Introduction
A financial bubble is the aspect of trading in high volumes at prices that are significantly at variance with intrinsic values (Holloway, 2008). In the 2000s, the Canadian housing market has displayed both prices and high volumes that are significantly at variance with intrinsic values. However, the Canadian community rests on an ever-rising buying trend. For instance, the 70% of Condo buildings in Toronto and Vancouver being were sold out by the first weekend after presented for sale. A serious investigation into the Canada’s housing market condition signals a growing bubble that is about to burst. The paper touches on the most significant points concerning the current situation. The key objective of this research paper is to present accurate information showing the state of the housing market in Canada and the probability of a housing bubble. The research uses the “Cost of Borrowing” structure and inspects the significant items of mortgage payments and interest rates. In essence, the discussion will cover the fundamental and non-fundamental drivers as well as the assessment of these factors.
Fundamental Drivers
The bubble discussion is not thorough without significant fundamental assessments, which include income, population, the mortgage interest rates, houses as prestigious goods, and the high rental prices.
Income
There are many dimensions that measure what the value of a particular home should be and most famous among them is the price-to-income ratio, but more uncertain variables need also to be considered (Walks, 2014). The rental, real estate, and leasing industry subsidized nearly 12.5% of Canada’s GDP in 2013. While the current data displays the income gap between Canada’s richest and poorest broadening marginally between 1999 and 2012, lower-income families profited more from the housing boom. Throughout the period, real estate’s total wealth share rose from 46% to 57% for households in the lowest 20% income bracket, in comparison to only a 6% point rise to 40% for those in the highest earning bracket. Usually, a housing bubble bursts when the price increases to a level where supply begins overtaking demand. Home prices increase to an inflection level where it is not affordable for people to buy houses. At this point, demand starts constricting (Coy & Dmitrieva, 2015).
Rising house prices principally drive housing bubbles. In fact, amplified market demand for houses with inadequate supply leads to increased prices. Higher prices attract entrepreneurs enter the market to make short-term profits, producing an artificial demand, which drives the prices up. If the price rise is not supplemented by a corresponding rise in income (rarely the case in an exaggeratedly inflated market), the consumer’s affordability tends to decline with rising prices. The US housing bubble was a consequence of Americans with the poorest credit being lent money to purchase houses they could not afford. The US economy was badly crushed as a result.
In Canada, home prices are 3.9 times the median income, making them un-affordable. Likewise, the slump in oil prices supplements to the typical Canadians’ financial woes. The drop in oil prices, unaided by a corresponding increase in median income, led the Canadian public to adopt more debt to fund home purchases. The slump in oil prices affected the oil-rich Canadian economy as well as shares in the financial market and energy companies, including Enbridge Inc. (ENB), Suncor Energy Inc. (SU), and TransCanada Corp. (TRP) (Holloway, 2008). As a result, the economy has been poorly affected, resulting in high cost of essential products leading to people living beyond their standards. Prices of owning a home in Canada are abundantly posing the risk of a housing bubble in the nation.
Skyrocketing housing prices and thriving exports of commodities are inspiring Canadians to spend far beyond their means, while indulging into credit, imitating their American counterparts. Reasonably, high-profitable bonds and other investments, as well as alleged economic stability, have attracted inflows of “hot money” investment into Canada from low-yield, but wealthy nations, Japan, and the US. Unquestionably, the hot money jackpot flowing into Canada is facilitating to expand the household and housing liability bubbles. The money has a problem of the propensity to change the direction on a dime and move straight back from where it came, which will worsen Canada’s popping bubble as credit dries up.
Population
There is a notion that that as the Canada’s population is growing it drives the fuel price up making the prices of the houses reach to unsurpassed highs nearly every month. However, this notion may not be true. Canada’s employed-age population (15-64 year-olds) is increasing at the slowest pace in scale, a trivial mean of 0.4% increase, which is long-term. In 2010, 240,000 people were added to Canada’s working-age population. Currently, that amount has reduced to only 90,000 (Toronto, 2014).
An external spectator might note that against a background of an extraordinary reduction in population growth, the residential construction activity level should slow abruptly. However, that has not occurred. Actually, during the first quarter of 2015, Canada’s residential investment reached 7.1% of GDP, the utmost level since 1989 (which, unexpectedly was the peak of the last housing cycle) (Toronto, 2014). Obviously back then, the growth of population was triple what it is present, so by that time there was a demographic justification for a high level of investment in housing. The current level of construction means that Canada is building not less than two new houses for every added person in the working-age population.
