government is extending a work-sharing program that lets some employers hang onto skilled workers while they deal with money problems. Under the program, workers can drop to part-time hours and the government will top them up with Employment Insurance... 

Flaherty also cut in half the increase in EI premiums employees and employers are expected to pay starting Jan. 1, 2012. 

EI premiums were set to increase in the new year by up to 10 cents per $100 for employees and 14 cents per $100 for employers. Those increases will now be capped at five cents and seven cents respectively...

Border and trade talks with the U.S. will mean more spending on border infrastructure, Flaherty said after the speech.

So we have: corporate tax reductions (in the form of slowing EI premium increases), extending EI benefits, and non-residential infrastructure spending.

Though it would be unlikely to be announced, I expect there will be a slowing of public sector layoffs going forward. I'll have to wait until the new year to find out for sure about the R&D tax credit and grant prediction but I expect it won't be cut. I'm not sure about the CCA acceleration.

So far no major surprises. I am also anticipating that there may be further mortgage credit tightening announced in January, though I'm not certain if mortgage insurance will be the mode by which the government acts. Speculation has spread to the low-ratio loan market and, ultimately, the Government of Canada will be on the hook for many of these loans should prices retrench -- banks may not be aligning borrowers' ability to pay with longer-term rates in mind. Further curbs to mortgage lending may show up behind-the-scenes through OSFI decrees.

Canada and Fiscal Stimulus Round 2 Fight!

Mark Carney is in Washington this week trying to convince 17 Europeans to agree. He was generous to take 20 minutes of his time to talk to The House's Evan Solomon on Europe's sovereign and banking debt crisis. Europe's woes are interesting -- Carney understands that to keep Greece and other countries a part of the common currency there will need to be large fiscal transfers to enable smooth transitions of these economies to lower their wages until they are competitive again. The more interesting part for Canada's housing market is Carney's comments (or lack of comments) on what Canada's government and central bank will do in case of a European-centred credit crunch giving the rest of the world a cold.

I'll summarise Carney's comments on how Canada will react to a potential impending global downturn (feel free to listen; unfortunately I don't have time to transcribe the most interesting bits):

• Canada's banking system will remain solvent one way or another.
• The US and Europe look to be undergoing slow growth for some years to come.
• Canada's businesses have been investing in capital equipment and need to continue to invest, making up for a chronic productivity gap with other countries.
• Canada needs to start selling and investing in ventures in the developing world.
• Elements of the massive fiscal stimulus unleashed in 2008 and 2009 can be retooled for 2011-2012, however many of the measures were less "effective" than desired [By less effective not sure if he means with undesirable side effects].

What Carney didn't say:

• Household debt issues were not discussed or alluded to.

Even with a massive fiscal stimulus emanating from Europe, which is looking unlikely, we should fully expect another round of fiscal stimulus to aid the Canadian economy. Given Carney's comments over the past year on: high household debt levels , robust house prices and sales despite tightened credit conditions, plum corporate balance sheets, and his relative silence on government fiscal spending, I will formulate some guesses on what fiscal and monetary stimulus will be concentrated on:

Highly probable

• Accelerating capital cost allowance for businesses
• Slowing of public sector layoffs
• Lower corporate taxes
• Employment insurance hiring incentives
• R&D tax credits
• Extending employment insurance benefits
• Targeted but piecemeal government spending programs, geared towards non-residential infrastructure.

Somewhat probable

• A second "Canadian Action Plan"
• Energy efficiency upgrades
• Reducing Bank of Canada's overnight lending rate

Unlikely

• Reducing CMHC requirements for loans

When a stimulus of the magnitudes required to stave longer lasting effects of a second recession, my feeling is the government is aware that increasing household leverage risks tipping households into an unsustainable debt spiral similar to what Ireland experienced a few years ago. This does not mean Canada is the next Ireland or Spain but the effects of overleveraged households should be obvious to anyone who has read the literature on these countries' housing busts. It may even be the case that if a stimulus is unleashed that commensurate crimps on residential investment will be required to ensure investment money flows are properly targeted away from the overbought housing market, and instead concentrating more on consumption with broader wage growth.

