I have often heard people explaining the high prices of Vancouver Real Estate by making a simple story around one factor. For example, some people think that foreign investment is responsible, and cite immigration programs or anecdotal evidence of the presence of Chinese investors in condo pre-sales. Or, some other people blame low interest rates, and think that if interest rates go up, prices will collapse. The truth is that you cannot look at one factor alone to explain what is happening.
Once again I cite Robert Shiller on Irrational Exuberance:
But one of the first lessons of economics should be that there are many factors that seem sometimes to “explain” speculative prices, too many for us to analyze them comfortably. We have to resist the temptation to oversimplify by singling out only one.
Understanding the factors that precipitate market moves is doubly difficult because the timing of the major market events tends not to be lined up well with the timing of the precipitating factors. The precipitating factors often tend to be medium-term trends that catch the public’s attention only after they have been in place for a long time. The timing of specific market events is, as we shall discuss in the next chapter, directly determined by people’s reactions to the market and to one another, which impart to the market complex internal dynamics. But we must look at the precipitating factors if we are to understand why the market moves.
Those who predict avalanches look at snowfall patterns and temperature patterns over long periods of time before an actual avalanche event, even though they know that there may be no sudden change in these patterns at the time of an avalanche. It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the dramatic movements of stock markets and other speculative markets.
Shiller, Robert J.. Irrational Exuberance: Revised and Expanded Third Edition (p. 40). Princeton University Press. Kindle Edition.
Hence, like in avalanches, there are many factors that have played a role in the current situation. We’ll discuss some of them in this entry, but first, let’s look at the history of the prices in Vancouver to see when these factors appeared and if they can explain the anomalously high prices of Vancouver real estate.
History of Vancouver prices
In every REBGV monthly stats package, they include this chart:
The nice thing about this chart, is that it goes all the way back to 1977. The problem with it, is that it is not adjusted by inflation. In a previous blog entry I adjusted by inflation the data from 2005 (data from 1977-2005 is not available for download), and that a lot of the increase we see in this graph was due to inflation. However, not all of it. We already discussed that there was an anomalous increase in the 2015-2018 period that is not due to inflation.
Another way to look at it is to look at what the price to income ratio has been over the years, as this should not be affected by inflation (incomes normally go up with inflation). In page 30 of demographia’s new report (http://demographia.com/dhi.pdf), a chart of the change in price to income
An old blog entry I found on another blog (https://northamericaneconomics.com/tag/home-price-to-income-ratio/) also reported the changes on price to income and price to rent ratios from the 90’s to ~2010:
So we can see that these anomalous changes in prices are relatively recent. What happened in the early 2000s and the 2015-16 period? Let’s look at the different factors
Undeniably credit accessibility is a major factor driving asset prices. Ray Dalio explains how credit plays such a key role in the price of stocks and real estate in this eloquent video:
Ray Dalio also writes in his book on Big Debt Cycles (https://www.principles.com/big-debt-crises/):
Bubbles usually start as over-extrapolations of justified bull markets. The bull markets are initially justified because lower interest rates make investment assets, such as stocks and real estate, more attractive so they go up, and economic conditions improve, which leads to economic growth and corporate profits, improved balance sheets, and the ability to take on more debt—all of which make the companies worth more.
As assets go up in value, net worths and spending/income levels rise. Investors, business people, financial intermediaries, and policy makers increase their confidence in ongoing prosperity, which supports the leveraging-up process. The boom also encourages new buyers who don’t want to miss out on the action to enter the market, fueling the emergence of a bubble. Quite often, uneconomic lending and the bubble occur because of implicit or explicit government guarantees that encourage lending institutions to lend recklessly.
As new speculators and lenders enter the market and confidence increases, credit standards fall. Banks lever up and new types of lending institutions that are largely unregulated develop (these non-bank lending institutions are referred to collectively as a “shadow banking” system). These shadow banking institutions are typically less under the blanket of government protections. At these times, new types of lending vehicles are frequently invented and a lot of financial engineering takes place.
The lenders and the speculators make a lot of fast, easy money, which reinforces the bubble by increasing the speculators’ equity, giving them the collateral they need to secure new loans. At the time, most people don’t think that is a problem; to the contrary, they think that what is happening is a reflection and confirmation of the boom. This phase of the cycle typically feeds on itself.
Dalio Ray. A Template For Understanding BIG DEBT CRISES (p. 17)
Greenleaf Book Group
Ray Dalio nailed a number of factors right there that are part of the credit cycle:
- Low interest rates
- Fear of missing out
- Government guarantees
- Shadow banking
Low interest rates
As interest rates are low, people can borrow more for the same asset. See also Bank of canada rate since the 90s (which determines the variable interest rate):
It is of particular interest to note that the interest rate dropped from 1% to 0.5% in the 2015-2017 period, where the anomalous increase in prices took place.