The world does not remain still. Population growth and inflation have an impact on many aspects of daily lives, together with collective unsettled mortgage credit value in Canada. As population increases, so does the mortgage credit to accommodate this growth. As home prices increase owing to the inflation, so does the mortgage credit. The gap between the debt in the form of residential mortgages amassed by Canadians and the collective effect of the inflation and population increase is astounding. During the 1981-2009 period, the growing impact of population increase and inflation warranted a 210% rise in residential mortgage credit. In fact, fluctuations in outstanding mortgage debt have totaled 820%, or four times the natural growth. The swift increase in the residential mortgage credit suggests a buildup of debt among Canadians (Rickman & Guettabi, 2015). Currently, as a percentage of income, Canadian owe more than ever before. Indeed, the business community members have their worries concerning the swelling debt. Housing accessibility alters the demand/supply and unavoidably influences the price drive, as the shortage of homes ignites struggles for available residences. The possible inability of the construction industry to correspond with the population increase in the nation may be the underlying aspect of understanding the present price (Gjerstad & Smith, 2013).
According to the graphical history, in the late 1980s, new homes were being built for each person added to the working-age population. It is evident that there was substantial overbuilding in that period, mainly in Ontario, where house prices consequently dropped 25% between 1989 and 1993 as demand was overwhelmed by supply. The drop in prices transpired despite the Bank of Canada slashing down the overnight rate by 1,000 basis points (10%), which aimed to maintain the prices. Canada’s present housing construction level is unquestionably extraordinary about fundamental demographic trends. The condition proves to be problematic for almost 7.6% of all jobs in Canada are in the construction industry. Therefore, there is a lot riding on understanding the dynamics of the current boom (Toronto, 2014).
The Mortgage Interest Rates
The demand situations reflected in the prices of land are usually considerably higher than those of any other buying a regular person would do in his lifetime. Ideally, a purchase of real-estate should be fully be financed by the buyer’s savings, which is hardly the case in the present world, a borrowing-lending movement must be involved (McClearn, 2010). The sum changing hands is in various cases equivalent to buyer’s potential earning of a lifetime of the Ten, twenty and even thirty percent deposit of a classic real-estate deal makes a substantial influence of 9:1, 3:1 or 19:1 respectively. Great leverage climaxes the need for the cost of borrowing, managing provided that this symbolizes the greater percentage of the capital employed in a real-estate operation. The nature of leveraged purchasing is enclosed in what is usually known as a “mortgage.” A mortgage is the handover of the property interest to a lender as collateral security for a debt. Mortgage encounters are can be direct, such as refinancing, borrowing, and frequent payments. They can correspondingly be indirect, like mortgage discussions in the newspapers or the discussions with associates. However, regardless of the extensive exposure to mortgages, the details and structure of the mortgage are not understood.
The study by Albo, Gindin and Panitch (2010) reveal that almost a half of the present holders of the mortgage had only precise, simple mortgage structure understanding or no understanding at all. Of the 30 interviewed holders of a mortgage, 15 % understood percentage changes in the mortgage lending rate as being only applicable to the monthly payment, instead of the whole amount borrowed. These people regarded an increase of a percent in the mortgage lending rate as a percent increase in their monthly payment. In their view, a 10 percent increase in the mortgage rate would increase their payment on a monthly basis by equal 10 percent, and their current hypothetical $2,500 monthly payment would grow to a mere $2,750. This main misconception and the very ambiguous understanding of the lending rate monthly payment association showed by another 35 percent of respondents. The explanation can be discussed as follows.
The uncomplicated annuity formula or any calculator of mortgage indicates that, for rates ranging between 4% and 14 % on a mortgage that is amortized over 25 years, an upsurge in lending rate by 1% would culminate in a monthly average payment increase of 9%. A change of 1% in mortgage lending rate will represent 9% change in monthly mortgage payment amount 15% of the respondents expected a hike of 10% mortgage rate to increase their $2,500 monthly payment for a total of $2,750. In actual sense, an increase of 10% in interest rates from 4% to 14 % on a mortgage that was amortized over 25 years will make the $2,500 monthly payment to $5,701 or 128% increase. The annuity formula is an astounding discovery for those who did not budget for it. 9:1 ratio can be devastating or advantageous. Nevertheless, if the rates are to rise, it can spread greatly through the levels of borrowers, affecting those found unprepared (Carney, 2009).