In summary, I expect the chances of a second fiscal stimulus package from the federal government are high, and we should expect that household borrowing will be carefully watched -- even regimented -- to ensure their debt-to-income ratios are not increased further. This will likely mean higher federal deficits in the next one to two years, and a probability the government misses its "balanced budget in 2014" pledge.

Danielle Park on Canadian Housing

Danielle Park gives an interview on howestreet.com on the Canadian housing market.

You can listen to the 16 minute interview here.

Hoorah for 2008 and Predictions for 2009

2008 in Review

2008 was the year that the entire world woke up to the fact that houses don't go up in value forever and the entire mess of a year that 2008 was can be summarized in that fact.  Stock, bond, and commodity markets all reacted to the spectre of a long and protracted recession with no quick turnaround in sight.  It is truly amazing to see how consumption and borrowing against the value of a home had an impact at inflating the US and Canadian economies.

Locally, house prices fell dramatically starting in May and benchmark prices are now down nearly 14% in the REBGV area and just over 9% in the FVREB area.  The pundits are still calling for a spring turnaround and many real estate agents will likely be disappointed with their incomes during 2009.  They had better learn how to get sellers to drop the price fast or no paycheques will be forthcoming in 2009.  I fully expect that many real estate agents and mortgage brokers will try to find other work during 2009.

Prediction Time

I was 2 for 3 on my predictions for 2008 but I missed a big one as I didn't see how bad the stock, bond, and commodity markets would turn out.  

Predictions make fools of us all unless we are lucky enough to guess correctly.  Sometimes an educated guess is better than nothing however and it is kind of fun to toss around what we think is coming during the next year.

Here are my thoughts:

1) Real estate prices in the Metro Vancouver area will fall by 20% or more during 2009 from current levels.  The fall in prices will be worst for apartments and will be best for moderately priced suburban detached homes.

2) BC will enter recession sometime in 2009.  Canada and the US will continue in their recessions throughout most, if not all of 2009.

3) The Vancouver construction industry will be decimated during 2009 with many more projects hitting the completion phase and the need for labour dries up.  See historical employement statistics here.  The Metro Vancouver area will probably see a loss of 50,000+ jobs in 2009 from the construction, retail, finance, and real estate professions.

Ratio of Owners to Renters

I was thinking about the state of the current real estate market in Greater Vancouver and I was wondering where future buyers of real estate are going to come from given the abysmally low current sales levels and the atrociously high prices. Who can afford to buy and how big is that pool of buyers compared to the population.

I had a look at the historic census data on home ownership versus renters in 1991, 1996, 2001, and 2006 and this is what I found. CMA = Census Metro Area.

In 1991, there were 588,590 occupied dwellings in the Vancouver CMA. 334,420 (57%) were owner occupied. 254,170 (43%) were rented.

In 1996, there were 692,720 occupied dwellings in the Vancouver CMA. 411,400 (59%) were owner occupied. 281,320 (41%) were rented.

In 2001, there were 758,390 occupied dwellings in the Vancouver CMA. 462,645 (61%) were owner occupied. 295,745 (39%) were rented.

In 2006, there were 816,770 occupied dwellings in the Vancouver CMA. 531,725 (65%) were owner occupied. 285,045 (35%) were rented.

We can safely assume that the owner occupied percentage has not fallen from the 2006 level. The current housing bubble was born out of a natural predilection towards home ownership and demographic trends, developed rapidly via low interest rates, and grew into a fat, disgusting beast via irrational ownership psychology and greater fool mentality. It is now time to pay for these excesses. Some of the excesses were part of the natural cycle but the bubble developed out of the unnaturally low interest rate environment and the bubble mentality

Given the above data, I just don't see any turnaround soon. Most of the potential buyers are gone. There are no more greater fools. The supply of homes for sale continues to build but there are very few willing buyers at todays prices. I expect that some renters may be convinced to buy if prices came in line with rents but this pool of buyers has shrunk over the past 20 years so there is little opportunity. Add to this the fact that many baby boomers will be looking to downsize from their large suburban homes into smaller dwellings over the next 10 - 15 years and you have a recipe for a very long and deep correction in housing.

