Listings are way down from last year, putting more upward pressure on house prices.

That’s all great news for a homeowner who is selling, but not so great for first-time buyers who are just barely able to pull together a down payment to get into the market.

The speed and strength of Canada’s housing recovery has prompted plenty of debate about whether there’s a housing bubble forming, as we discussed two weeks ago. While many don’t agree that bubble conditions exist yet, most think that if prices don’t stabilize soon, there’s going to be trouble.

In an entertaining analysis of the resale housing market, TD Bank Financial Group economist Pascal Gauthier writes that the housing market’s recovery in 2009 from the downturn last year was "the mother of all rebounds".

He says seasonally adjusted monthly sales hit all-time record volumes this year and are on a pace to continue, with prices five per cent higher than the peak in 2007 before the downturn. "Extrapolating this trend echoes Buzz Lightyear’s mantra, ’to infinity, and beyond!’ Back here on earth, however, this latest housing cycle raises a number of concerns," he says.

Pascal estimates that "the typical home remains overvalued by 12 per cent at the national level. Unfortunately, sheer momentum suggests that this overvaluation is likely to increase over the course of the next few quarters, peaking at 13 to 15 per cent" in the first half of 2010.

House prices are rising faster than income in Canada, putting a strain on affordability. "Existing home prices have outrun personal income every year since 2002, by eight per cent on average versus five per cent," says Sal Guatieri, senior economist for BMO Capital Markets. "After climbing 87 per cent in the past seven years, prices are at record highs relative to income."

Guatieri says that "while classic bubble indicators (like condo flipping, ’buying on spec’ and loose lending standards) aren’t flashing red, houses are by no means cheap. When interest rates normalize, affordability will weaken."

He offers the example of a buyer with five per cent down on a house that cost $343,000 (the average price in October), financed over 25 years at current variable rates of 2.25 per cent. That buyer could see his monthly mortgage payments jump by 50 per cent ($714) to $2,133 if rates climb by four percentage points, which Guatieri says is "a reasonable assumption given estimates of the neutral overnight rate.

"In all likelihood, as affordability declines in response to higher prices and rates, demand will soften and price increases will moderate," says Guatieri.

"However, if prices continue to leap-frog incomes in coming years, the odds of a market correction will escalate, especially if interest rates exceed neutral levels."

Pascal says that while the "misalignment of home prices with the fundamental drivers, such as demographics and income, cannot last," it’s not clear when "the two will eventually realign."

He says that while the market rebound was "a tad overdone", "it is not so much the current level of prices which raises concerns. What raises eyebrows is where the current market momentum will bring prices next year."

Pascal says the danger isn’t that the real estate market will cool more than anticipated in the near term, but "the risk is rather that the market remains as hot as it currently is for too long, eventually running head-on into monetary policy tightening (and longer term bond yields rising). There is more than adequate time for the housing market to cool before then, but history suggests that if it fails to do so, the ensuing adjustment would be a rude awakening."

Several factors could calm the growth in sales and prices: the belief that pent-up demand for housing has been eased; more listings coming onto the market to help moderate prices; and the theory that some buyers who planned to get into the market next year have moved their purchases up to take advantage of low interest rates.

Both economists are also concerned about rising household debt in Canada. Guatieri says household credit has grown twice as fast as personal income since 2002, but that the rate is slowing. Pascal warns that debt-serving costs are going to rise during the next few years, and "while most households can handle this rebalancing act, those already overstretched or getting into homeownership on the margins of affordability would do well to plan ahead by building up equity and saving through other means."

Published: December 9, 2009

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