The bank rate refers to the rate of interest that the central bank charges on the advances and loans that it offers to financial institutions and commercial banks. In Canada, the bank rate by definition is the limit on the high side of the overnight rate band that is announced each month by the Bank of Canada. The bank rate fixes the comparative cost associated with capital borrowing. By chronological criteria, in the last 75 years borrowing in Canada has not been cheap. The current bank rate is 4.8 percent below its 75-year average. In the Bank of Canada, the interest rate has never been lower, and there is no possibility of lowering it. The bank rate can only shoot up from the current level. Though directly associated with other forms of lending events in Canada, the bank rate is inappropriate in the many borrowers’ contexts (Elliott, 2009). After the bank rate starts rising, it will be followed by the mortgage rates. We can only imagine how far they will go. With no reference to the largely unreliable and complex economic models, the historical data will assist in understanding the possible future mortgage rate levels.
The succeeding segment of the paper deals with numerous scenarios and examples relating to mortgages. It must be well-known that this article uses a normal mortgage repaid in 25 years on a monthly basis, and a similar principal amount of all instances. Currently, the rate stands at 5.49%. Supposing the principal amount is identical, and then there are three situations relating to the conceivable bank rate direction. In the moderate inflation the bank rate increases, but to a reasonable four per cent. In the average inflation, the bank rate reaches its long-term average. In the case of high inflation, the bank rate surpasses its long-term average. In situation 1, the bank rate touches moderate level and stays at that level of 4%. From the evidence provided by history, the 5-year rate of the mortgage would be roughly 1.5% or 2.5% beyond current levels. According to the 9:1 ratio earlier discussed, a 2.5% escalation will lead to a roughly 24% increase in monthly payments. The second setting propels the bank rate to its historic average of 5%, a 4.8% increase from current levels. The outcome of such interest rate will be an estimated 35% monthly mortgage bill hike. The last case comprises a circumstance considered impossible in existing environment deflationary talks (Pollock, 2012). Assuming that the deflationary fears have failed to occur, Canada will be forced to increase its rates to 10% above-average. Therefore, in the 9:1 ratio, the monthly mortgage payments will increase nearly 55%.
The linear formula for approximating the effect on diverse households does not exist. Another significant concern is the yield curve location position. A yield curve refers to the relationship between the rate of interest and the maturity time of the debt for a specified mortgagor. The yield curve is the interest rates visualization for loans with diverse maturities, or the last date of loan payment when the due principal should be paid. Loans with dissimilar dates of maturity usually carry different rates of interest. If all dates of maturity and their matching rates of interest for a definite time are plotted on a chart where a yield curve is drawn. The yield curve’s left part contains short-term maturities, hence is known as “short end.” The right part represents longer durations maturities hence referred to as a “long end” of the yield curve. Usually, the yield curve progressively slopes upwards. In various circumstances the gap between the long-term and short-term rates broadens, and the gradient of the yield curve becomes prominent. The condition is referred to as a “steep” yield curve, and it is precisely how the Canada’s yield curve is at the moment. When the yield curve starts to incline to its “normal” levels, the leveling can be realized by raising short-term rates, declining long-term rates or both. As was deliberated earlier, the 5-year rates are not likely to drop any further, and will finally rise. Consequently, there will be a rise in short-term rates as well. Nevertheless, short-term rates are anticipated to rise more swiftly than the long-term rates owing to the fluctuations of the bank rate. The short-term rate will sharply fluctuate up, implying the 1, 2, and 3-year mortgages will be steeper than the 5 and 10-year mortgages. Shorter-term mortgages may still have a lower rate than 5 and 10-year mortgages. Nevertheless, the rise of the short-term rates is likely to be greater than that of the long-term rates. Whereas the owners of homes under 5-year mortgage contract is anticipated to pay 25, 35 or even 55 percent more in the coming days, those borrowed under the 1- and 2-year maturity terms can anticipate their payments to increase by 40, 50 and 70 percent correspondingly in the discussed earlier scenarios.