Statistics from here. http://www.metrovancouver.org/about/statistics/Pages/KeyFacts.aspx

Monthly Speculation

Well, it is the end of July and the Vancouver area real estate market ain't so hot anymore. We've got over 20,000 homes listed for sale in the REBGV area, over 11,000 for sale in the FVREB area, and yet another 1,100 homes for sale in the CADREB (Upper Fraser Valley) area. This brings the grand total of listings to well over 32,500 and sales so far down the toilet that it's nearly unbelievable. This brings our total months of inventory for the entire region to over 9 months and we are at a listings per person ratio in excess of 1 listing for every 75 residents of the area. Population stats here: GVRD, FVRD.

This means that our current inventory levels are higher than the bubbliest of bubbly US markets and sales still have further to fall which is going to put even more pressure on prices. I fully expect Months of Inventory to be well above 10 by September / October and even higher in the wintertime. The pressure for price declines will be enormous as some sellers will need to sell and they'll have to cut their price dramatically in order to do so.

We've discussed price changes before and the relationship between price changes and the supply / demand function (Months of Inventory). Given that relationship, if April was the official top of the market for prices, July should prove to be the month that the market turned sharply negative in terms of price changes.

My personal speculation is that benchmark prices will likely be down 2.5% give or take 1%. What's your thoughts?

CANADA’S HOUSING BOOM COMES TO AN END - TD Economics

Under the category of "Well No Sh*t Sherlock." Comment in italics are mine.

CANADA’S HOUSING BOOM COMES TO AN END
June 26, 2008

Over the past couple of years, TD Economics has repeatedly forecast that Canada’s major real estate markets would experience a significant cooling. In fact, housing remained stronger for longer than we had anticipated, largely due to increased affordability through new financing options, such as no money down or extended amortizations. Regional economic strength related to the commodity boom also helped to fuel unsustainably elevated home price growth in the west. Nevertheless, our last Special Report on Canada’s housing market, Canada’s Red Hot Real Estate Markets to Cool (April 10, 2008), stressed that there would be a significant adjustment in real estate activity in 2008-09, with national average home price growth slowing sharply from the 11% posted in 2007 to a low single digit pace. There is now clear evidence that this slowdown has taken hold. The year-over-year price growth for existing homes in Canada’s major markets fell to only 1.1% in May, down from 8.6% just four months earlier. The trend has been broadly based, but it has been particularly sharp in some of the markets that had experienced the most dramatic price growth. Calgary and Edmonton home prices in April and May fell to below year-earlier levels. The combination of significantly higher listings, reflecting the desire of homeowners to take advantage of the past increase in prices, and weaker demand, due to the past erosion in affordability, are leading to declining sales and softer price performance across the country, but particularly in the west.

The key question is how far the recent trends will extend and whether Canada will experience a broad based housing correction. In our opinion, sales are likely to continue to decline in the coming quarters and price growth will slip to 2% on a national average basis in 2008 and rise only to 3.5% in 2009. However, this national average will mask very different regional price trends. Most markets will see low to mid single-digit gains, but Saskatchewan and Manitoba will continue to post double-digit gains in the near term followed by a significant cooling in 2009 – with the risk of a mild price correction in the major cities that have recently experienced extraordinary price growth. Alberta will have further weakness in the near term, as Calgary and Edmonton will likely see prices continue to fall for another 3 or 4 quarters, dropping 8% to 10% from their peak, after which prices should stabilize and start rising at a low single-digit pace. Aren't we already down that far?

Cashing in, not foreclosing

From an economic perspective, the recent behaviour of Canada’s real estate markets and the outlook for 2008/09 can be best explained in terms of the trends in supply and demand – the interaction between which determines prices. Wow, I could be a bank economist too!

On the supply side, past price performance has strongly encouraged additional supply in both the new and existing home markets. Housing starts averaged a strong 234,000 units in the first quarter. While we expect new home construction activity to remain robust, starts should gradually edge down to a lower level of around 200,000 units over the course of the next 18 months.

We had anticipated an increase in new listings as a result of solid price gains in the last couple of years, but the recent surge in new listings has been far greater than anticipated. The jump in supply of homes for sale is assuredly an attempt to take advantage of the past home price appreciation on the part of homeowners and real estate investors.

