If Canadian real estate prices won’t wait for incomes, what happens next? Last week the Canada Mortgage and Housing Corporation (CMHC) asked me to speak at their Housing Finance Symposium. If you haven’t read part one of my notes, it’s worth checking them out for a little context. If you have, today we’ll be building on those notes. We’ve determined home prices won’t wait for incomes to rise, so how do we determine what they’ll do?
While we can’t say with 100% accuracy, we can process a metric f**k ton of data, and come up with some pretty good assumptions. We can then backtest those models, to see how they work.
X Will Happen Sometime Isn’t A Forecast, It’s A Guess
Last week we discussed how unlikely it is for Canadian home prices to stay flat until incomes catch up. Ironically, the day before a big bank economist gave that exact unrealistic forecast. Forecasting isn’t an exact science, but the biggest problem you can probably see are timelines. If home prices aren’t going to stay flat until incomes catch up, where do they meet? When, and if home prices decline, how long will they decline? This is where you would need an additional model, and today we’re going to use one we’ve been developing here at Better Dwelling – median credit market exhaustion.
Real Estate Is Not Like The Stock Market… If You Don’t Understand Stocks
We’ll get to the model in a second, but first you need to understand something about the stock market. Have you ever heard someone say real estate markets aren’t like the stock market? Usually you’ll hear this from people that have no idea how the stock market functions. They’re still under the impression that company fundamentals matter. Fundamentals matter as a basic screening tool, but they don’t factor into pricing as much as buyer expectation. How else do you explain people paying the second highest premium for the S&P 500 in history? No, #MAGA is not an acceptable explanation – even if you heard it on Fox news.
Inflation adjusted premium paid on S&P 500. Source: Shiller P/E.
Measuring buyer expectations is exactly what anyone that wants to build a robo-trader should do. It’s hard to predict a company’s future revenue, but it’s easy to determine when buyers will think something is overvalued. All you need is a little artificial intelligence, machine learning, data, and tens of thousands of dollars in servers. Probably a good time to thank Microsoft for the server time they give us, thanks!
Median Credit Market Exhaustion
Median credit market exhaustion sounds complicated (and it is), but it is a simple concept. Basically it’s a score that’s the difference between what the median family can borrow on conventional mortgages, and the price of a typical home. A Department of Finance employee specifically asked me if it factors in interest rates, and yes it does. It also factors in inflation, credit defaults, applicable lender policy frameworks, and another six pages of potential lending and housing impact factors. It’s a little more complicated than most models I’ve seen used by the government, but once again – it’s not perfect. You’ll see what I mean.
What To Look For In This Model
We look for a break from typical tolerance levels, just like we would with a chart for equities. We try to establish different tolerance levels, which is similar to trading ranges. For those that don’t know, a trading range is a psychological range. It’s the range where buyers will buy and sell a commodity, based on historical acceptance/rejection of prices. Just like the stock market, this has nothing to do with fundamentals. It has everything to do with buyer expectations.
Every city has a different tolerance level, and it requires machine learning to determine it for every market. What we’re looking for is a break from range, which indicates a major shift in opinion. When it breaks above the tolerance, we get a market that’s undervalued. When it breaks below the tolerance, we get a market that’s overvalued. We can get a lot more from these numbers, but that’s what you’re going to have to know for the next part – when we apply it to Toronto real estate prices.
Toronto Real Estate 1976 – 1989
Any of you old enough to remember what Toronto real estate was like in the 1980s? It’s been a while, so I’ll give a quick lesson for younger readers. Prices skidded lower from 1976 – 1986, before nearly doubling over the next three years. Prices peaked in 1989, before falling until 1993. From there, they made a healthy walk lower until 1996. There’s a lot of stories about how it was the end of the world, and people lost their shirts – which are mostly exaggerated. People did lose money if they needed to flip shortly, but the biggest loss was mostly the cost of opportunity.
Got it? Now pretend it’s 1989 and you have no idea what’s about to happen. The banks just predicted flat home prices until incomes catch up. You’re sitting there with a Better Dwelling Median Credit Exhaustion Model. Yes, the scenario has some time travel issues, but that’s besides the point. The model looks like this.
Source: Better Dwelling.
Note, the original model presented used benchmark dollar values. Unfortunately, I had to explain benchmark dollar values to a number of analysts by email, so we’re just going to use an index for today.
Looks like… not a whole lot, I know. What you’re seeing is the model showing how quickly credit ballooned from 1976 to 1989. It stays within to the 50 point range, only breaking in 1987. Remember it’s 1989 so we don’t know what’s going to happen next. Let’s call a top, and try to peg where credit market sanity will be restored. We’ll also assume that this is going to be an orderly correction, since we have nothing to indicate anything will happen other than prices correct. Toronto isn’t going to lose a major industry as far as we know. The leg lower took three years, so let’s assume three years up (which is the red projection line). Let’s see how that worked out.
Source: Better Dwelling.
Not perfect, off by one year. Better than the 40 year bank prediction I showed you last week. We still can’t build an automated home trading robot here, but we’re getting closer.
