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Canada's real estate bubble: Spot the signs and prep for the pop

How many times have you seen headlines shouting that the real-estate bubble is about to burst?

In fact, experts say it’s impossible to say for certain when, or if at all, a bubble is going to pop. However, they agree that there are clear warning signs when things in the market aren’t quite right.

Darrell Cook of Edmonton’s Realty Executives Progressive recalls the real-estate bubble in the Alberta capital in 2006 and ’07.

“Supply was very low, and the demand for housing and investment property was great,” Cook says. “Our market saw multiple offers on many properties with a great number of homes selling above list price for a sustained period of time. At one point, some property values were increasing by $25,000 to $50,000 per month or more.”

Low interest rates coupled with rapidly increasing prices can create a storm of panic-buying with investors hoping to cash in, he explains.

“Buying a second or third property can be a great opportunity, but it can also be risky business, especially in a rapidly escalating market,” Cook says. “As a result of the bubble bursting in 2007, today many properties are still valued lower than they were at the height of the market.”

Craig Alexander, senior vice president and chief economist of the TD Bank Group, says that bubbles like the one that burst in Edmonton are always obvious—in retrospect.

“We can make educated guesses as to whether the price of real estate makes sense based on economic fundamentals,” the Toronto-based Alexander says. “But in truth we can’t actually predict with accuracy that something is a bubble until after it’s corrected.”

There are several measures that can be used to assess whether real estate is overvalued. One is the market’s price behaviour in isolation.

“Traditionally a bubble is formed when you have rapidly rising and accelerating price growth until such time when something suddenly changes behaviour, then it crashes.”
From this perspective, the good news is that in Canada, there aren’t the typical warning signs of a bubble nationwide. 

Housing prices cooled down in late 2008 early 2009 and have picked up again, Alexander notes, but they’re not escalating at the kind of breathtaking rate that would characterize an impending burst.
Another way to test for a bubble is to assess how the real-estate market is doing relative to underlying economic fundamentals in each market.

“You look at what’s happening with employment, what’s happening related to income and to capacity of households to borrow; you’re really looking at affordability,” Alexander says. “In other words, what is the behaviour of the prices of homes relative to average family income?”
Demographics also come into play.

“Over the long haul, the main driver of real-estate prices is household formation: the number of people you need to provide shelter for. If you have very strong population growth you can generally support stronger real-estate gains. If you have slowing population growth, you would expect some moderation in demand for real estate.”

Then there are geographical factors. Land scarcity—such as in Vancouver and Toronto, for example—drives up the value of real estate.

Put all those fundamentals together for an overall Canadian picture, and Alexander boils things down to this: “Our assessment is that on a national average basis, real estate is probably overvalued by 10 to 15 percent,” he says.

“It’s not a U.S.-style overvaluation. It’s not as dramatic as some market pundits are talking about. But if you actually unwound 10 to 15 percent overvaluation in a period of one year it would be a housing-market correction three times bigger than what we had during the early-90s correction.

“Again, it’s not US-style overvaluation, but at same time you shouldn’t be complacent about the risks.”
And there are certain Canadian cities that are closer to trouble than others.

“When you look at the fundamentals...the Vancouver market is definitely flashing a bright red light,” Alexander says. “Think of it as a graph: you can plot home prices in Vancouver versus personal income, and the slide looks like a hockey stick; it’s shooting up toward the moon. When you look at it, you think ‘That can’t last.’

“I can’t tell you whether something’s a bubble until after it bursts, but I can tell you when something makes no sense, and Vancouver home prices on the basis of domestic affordability make no sense.

“The other market we are concerned about is Toronto condos,” he adds. “There are so many condos under development there’s a fundamental question of the ability of the market to absorb them all as they come onto market.”

Based on economic figures, Alexander says two Canadian cities are flashing a yellow light: Quebec City and Montreal. 

“These two cities are sending off a warning signal. The price growth that has happened in those two markets seems excessive relative to employment, income, and borrowing capacity.”

Alexander points out that sufficient data is lacking when it comes to Canadian real estate in general: little information exists regarding how much property is being purchased by foreigners or how much is being bought strictly for speculative reasons. 

“This basically means you don’t have enough data to make definitive assessments, and this is one reason why you have debates,” Alexander says. “What I’m really saying there is overvaluation.

“The data that we have does not support the argument that there’s a big national bubble, but you could actually argue there are bubblelike qualities in certain markets. And Vancouver is definitely the market that is setting off most warning signals.”

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