It should be stressed that the rise in listings does not reflect homeowners of principal dwellings desperate to sell, and this is the dominant difference between the Canadian and U.S. experience. Indeed, the U.S. has been characterized by an abnormal rise in delinquencies and foreclosures or large negative equity positions. In Canada, speculators may be quickly dumping properties on the market to get out while the times are good, but individuals that have a principal dwelling are not under financial duress. This distinction is crucial to evaluating the impact of weaker home price performance on personal wealth and consumption. Canadian consumers are also nowhere nearly as leveraged through their home equity as American consumers are. Except in Vancouver where people are overleveraged to the max.

A few more important distinctions also bear noting as the U.S. housing bust struggles to find a bottom, which naturally arouses fears that a similar unwinding could take place in Canada.
First off, many of the seeds that sowed the current U.S. housing bust were never planted in Canada. Interest rates and mortgage rates were significantly lower for significantly longer in the U.S., especially in the case of adjustable-rate mortgages (ARMs) with low initial teaser rates. The bulk of surging delinquencies on mortgage loans occurs precisely when the rate adjusts to a higher level. ARMs never took hold in Canada. No spike in mortgage payments means no spike in delinquencies. As economic conditions will be weaker over the forecast horizon than they were in 2007 and mortgage rates likely modestly higher, delinquencies in Canada will only rise to reflect domestic economic conditions. A surge to high levels is nowhere on the horizon.
Furthermore, it wasn’t just that borrowing costs were lower in the U.S. than in Canada. Overall lending conditions in the U.S. had eased to the point of becoming much too lax, introducing a systemic default risk, which is now a reality. Subprime mortgages were a significant chunk of originations in 2006-07. Not so in Canada, where they peaked at 5% in 2006 before vanishing. In the U.S., the additional supply of homes for sale as a result of ‘involuntary’ listings and / or foreclosures more often than not reflect desperate households trying to minimize their loss. In Canada, voluntary sellers are trying to maximize their capital gains. The difference is far from trivial.

It is also telling that the run-up in prices in the U.S. was, for many large markets, not supported by economic fundamentals. As per Nevada, Arizona, California, and Florida, it seemed to be driven much more by speculative activity. In Canada, markets whose economies have been booming are those whose housing markets caught fire. Witness the experience of Calgary, then Edmonton, and now Regina and Saskatoon. No mention of Vancouver - but why? Could it be because we have excessive speculative activity? Valuations in these markets also started below national levels and arguably had some catching up to do, contrary to the hottest U.S. markets during the run-up which were already higher than the U.S. average. This is unlike Vancouver where we've seen already high house prices rise to levels that are completely detached from rents, incomes or anything remotely resembling a fundamental level.

Finally, financing and economic conditions are largely more supportive of local demand in Canada. Lending has not tightened nearly as much as it has in the U.S. And, as noted above, lending never became as lax. For example, the vast majority of mortgage applicants in Canada were income-tested on the basis of the 3-year or 5-year posted rates; whereas in the U.S. it was common to either dispense with income testing or test on the basis of the low introductory teaser rate. Furthermore, the credit crunch has hit U.S. lenders’ balance sheets harder. The bulk of mortgage origination in Canada is sourced at well capitalized financial institutions. Homes currently being listed in Canada, if priced reasonably, will find buyers who can finance their purchase. In the U.S., despite much lower prices, financing is often hard to obtain, even for credit-worthy potential buyers. The recent Federal Reserve cuts to the policy rate by a full 3¼ percentage points have had little traction into relief on mortgage rates. Clearing the large inventory overhang is all that more difficult in such circumstances that are simply not present in Canada.

The main conclusion is that there has been an increase in supply (i.e. new listings and new home construction) in Canada . That will act to dampen home price appreciation and create a pullback in prices in selected cities where markets went too far, too fast. However, the increase in supply in Canada will pale in comparison to the dramatic surge experienced in the U.S. that caused the worst American housing correction since the Great Depression.