Fast Forward To Today
Take your scrunchies out, and mute the Milli Vanilli – we’re fast forwarding to today. Quite a few people have been saying Toronto real estate has been overpriced for the past decade. That’s not what we see here. Actually, there was some prime buying opportunities in the 2000s according to this model. It’s not until 2015 that we break out of range. From there, we actually drop right down to today, where we’re nearly at the point we were in 1989. Now, this doesn’t mean people can’t afford Toronto real estate anymore. There’s tons of numbers that say otherwise, and a heck of a lot more people can support higher prices. However, this is the point where prices detach from lending conditions dramatically. This historically sparked people to question whether the risk/reward opportunity exists.
Source: Better Dwelling.
Let’s apply the same forward assumption that we did in 1989, and assume that it’s going to be an orderly correction. I know, some very smart people think it’s going to be the end of the world, and others think it’s going to take out the whole economy. At this point, we’re not considering any other data – so all we know is prices will have a correction. The first negative print was in 2013, and if bottom is today – we’re at a four year drop. If we assume a symmetrical restoration of credit market expectations, we would see prices stop dropping in 2021. Basically, this model is showing a four year drop in prices on the horizon.
Note, if credit markets loosen – this number could go lower. Although with an increasing crackdown on credit, that’s pretty unlikely. There’s also people telling the government things like this in private right now.
IMF Director Lim says the higher the debt, the more severe the recession will be, in regards to Canadian real estate.#cdnpoli#HFsympo2017
— Stephen Punwasi (@StephenPunwasi) October 10, 2017
Now, this is just one model – although it’s much more complicated than most residential real estate pricing models you’ll see. In the next and final piece in this series tomorrow, we’ll discuss layering models. This helps us build precision, and accuracy – as well as gives us final price targets for homes – and when incomes actually do catch up to push prices higher. We’ll also be publishing all two-hundred and some-ought models we’ve created in the near future, so you can benefit from our robo-housing economist as well.
Note: This is not advice on dealing with investments – either real estate or equities. Consult a specialized professional for those matters. I’m just giving you better questions to ask those professionals.
Update: Part 3, combining models to build better forecasting timelines is now published. Enjoy!
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Awesome, thanks. So right now it would take 4 years for prices to fall back into range, but that doesn’t give us a loss – correct? Just a roll back of prices/tapering of price growth?
After 4 years, we should expect growth of home prices again?
I could be wrong, but that was my read here too.
Nothing in this tells us where prices are, just that credit conditions will taper price growth until 2021. Here’s where Realtors are going to argue that this means prices will move sideways for 4 years, and bears argue a 4 year fall. Without knowing any additional variables, we actually can’t tell what this means.
He’s discussing here how long prices will have at downward trend for, and this model predicts prices falling eschew year for the next 4 years, similar to what prices did in 1989.
Excellent. Look forward to part 2. I’ll draw a warm bath tomorrow, and eagerly await the newsletter.
Haha, but seriously. Cool stiff you’ve been working on.
Wait, so how fast do prices fall? Does that mean a crash or just a slight pullback? Trying to figure out if buying in Toronto makes sense right now.
Don’t Buy!!! I estimate price drops for 3 years. Toronto will drop about 50% from April’s peak. Outer edges of GTA will drop about 65%.
Can you please do one of these charts for Vancouver. It feels like it’s going to go up forever, I would just like to know if I’m going to be missing out or a deal is around the corner.
Thanks for sharing this. It is difficult/impossible to find this kind of analysis in mainstream media.
Given the willingness of central banks to use unconventional methods to prop up asset values lately, might they try something unprecedented to keep the party going? Could this 4-year drop be artificially lengthened, or are the processes underway in Canada ‘s big markets out of the hands of Canadian politicians and bankers?
I like this graph, and I am praying for a correction, as I dont see the investment as worthwhile to get into the market. Realize you mentioned it already, however, it does not account for the increase in demand due to people moving to Toronto, and the role of foreign money as well. This could easily offset the credit exhaustion point as there will be buyers to fill the void where the ones who’ve reached their credit limit step aside. I think there are more variables propping up the market than there were in the 80’s.
Personally I live in Montreal, and I am very pro immigration, and embracing of our multi cultural city, however I feel a little peeved at foreigners who just buy their way in. And living in my neighborhood, I can see there is chinese speaking newcomers at my grocery store. I am not annoyed that they are here, however I am annoyed that the policy that allows them to come and buy a home here is so easy, as long as they have the money, which in turn keeps me on the sidelines, having to pay way too much money for a fixer upper, with foundation issues. If they are here to start their lives as Canadians, then great. That said, I suppose if they only own it for speculative purposes, or to park their cash, Im truly annoyed by that. But im under the impression they arent creating jobs, or bringing money to the economy, but rather tying up homes, while they park their money here – and the from what I understand the Couillard government is the open door that brings this abuse into the country.