Houses are a Prestigious Good
Despite the market dynamics, houses in Canada reamin a prestigious good, which everyone wants to own. In the affordable house price environment, mortgage rates are not problematic. Nevertheless, if the homes owners use only a slight portion of their income to home ownership, a 25% or even a 50% increase would not be a problem. The Canada’s current housing affordability indicates that a series of substantial enhancements in Canada’s housing affordability ended in the 2009’s third quarter. For instance, Vancouver household (that is a family of typically two income earners, not a single person) uses over 70 cents of every pre-tax dollar they earn on house ownership costs. Subtracting inevitable taxes, the amount would increase to approximately 100% of a typical household income in Vancouver. On the other hand, a regular Toronto and Montreal home uses over 57% and 47% of their pre-tax income on house ownership costs, or nearly 80% and 70 % of their after-tax income respectively. Vancouver’s prices of property are reaching not only unsurpassed high nominal terms, but are surpassing those realized in the former real-estate bubble in real-terms (Albo, Gindin and Panitch 2010).
Nevertheless, speculators indicate that housing affordability that may be termed as a housing market health measurement seen in Toronto, Calgary, and Montreal, is not nearly as bad as in the late 80’s housing bubble. The speculation can easily be disproved by referring to the cost of borrowing. Economics Research on housing affordability measured by RBC illustrates that the amount of average pre-tax household income necessary to service the mortgage payments cost (interest and principal), include the utilities and property taxes. Of these constituents, mortgage payments constitute about 80% of the total costs of housing. In 1990, the 5-year mortgage rate was 12 % during the peak of the real-estate bubble. In 2009 when RBC compiled its report, it was 5.59 %. The mortgage rates hide the essential prices by twisting numbers of affordability. The poor affordability in the last bubble witnessed was not due to housing prices, but high costs of borrowing (Carney, 2009). To neutralize the condition and capture how present real-estate prices relate to those of the late 80‟s bubble, it is essential to regulate the mortgage rates affordability measure.
In both Montreal and Vancouver, current prices of real-estate significantly surpass those perceived in 1989 peak real-estate bubble in both nominal and real terms. If present the mortgage rates were at 1990 experienced level, the costs of ownership of a regular Vancouver house would exceed 100% of pre-tax household income. Current prices in Canada’s four main cities are not low in every dimension. Reasonably, in real terms (proportionately to the homeowners’ income), they stand at the same point or higher than those above the previous real-estate bubble. Between 1996 and 2009, the regular household income increased by 23% to 32% in the Canada’s largest four cities. Over that period, the regular house prices in these cities rose by between 100% and 200%. The gap between the house prices increase and income is most conspicuous in Vancouver. In fact, from 1986 to 1991 house prices doubled up, and then they tripled in 2002. Consequently, the prices had risen more than six times by 2008. House price increases have averaged, and everybody wants to own a house since it is a prestigious good.
Figure 1 shows the Housing affordability trend in Canada
Source: Albo, Gindin and Panitch (2010).
Rental Prices
The price-to-rent ratio relates to the prices of residential real estate to the monthly rents earned from the property. It is a fundamental assessment for properties of investment as investors relate investments-costs to the anticipated cash flows. The price-to-rent ratio is a valuable metric as it modifies any inflationary alterations and puts a comparative housing price in perception. Logically, price-to-income ratio, which shows affordability of housing from the homeowner’s perspective, is higher in several European nations as compared to Canada. Some of these countries, include France, Germany, UK, Ireland, Spain, Netherlands, and Norway. New Zealand and Australia on the other hand, surpass Canadian valuations on the price-to-income ratio basis. Nonetheless, after a 5-year broadening period, the gap between Canada and these countries has finally contracted. Currently, Canada’s price-to-income ratio is close to the other countries’ current levels. In relationship to the US, which experienced a recent bubble, the Canadian ratio is slightly above the US levels. Throughout the housing boom years in the US, Canada “outperformed” the US on the rental affordability. During the real-estate bubble, prices of housing in the US stayed more affordable than in Canada. Currently, Canada’s real-estate on per-income basis is 24% more costly than homes in the US (Pollock, 2012).
Between 1992 and 2009, the price-to-rent ratio increased in most OECD nations with the exemption of France, Japan, Italy, Korea, Finland, and Switzerland. Nevertheless, by 2009 most OECD nations experienced major downward, as home prices came down from their highs. The ratio in Canada has reduced, but not closely as much, and is currently second highest after Ireland. From the viewpoint of the investors, higher price-to-rent ratio makes Canada unattractive place for investment; a similar investment in other nations would bring higher rental income. The high price-to-rent ratio signifies fairly high home prices in Canada. In the direct relation to the post-bubble, US discloses an extremely unappealing investment environment that currently exists in Canada. In the US, equally priced properties bring 50% more in rental income than in Canada.