Decaffeinated sales

On the demand front, the dominant theme is that the past price appreciation in Canada has eroded affordability, reducing demand for new and existing homes. Nowhere is this truer than in Alberta and British Columbia. National sales did remain elevated for longer than expected, but are now pulling back more sharply than even our spring forecast due to reduced affordability and greater supply. The year-to-date (as of May data) percentage drop in sales for Canada’s major markets seems dramatic at -12.5%, but sales are in fact simply returning to the solid levels typically experienced in the three years (2004-06) prior the 2007 sales boom. (See sales charts for some major markets at the end of this report.)

Just as Calgary and Edmonton led the way up in sales growth, they are now leading the way down. Home sales in these two cities were down 34% and 30%, respectively, year-to-date as of May. However, Edmonton resale activity is tracking close to 2005 levels, while sales in Calgary are faring worse and look likely to revert back to 2004 levels, near 26,000 units. Our base-case scenario for Alberta home sales for the remainder of 2008 builds in an even greater decline in sales in the near term before levelling off late in the year for a net annual sales drop of 40%. As a result, after two years of percolating over 70,000 units sold, Alberta is more likely to record sales volumes in the 40,000-50,000 unit range this year and next.

The return to norm in resale activity is not confined to Alberta, and nor did we expect it to be. Our April forecast had sales declines for all provinces, except three (Saskatchewan, Manitoba, and Newfoundland & Labrador) that represent only 5% of the national total sales. Only Manitoba is disappointing our April forecast. Sales in Winnipeg are down by an unexpected 3.5% year-to-date, implying a likely sales decline of about 4% in Manitoba in 2008 – but this is only a shift from marginal sales growth to a marginal sales drop.

Sales are also weaker in other parts of the country, with British Columbia and Ontario sales down by more than 10%. Softer demand is therefore not an Alberta-specific theme. While affordability had not eroded to the same degree in other markets, it also had not improved for most markets, on a quarterly basis, since late 2006. Affordability remains at challenging levels for many potential buyers in Vancouver specifically, but also Toronto. Resale activity in Vancouver is tracking significantly below last year’s levels and we expect sales for 2008 as a whole to end up almost 20% lower than 2007. Toronto is expected to experience 10% lower sales.

Affordability to improve

Based on our assessments of supply and demand, what are the prospects for the next 6-12 months? Over this time span, both sides of the market are unambiguously pointing to softer price growth in most major markets. Just how soft, is a matter of location. For Canada as whole, we expect existing homes to appreciate by only 2% this year, a downward revision from our last forecast of 6%. Slower price growth – or declines in certain cities – but still solid underlying economic fundamentals will lead to an improvement in affordability. However, the relatively high prices in many markets will remain a key factor crimping demand.

Looking beyond the next 12 months, as affordability improves in some markets or stabilizes in others, and demand slowly absorbs homes being listed, we expect demand to start pulling prices forward at a slightly quicker pace in the second half of 2009. However, because the current rebalancing has abruptly shifted conditions from seller’s market territory to balanced market conditions in many cities, the price weakness will probably extend into next year. As a result, while prices will improve in 2009, the annual average resale price growth will still be modest at around 3.5%. I don't see prices going up as an 'improvement' - how does that help my family's financial situation exactly?

Turning to a regional perspective, Saskatchewan’s major markets offer an exception to the cooling trend on an annual basis, but this is mostly a question of timing. The price surge above 30% growth came late last year and much of that momentum is being carried into this year. But if Regina and Saskatoon follow the path just recently threaded by Calgary and later Edmonton – and we think they will – Saskatchewan’s price growth will have come back down to earth by early next year. We are looking for 2-3% price growth in 2009, with a risk of a mild price correction.

On the flip side, every other province, except Newfoundland & Labrador, and most notably the four largest provinces in the country, will experience significantly weaker home appreciation this year compared to last. Alberta will most likely experience a slight depreciation of 1-2% in home values on an annual basis. This correction will be concentrated in its largest urban markets of Calgary and Edmonton, where prices are expected to fall by 2-3%, with the rest of the province faring better. After stunning cumulative price gains of 45-65% in the last two years in those markets, our base-case forecast builds in a peak-to-trough correction of 8-10%. Our expectation is that monthly data will show year-over-year price declines for another 2-3 quarters of data (the typical duration of home price corrections in Canada), out to the first quarter of 2009. Alberta prices should then start growing again, albeit modestly at 1-2%, on a year-over-year basis. So TD Economics is basically forecasting home price declines in inflation adjusted dollars for quite some time.