Fear of missing out
There is nothing worse than seeing your family and friends get rich while you are left out. There are documented cases in a number of asset bubbles where people join because of peer pressure and media stories. Ponzi schemes work on that principle, as people leave reason behind and focus on how to join the party and get rich as fast as the other did. As asset bubbles tend to last long (see for example the dot com bubble https://www.youtube.com/watch?v=c4TlmkhE3Mw), critics who point out the irrationality of the bubble are ridiculed and most people want to join the party.
Last year the CMHC published a survey on 30,000 Canadians who recently bought a property and Vancouver and Toronto stood out in the number of people who paid more than what they had budgeted:
By looking and when they decided to buy, the authors concluded that fear of missing out was the most likely explanation for the data. Similarly, TD carried out a survey in 2016 (at the beginning of the anomalous increase) and showed that 20% of purchasers had FOMO and 40% did not understand how housing costs work:
A huge factor in driving easy access to credit is the role of the CMHC. This organization was established after World War II, to help returning war veterans find housing. It has since expanded its mandate to assist housing for all Canadians. The following table summarizes some of the changes they have implemented and their impact in the mortgage industry (source: wikipedia and MacBeth, Hilliard. When the Bubble Bursts: Surviving the Canadian Real Estate Crash):
|1954||CMHC introduced mortgage loan insurance, taking on mortgage risks with a 25% down payment, making home ownership more accessible to Canadians.|
|1999||The National Housing Act and the Canada Mortgage and Housing Corporation Act were modified, allowing for the introduction of a 5% down payment||Smaller downpayment required.|
|2001||Introduction of Canada Mortgage Bonds, aimed at ensuring the supply of low-cost mortgage funding and keeping interest low.||Canadian Housing Trust (CHT) established. The CHT purchased mortgages originated by the Big Six Canadian banks and sold bonds to investors and institutions. The bonds carried a government guarantee and AAA rating. Key to the rapid expansion of the mortgage industry in Canada|
|2004||CMHC introduces Flex Down, allowing the 5 percent down payment to be borrowed||Even the downpayment could be borrowed.|
|2006||Changes to the mortgage insurance rules under the National Housing Act (1969) to allow, among other things, 100 percent mortgage financing for borrowers (no down payment) and forty-year amortization||Amortization went up from 25 to 30 to 35 and finally to 40 years with zero downpayment|
|2007||CMHC starts to insure mortgages for self-employed borrowers||More people can borrow|
|2007||LTV limit raised to 80 percent from 75 percent for requirement that mortgage must be insured||More mortgages qualified for the insurance.|
|2008||During the 2008 crisis, the CMHC provided liquidity support to the banks by purchasing tens of billions of dollars in mortgages from the banks at a time when there were very few, if any, buyers for those securities. The program, called the Insured Mortgage Purchase Program (IMPP), was eventually authorized for up to $125 billion. At the program’s end in 2010 the total amount purchased was $69 billion. See full report||Banks could continue to lend during the Great Financial Crisis|
Many of these measures have been reverted, but once again, as Dalio points out, government guarantees played a big role in the late 1990s/early 2000s which is when Vancouver and Toronto price to income ratio started to accelerate.
A shadow banking system is the group of financial intermediaries facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight (Investopedia)
The US-housing crash of 2008 is often blamed on the subprime market, where deregulation allowed for creative engineering of debt vehicles that could be traded and moved to transfer the risk from one institution to another (Anybody has seen Big Short? Well, a better documentary is the one that got the Oscar in 2011: Inside Job). Subprime lending by private lenders was definitely a factor.
Well, the subprime mortgage in Canada is booming, as documented by Better Dwelling: https://betterdwelling.com/canada-has-a-subprime-real-estate-problem-you-just-dont-know-it/
This is also supported by a recent report by the Bank of Canada, where they studied the effect of the stress test, which resulted in an increase on private lending from 5.9% to 8.7%: https://www.bankofcanada.ca/2018/11/staff-analytical-note-2018-35/
In hot markets like Toronto, private lending has reached 20%: https://www.theglobeandmail.com/business/article-report-says-more-people-borrowing-from-alternative-lenders-not-banks/
The increase in real estate prices in Vancouver appears to be anomalously high since the early 2000s, and more recently in the 2015-2018 period. There are numerous factors that have played a role. Here we discussed a few of them, such as low interest rates, fear of missing the role of CMHC and the appearance of shadow banking. These appear to be the most significant ones. However, there are also other important factors I did not discuss (e.g. foreign investing, illegal money laundering, immigration, supply restrictions, etc), which I hope to do in a later post. For now, in the next entry I will discuss what to expect in the medium and long term based on my research.