Anyhow, I just want to afford a home in the end. Im hoping the market comes off 10-20%, at which point the price will seem super easy to manage. Homes used to be paid off in 10 years, my spouse’s parent bought theirs in cash. To have to think about scraping by for 25 years nowadays while being house poor, and sacrificing my retirement savings just doesnt seem like a value proposition to me.
Furthermore, with all this money stashed away in real estate, that means that money is not liquid and going into consumables which is what creates inflation and jobs. This whole real estate rich era we live is such a sham, you’re house could be worth $20 million, it doesnt matter because you cannot touch that money until your house is sold. If I am finally able to afford one, I hope to live a healthy long life and not have to sell it in favour of autonomy.
Thanks for reading my Tuesday morning rant, my wife is tired of listening to my belly aching, and thinks we should just pull the trigger.
I saw his Housing Symposium presentation, and he made a great point in the Q&A that actually really made me see the market in a different perspective. If buyers disregard fundamentals on the way up, why do you expect them to matter on the way down?
He’s right, a city like Vancouver is now more expensive than NYC, but is less dense. Process that for a second – Canadians are willing to pay more than people in one of the richest, and densest cities in the world. This has nothing to do with pricing mechanics, and everything to do with people trying to lock in their last chance at being rich. There’s not a lot of opportunities in Canada to make money, and there’s even less that the mass market can get into.
I’ve got news for everyone, we all can’t be rich. If 60% of the population just became millionaires, Canadian money either lost all value or there’s going to be a big flush on the way out as currency rebases. If you sold over the past year, congrats. If you didn’t, prepare to lose a significant portion of your net worth over the next few years.
Jack, I agree with you but until there’s serious government regulation, as there is in other countries, preventing foreign, non-citizen, residential real estate ownership, home prices will continue to escalate because Canada is money laundering heaven and has very lax foreign resident rules which allows foreign capital to cause price inflation.
Jack – you hit the nail on the head. It makes no sense to have so much capital in housing. Imagine the world we would live in where people were happy with just enough amount of space, that they could spend 33% of their income on entertainment without batting an eye. Instead, you become a debt slave to a bank(with the hopes of getting your money back ONLY if you decide to downsize) or a rent slave to a landlord who paid such high prices and has to recoup their expenses. I wish there was no money to be made in real estate, this way we’d have a more substantial economy.
No one can predict how low the market can dip especially in GTA and Vancouver. 1989 slide in GTA was quite mild and in comparison to 2008 US crash it was just a hiccup. Let’s not forget that 3 decades ago real estate contribution to GDP was miniscule, today this percentage is much much higher. The consumer debt levels are breaking all records, uncharted territory to say the least. In case the market take a serious dive, the recovery period could be very long and painful.
Love it when middle class people think that markets are random.
Here’s a secret. Familiarize yourself with how support and resistance levels work, because there’s whole skyscrapers of people that understand this. Markets are relatively zero sum, so in order for traders to make money – they need you to NOT understand this. This is called rotation, and you provide the liquidity after big money makes a profit, and you provide a discount when they begin to accumulate.
The system is rigged, but not in the way that it thinks. Wealthy people don’t explain how they make money, and allow you to continue to be fooled into thinking it’s luck.
When the market doubled (in a 3 year period) in Edmonton, Saskatoon and Regina in the early 2000’s – then prices did exactly nothing (for now almost a decade ) – no collapse. People always seem to think Real Estate prices need to collapse.
That’s absolutely not true. Regina saw prices double from 2007 to 2008. There was a drop between 2008 to 2009, but Canada ramped up easy lending conditions and devalued currency at a massive rate in order to support these prices.
If inflation is higher than interest rates, then money is artificially devalued to manage numbers. This is reflected in assets with inflation sensitivity. Remember this the next time you hear where interest rates are, and CPI is.
Does the model also account for the upward trend of the threshold? According to your part 1 article, you suggest the price to income ratio tend to trend upwards with occasional correction down to the support level. This must also mean that the typical home price should increase faster than the median income, hence your index would creep downwards over time.
[…] Update: Read part 2 here. […]
In July 2015 the average TorontoMLS price was $609,236
In June 2017 the average TorontoMLS price was $793,915
So……..”it’s not until 2015 that we break out of range”…..guessing the correction would then be around the +20% mark or $140,000 against today’s average price and spread over the next few years until support is met…….all the other downside global risk factors aside as if we live in a complete bubble?
Great article. One of the most logically and unbias I have read. When will you be making an app for your predictive analytics of the Canadian Real Estate market?? I run a real estate team in Kitchener Waterloo and I am looking for insight to help educate my agents and clients on the future of the real estate market. Love your thoughts on our Market!
Great read. You really nailed it!
[…] The Future Of Canadian Real Estate Prices Part 2: Modeling […]
[…] an elaborate dissection of multi-year data from various sources, Punwasi’s forecast model indicates that based on historical data trends “…a four year drop in prices on the […]
[…] of the world’s largest credit agencies is noting credit exhaustion at Canadian households. Equifax is seeing a declining number of Canadians paying off the balance on […]