Affordability has been a key issue in Canada’s most expensive market, Vancouver. Outside Alberta, where sales are down about 30% year-to-date, British Columbia is experiencing the largest percentage drop in sales year-to-date at close to 15%. This is not surprising given how strong sales (over 35,000 units) had been over the last six years. Vancouver has recorded a surge in listings since March, enough to bring the supply/demand relationship into balanced territory. Vancouver had not been balanced, by this measure, since late 2000. We therefore expect price growth to be subdued in the next 12-18 months. As a result of higher-than-expected listings, we now forecast 5% home price growth for the province as a whole this year (down from our spring forecast of 9%) and a similar outing next year – both a far cry from the 15% annual average home appreciation recorded over the last 3 years. We'll see how that works out!

Ontario and Québec homes have appreciated at a steady 6-7% rate over the last three years. Both provinces are expected to record only about half as much (3-4%) home price growth over the forecast horizon. Options have improved for potential homebuyers in Québec due to more listings, making the slowdown mostly a supply story. Meanwhile, the softer price growth in Ontario’s existing home market will be most closely related to a cooling in demand, resulting in weaker sales due to challenging affordability, particularly in the Greater Toronto Area.

Bottom line

Between 2005 and 2007, Alberta was skewing the national existing home market figures to the upside. Late in 2007 and early in 2008, Alberta home price growth came back down to earth, converging with national figures. The latest provincial real estate data show that Alberta is now more than a percentage point below the country’s average in terms of home price growth. In the past, we presented figures excluding Alberta to measure the impact of this particular market. As an example, Alberta boosted the national price figure by as much as 2½ percentage points in 2006. The distinction became irrelevant once Alberta had cooled back down to the national pace.
This exercise is once again relevant, and we are re-introducing these ‘ex. Alberta’ measures. Outside Alberta, we expect existing home to appreciate by about 3% this year. Including Alberta – which we think will record a 1.5% price decline – brings the national forecast down by nearly a full percentage point to 2%. For 2009, Alberta’s expected home price growth of 2% will not differ enough from the rest of the country to pull down significantly our forecast 3.5% for the nation as a whole.

The demand side of the home market is behaving largely as we forecast in the spring. Sales are down from the banner year that was 2007, but they are back to the average levels experience in 2000-05 in Calgary and Edmonton. Toronto sales have cooled, but they are still on pace with with elevated 2004-06 levels. Vancouver sales are one of the few cities where sales have dropped well below the levels experienced earlier this decade, and one cannot help but notice that this is also the market where affordability had become the most problematic. No kidding! I hadn't noticed!

Meanwhile, the supply-side is booming. This is helping to rebalance markets that had been in seller’s territory for an extended period of time, which is favourable to affordability and future demand. Recall that since 2002, Canadian resale home prices grew at an annual average rate of 10.2%, so a softer price performance in 2008-09 should not be too surprising. It is also a positive development that markets are cooling before the Bank of Canada embarks on another cycle of interest rate hikes. In our spring report, we highlighted the risk of a still hot housing market running into a monetary policy tightening cycle. It is currently not financing conditions which are causing demand to cool, but slowing economic conditions overall along with the lagged impact of past erosions in affordability caused by price surges in specific markets. History suggests that when a tightening of monetary policy cuts through a hot market, things can unwind in a disorderly fashion. Canadians will remember the bust of the late 1980s as a prime example. Cooling home markets also help to alleviate inflationary pressures which in turn diminish the need for further interest rate hikes. We do not expect the Bank of Canada to start hiking interest rates before economic growth ratchets back up towards 3% in the second half of 2009. Canadian housing markets should be cruising at a healthier, more sustainable pace by then.

Past Price Declines in the Vancouver Real Estate Market

In the past 30 years the Vancouver area has witnessed 4 major periods of real estate price appreciation and 3 subsequent periods of price declines. We are awaiting the 4th subsequent period of price declines which seems to be starting now.

