In theory, it’s simple. The laws of physics dictate that what goes up must come down, and economic principles tell us that a rapidly appreciating asset will eventually return to a price that reflects its intrinsic value. So why does everyone talk about a housing ‘bubble burst’ like it’s the end of the world? Particularly for people priced out of the crazy Canadian market, wouldn’t a correction be a good thing?
Stagnation, recession and defaults (oh my)
Bubbles burst when demand decreases or supply increases, causing prices to fall. A drop in demand for housing could be caused by a number of things, including rising interest rates, unemployment, stagnant salaries, fewer mortgages or shifting demographics. Increased supply is less commonly the source of a housing crash, but can happen – think out of control condo construction and suburban sprawl.
The most immediate impact of falling real estate prices would be felt by those who are planning to sell their homes. When middle-aged families looking to expand, older folks trying to downsize and investors hoping to turn a profit don’t get the offers they expect, they’ll probably sit tight until things improve. But if those at the top of the housing ladder stay put, there is no room for those moving up. This could block-up the market, making it harder for those trying to buy their first home.
The next thing we would see is a decrease in consumer spending. A drop in the value of a homeowner’s biggest asset will hurt their confidence and people will start to save more cash to protect themselves against an increasingly uncertain future. According to research from the International Monetary Fund, housing crashes cause spending to dry up for five years and stay flat for several years after that. When people stop spending, businesses struggle to make ends meet, unemployment rises, and economies fall into recession.
The less obvious but hardest hit victims of a bubble burst are those who have all their wealth tied up in their home. Those with large mortgages relative to income tend to be young and lower income. According to a report by the Canadian Centre for Policy Alternatives, a 20% drop in house prices would wipe an average of 45% off of the net worth of a twenty-something, compared to 15% of a fifty-something. One in six young people would be paying mortgages that exceed the value of their properties.
Although that sounds scary, young homeowners have time on their side. “Even if you’re underwater, it’s not a big deal, because as long as you live in this house and you pay your mortgage, that’s fine,” Benjamin Tal, deputy chief of CIBC’s World Markets, told CBC News. “From a practical perspective, as long as you have a job and you have income, I really don’t see a situation in which you should panic.”
So far, so theoretical
Real trouble begins if these people are hit by another setback, like a job loss, and can’t make their mortgage payments. Although it may be hard to imagine today, the likelihood of a double whammy hitting young and poor homeowners is much higher when consumer confidence and spending has already suffered. At this point, the price decline / spending / default loop can become self-perpetuating.
If mortgage defaults happened in large enough numbers, the government would need to step in to stop people from drowning in debt. As happened in the US in 2009, the Canadian government may have to introduce programs to help people by extending the term of their mortgage, reducing the interest rate, or allowing delayed payments. It could also introduce programs to allow people to change the principal on their mortgages to reflect lowered house values.
This would hurt the lenders that issued these loans. Moody’s credit rating agency tested a scenario in which house prices fell by 35 per cent in Ontario and British Columbia, and by 25 per cent elsewhere. It found that the direct losses to banks would be nearly $18 billion. Luckily, key differences between Canadian and US lending practices mean that this kind of loss would probably not cause the kind of widespread catastrophe that unfolded in the US.
Enough with the doom and gloom!
What if you don’t own a home? Isn’t there an upside to falling house prices? A light at the end of the tunnel? Is it possible that homes are finally about to become more affordable? If living spaces are less expensive, will rent get cheaper?
It’s tricky to predict what direction rent prices would move. Much would depend on what causes the bubble to burst in the first place. If people have to start searching for work elsewhere (for example, when oil prices recently tanked in Alberta), rents would fall alongside demand. But in the absence of financial or environmental catastrophe, it’s unlikely this would happen in more economically diverse cities like Toronto and Vancouver.
The more likely scenario is that low interest rates and a fall in house prices would encourage more investors into the market. Following the US housing crash, Wall Street firms were among the first to seize this opportunity, buying cheap homes to rent to foreclosed former homeowners. Now smaller landlords are emerging in Wall Street’s wake, and together they’ve lifted the share of single-family homes used as rental properties to a 30-year high. The number of entry-level homes on the market is down by 44% and median prices in this category have increased by nearly a third since 2012, according to research by Trulia. As a result, would-be first-time home buyers have struggled to get a foothold on the property ladder and rents are increasing faster than house prices.
What does this mean for those who are ready to buy?
Finally some good news. “In theory, the winners if housing prices fall hard are millennial buyers who are currently priced out of the market,” Rob Carrick, personal finance columnist at the Globe and Mail, told Apartmate.
“However, there will be a lot of scary talk about housing if prices fall and millennials are going to need buck up their courage to buy. Let me offer some insight from personal experience. Back in the early 1990s, my wife and I were looking for our first house in Toronto. It was just after a sharp correction in the Toronto market and many of the homes we looked at were on sale for much less than they had sold for a year or two earlier. My regrets about buying back then? That we didn’t but a six-pack of houses instead of just one. The best time to buy financial assets is when they have fallen in price. Applies in the stock market, and in housing,” Carrick said.
So if house prices fall and you are sitting on a stack of cash waiting to make a purchase, you could be in luck. Or more accurately, you could definitely get lucky if you find someone willing to sell a great place at a reduced price.
Just make sure you’re not overextending yourself. And if you’re one of the 40 percent of first-time buyersexpecting help from family members, don’t count on it. If the value of your family home falls by 30%, it’s a lot less likely that the Bank of Mom and Dad will be feeling solvent enough to cough up that down payment.
So when will this housing crash happen?
If you believe the headlines, the sky has been falling on the Canadian housing market for 20 years. The truth is that no one has a crystal ball.