Canadian Housing's Chilly Future, Part 1

 | Jul 23, 2015 | 4:08 PM EDT
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I received several questions recently about my prediction for a coming collapse in the Canadian residential real estate sector, which I discussed earlier this week. I think this is a very important issue, so I'm going to discuss it in greater detail over my next two columns.

Southern California's role
Let's start by looking at how home-price gains have traditionally occurred on both the U.S. and Canadian Pacific coasts.

Here in the United States, Southern California property values tend to lead the rest of the nation in price cycles both above and below housing's long-term sustainable averages (as I discussed last December).

Interestingly, Southern California prices also tend to lead Canadian Pacific Coast's property values as well.

Rising prices in Southern California typically move up the coast through San Francisco, Sacramento, Portland and Seattle, then on to Vancouver and eastward to southern Alberta. Conversely, when Southern California prices begin to fall, money flows back out of the Pacific Coast in both the United States and Canada, including Alberta real estate.

This pattern has been repeated with almost tidal regularity over the past 50 years or so. Although its rarely discussed by the financial media, real estate speculators who are aware of it have gamed this cycle time and time again.

There's no economic reason for this pattern to occur, but it does. However, something unusual has occurred in the most recent cycle.

True, Alberta's residential-development land prices tanked when Southern California home prices fell dramatically during the last U.S. housing crash, in keeping with the historical pattern.

But Vancouver home prices only dropped for about 12 months, then rebounded at an even faster rate than they had during the previous U.S. housing bubble. As a result, Vancouver's property prices were going up even as those to its east and south continued to fall.

Home prices vs. inflation
With that as a preface, let's next discuss the structural limits to home prices.  

Home-price appreciation is limited to a structural sustainable real rate that's equal to the rate of inflation. Price gains can only exceed inflation for brief periods of time, and then only at the cost of future periods where housing will lag overall inflation rates.

For instance, above-average home-price gains during the 1980s heyday of savings-and-loan financing were followed by sub-inflation increases during the decade following the S&L debacle.

It's true that home-price gains are often impacted by building restrictions, cost of capital, interest rates, underwriting standards, population growth, geographic location and other factors. But over the long term, home-price appreciation and inflation rates tend to coincide.  

That means that a sustainable rate for home-price gains is around 5% a year over the long term in both the United States and Canada.

What's happened in Vancouver
However, Vancouver single-family home prices have risen about 11% annually over the past decade. That means a home that sold for C$500,000 there 10 years ago is worth around C$1.5 million today.

Vancouver's home-price gains have also accelerated over the past decade, just as they did in the runup to the U.S. market's 2006-2007 peak. All told, Vancouver has experienced about 20 years' worth of home-price appreciation in just a decade.

That's almost exactly the same situation the United States faced during the last housing boom. And it's just as mathematically unsustainable in Canada as it was in the States -- regardless of the source of purchasing capital, which I'll address in my next column.

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