For the historical perspective:

In nominal dollars:

From 1975 to 1981 real estate prices in Vancouver rose 240% and subsequently declined 35% over 18 months.

From 1982 to 1990 real estate prices in Vancouver rose 115% and subsequently declined 11% over 12 months.

From 1991 to 1995 real estate prices in Vancouver rose 44% and subsequently declined 14% over 6 years.

From 2001 to 2008 real estate prices in Vancouver rose 116% and subsequently declined ??? TBD ???.

In real inflation adjusted dollars:

From 1979 to 1981 real estate price in Vancouver rose 120% and subsequently declined 51% over 5 years.

From 1985 to 1990 real estate price in Vancouver rose 70% and subsequently declined 15% over 9 months.

From 1991 to 1994 real estate price in Vancouver rose 35% and subsequently declined 23% over 5 years.

From 2001 to 2008 real estate prices in Vancouver rose 87% and subsequently declined ??? TBD ???.

In Summation

All I can really say about the past price movements in the Vancouver market is that after every price runup there has been a price decline. Well duh!! Personally I would rather focus on the following criteria, which is the ratio of rent payments to mortgage payments.


As I have mentioned before, my formula for determining a purchase price for a property that I'd like is this:

{Fair Price} = [1/{Five Year Fixed Mortgage Rate}] * [{Annual Rent} - {Property Taxes + Maintenance}]

For example:A townhouse rents for $1500 per month has maintenance of $150 per month and property taxes of $150 per month. The five year fixed mortgage rate is approximately 5.9% right now.

{Fair Price} = [1/0.059] * [{1500 * 12} - {150 * 12 + 150 * 12}]
{Fair Price} = [17] * [18000 - 3600]
{Fair Price} = $244,800

Where I am looking to purchase this means that I am looking for a price decline of approximately 30%. Rents could increase as well but I see this as being unlikely since I haven't heard of too many people getting huge raises recently to be able to afford sizeable rent increases.

Guesstimates

The local real estate boards will be out with the monthly numbers tomorrow and I am guessing we will have price declines across the board. The inventory level is reaching super-bearish levels in the outer areas and bearish levels closer in. These levels of inventory are so high that it is unavoidable to have price decreases as sellers compete for buyers.

What are your guesses at the numbers?

Mohican thinks:
REBGV - down -1.5% MOM
FVREB - down - 2.0% MOM

Oh - - - if only I could short Vancouver real estate.

2008 Crystal Ball

Well, my crystal ball is broken but maybe yours isn't. I'm interested in hearing what everyone out there thinks about 2008.

Will the Vancouver area real estate market continue to defy fundamentals and continue on its heavenward ascent?

Will the Canadian and BC economy thrive through a US economic slowdown?

Will the stocks, bonds, cash, gold, real estate, or other commodities be a good investment in 2008? Which one will be the best?

I don't really think anyone can "predict" the future but we can make some educated guesses. Here are mine.

1) 2008 will be the year of turning for the local real estate market. I think we will see year over year declines by summertime - at least in the Fraser Valley.

2) The Canadian and BC economy will slow down dramatically in 2008. Labour shortages will be a thing of the past by the end of the year in BC.

3) I have no idea about the stock market but I think it will be another good year for growth stocks. I like value stocks always but will they go up in value this year? I don't know or care since I am just looking for bargains with good earnings and dividends. I think agricultural commodities will be a good investment among other commodiites. Financial stocks will probably not fair that well but could be good buys this year as they will be continually battered in the news.

Please DO NOT take this as financial advice as I always recommend having a diversified portfoli0 and a proper financial plan.

November Vancouver CMA CMHC Data

CMHC released the starts and completions data for the November period this morning and here is what the data says.

One month starts were at an all time record high for the Vancouver CMA in November at 2768 units. The previous all time high was April 2004 at 2479. Clearly developers are building like crazy as they must feel that they can sell these units once they complete or perhaps it's a rush to the exits.