In addition to the discussed assessment metrics that indicate the out-of-balance conditions in the housing market, the price-to-rent relationship carries additional meaning. First of all, individuals at all times can choose between renting and buying. The direct replacement for owning a home is renting it. Justifiably, ownership of home necessitates a certain premium, as a mortgage is progressively paid off and on a long-ample scale the price will always appreciate. Similarly, there is the human factor of prestige and pride associated with ownership of a home. Nevertheless, when the premium surpasses certain bounds, possessing a house stops making financial sense (Dobbin, 2011). For example, if monthly ownership costs for a Condo are $14,000, whereas the identical component in a similar house can be rented for $5,000, buying it basically cannot be reasonable from the financial perspective.
At the justifiable price, a house or a Condo can be bought with the aim of renting it out. The tenants would cover most or all costs of ownership, ultimately conveying a stable income flow to the unit owner. Nevertheless, if the price of the property is too high, the owners will have to subsidize somebody in their apartment, as the rental income would not be enough to cover all ownership related costs. The last idea is “if I cannot afford to live in it, I’ll move out and rent it out”. This idea depends fully on the notion that property can be rented out at a preferred price (Albo, Gindin & Panitch, 2010).
The notion is accurate, but the property price has to be right. For instance, analyzing a 2-bedroom apartment situated in Toronto, the following aspect may be derived. Currently, a normal rent would be around $1,300 in an apartment building. A 2-bathroom, 2-bedroom Condo would be priced about $450,000. The monthly ownership expense would be around $3,850 (a mortgage payment of $3,000, maintenance fees of $625 and property tax of $225). The monthly variation between owning and renting will be about $2,550, which would transform into roughly $30,000 per annum. We have to assume that housing prices in Toronto are highly unlikely to avoid a collapse, and that are steadily rising at a pace of 3% a year. Simultaneously, maintenance fees, rents and property taxes keep up with inflation and increase at 3% per annum. All savings from owning Condo versus choosing a rent (The difference between the ownership costs and rent) reinvest in safe bonds at 5%. There are no transaction fees associated with Condo sales. During a period of 5 years, the renter will accumulate $176,000, whereas the Condo owner will have $143,710 for selling the item for $464,000. In 10 years, $395,000 will be accumulated by the renter, whereas the owner of the Condo will make $298,000 for selling the unit at $538,000. Lastly, at the mortgage’s term end, the house is entirely paid off and is at that moment worth $838,000. Nevertheless, in that period the renter will accumulate $1,438,000 in savings and safely investing the difference between the ownership cost and the amount of the rent.
The example shows that the current prices of housing in main Canadian cities signify a better choice from the financial perspective. Supplementary factors like unavoidably transaction costs and rising mortgage rates will advance compounding of the issue. This example certainly does not mean that rents are always a better option. In normal circumstances, the balance may without difficulty shift in favor of owning a home. Nevertheless, at the present untenable and over-inflated real estate prices, apartment renting makes a lot more financial sense. In such circumstance, it is not improbable to visualize a 40% to 45% drop in healthy home price in Vancouver, 25% to 35% in Toronto, and 15% to 25% in Calgary and Montreal. On the occasion, a renter will be more comfortable by far. If asked about their coherence for buying a property at the height of a probable bubble, various purchasers would respond “I am planning to dwell in this house, so I do not care if the price lowers.” Owners that dodged buying a home in 1988 and 1989 bought the same assets in 1992 at nearly a 30 percent discount (Pollock, 2012).
On the price-to-income dimension, Montreal and Calgary are very close to Toronto, while Vancouver is ominously less affordable. In a period of 13 years from 1996 to 2009, rental costs in Toronto grew by 36%. In the same period, the ownership costs increased by 110% owing to the dashing housing prices, increasing the cost of maintenance and the property increases in property taxes. Extraordinarily, the premium ordered by a Condo for ownership over renting an equal-sized apartment rose from 82% in 1996 to about 180% in 2009. Current prices of housing in main Canadian cities signify a better choice from the financial perspective. In fact, the above facts, indicate that the Canada’s housing bubble is about to take place.
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