Completions ticked up a bit to a modest 1466 units. I think we can expect the completions number to trend upwards during 2008 as many projects that were started two years ago come online. The completions and starts numbers can be extremely volatile as one project can represent several hundred units.

Completed and unabsorbed inventory continues to relentlessly rise as newly completed unts are unable to be sold and this inventory is building. Completed and unabsorbed units in the Vancouver area at the end of November were 1337. Contrast that with Toronto, with double the population at 980. I have been watching this number as a barometer of demand in our local market. It seems demand at current price levels is lacklustre.

Now it is time to look like an idiot but have a little fun making predictions! Whenever the starts outpace completions it is a bull market for real estate and when starts drop below completions it is a bear market in real estate (see the red and green arrows).

I expect three things in 2008 in the Vancouver new home market:

1) Record levels of starts as developers see the writing on the wall and it becomes a rush to the exits much like has been seen in US bubble markets.

2) Record levels of completions as Olympic projects finish and labour becomes available to go full steam completing residential units and many condo towers complete. Unabsorbed units will rise throughout the year and we will witness big discounts by developers first in the suburbs then in the city.

3) Near record levels of units under construction as we are at all time highs right now and construction will fall as the number of units being completed outpaces new starts.

I suppose that I won't look like an idiot if all of the above turns out to be accurate but I more interested in the discussion about my predictions than in being right.

Statistical Speculation

It is the end of the month and you know what that means for data addicts like me . . . the local real estate boards will release their statistics package outlining inventory, sales, and prices for our local real estate market early next week - probably Tuesday.

So let us speculate, unscientifically of course, on what the data will be.

Last month saw 6 months of inventory in the Fraser Valley Real Estate Board area with no significant price changes. Prices have not risen in the Fraser Valley since the July / August period and seem to be stuck at that level for the time being. We need more inventory and/or lower sales to see further price declines. Will we see that this month?

Last month also saw 4 months of inventory in the Greater Vancouver Real Estate Board area with modest price appreciation. Price growth is still robust in the GVREB area, although some areas are showing weakness, especially in the outlying areas. Inventory and sales are still bullish in the Greater Vancouver area and we need to see inventory grow and sales shrink before any price correction can materialize. When will we see this happen?

Prophetic Thoughts (or pathetic thoughts!)

After my brain was prodded by a discussion today at Chipman's blog on Months of Inventory, I did some MS Excel divination on the current real estate market numbers. To recap, as of March 31, we are seeing slower sales than last year, we are seeing a big increase in listings, and prices at all time highs.

For some historical context, in 2 of the last 3 previous real estate market downturns, we have seen new price highs in the first quarter of the year and subsequent declines, which are often sharp declines. The 3rd market decline saw a price peak in the second quarter.

In previous analysis, we have seen a very strong negative correlation (-0.81) between Months of Inventory and Quarterly Price changes when looking at the Fraser Valley Real Estate Board market statistics and I believe that this correlation can be helpful to predict future market price movements.

That said, I will go on record at this point and say that we are at the market top right now. Prices will not be this high again for at least 5 years and probably longer. The reason I say this, in addition to the reasons above, is that my "months of inventory price prediction tool" in MS Excel says so! I will explain.

To explain the tool briefly, I have made some assumptions about the sales rate and the listings rate which I think are fair, considering the trend today, and then, given the correlation, I have extrapolated quarterly price changes from there. Sales, I believe, will stay at a rate approximately -10% and -20% below 2006 levels (I used -10% for my tool). Active listings will increase throughout the year until October (this is in line with previous years and I have made sure to use fairly conservative numbers in the tool, in line with the current listings growth trend). This chart illustrates my assumptions. Months of inventory will be flat until June and then skyrocket to 9 to 10 months of inventory by year end. Surprisingly, this is with 'normal' seasonal changes starting from our current point.

The tool I have created says that we will likely see YOY price decreases in the Fraser Valley in August 2007. The tool also also suggests that by December YOY prices will be down 8-12% from December 2006. This will only be the beginning and prices will likely decrease a further 12-15% from the top after the end of the year through 2008. That said, it is difficult to say what will happen further than 6-8 months out though with any degree of certainty.

Will I be right on, close, or way off? Who can know? We will see. What do you think?