Many a child has delighted in popping a wad of Bazooka gum in their mouth, chewing vigorously, and then trying to blow the biggest bubble possible. The resulting end is inevitable – a sudden burst and then pulling the pink gum off their face.

Housing bubbles are not as much fun. But they can be just as sticky, messy and unpredictable.

Bubbles are as difficult to define as they are to spot. However here are a few definitions: Unsustainable patterns of price changes; deviations in prices that can’t be explained by fundamentals; and the mass refusal to acknowledge reason. We often don’t know with certainty that a bubble has existed until after it has burst.

The typical pattern of a housing bubble starts with price increases that are associated with euphoria as homeowners become wealthier. As wealth continues to increase, a mania may occur, and more buyers rush in as further price increases are forecast.

Eventually an event occurs – perhaps a change in government policy, increased interest rates, or a reassessment of market values – that leads to a pause in price increases. Some investors who borrowed heavily may find themselves under water, unable to make mortgage payments, and forced into distress sales. As prices decline, a crash and panic may follow.

During the 2008-2009 financial crisis, Canadian house prices fell by only 8 per cent – and then recovered by 2010. House prices have doubled since 2002, with annual growth of 5 per cent above consumer inflation. Vancouver, Victoria, and Toronto rose at much faster rates. With the current high prices in these cities – even with some recent weaknesses – have they been experiencing bubble-like symptoms? By two conventional metrics, the answer is yes.

The first measure is the price-to-income affordability index: The average house price relative to average disposable income in that city. The higher this ratio, the less affordable a house becomes and the more susceptible the market is for a decline in prices.

Over the past 25 years, the ratio in Canada has been about 3.5 times, but has recently been 4.5 times – almost 30 per cent higher. Since 2007, this ratio has grown faster in Canada than in almost every other major developed country. Recently in Toronto and Victoria the ratio was over eight times, and in Vancouver, despite recent price drops, about 10 times.

The other measure is the price-to-rent index, which is analogous to the price-earnings ratio for stocks: how much it costs to buy a house relative to annual rents (rents are like the earnings one could derive from owning a stock). Since 2007, this ratio is up 20 per cent, which again is among the fastest in developed countries.

According to recent analysis by the Economist, Canadian house prices are overvalued by 32 per cent relative to income, and by 76 per cent relative to rents, for an overall average overvaluation of 54 per cent compared with long-term averages. Only a handful of countries such as Belgium, Hong Kong and Singapore were more overvalued.

The key lesson we learn from history is that housing bubbles do burst. In Finland, house prices almost doubled between 1987 and 1989, but by 1992 were about 50 per cent off the 1989 peak. Japan experienced a real estate bubble between 1985 and 1990. House prices in Britain have declined by more than 20 per cent from their recent peak, in Spain by more than 25 per cent, in the U.S. by more than 40 per cent and in Ireland by 50 per cent.

Closer to home we have previously witnessed large price drops with slow recoveries. In Vancouver, prices dropped from 1995 to 1999, and it took until 2003 for prices to surpass previous peaks. In Toronto, prices dropped from 1989 to 1996, and it took until 2001 for prices to recover.

There are several key lessons for potential buyers, particularly in hot markets. Keep your emotions in check when considering a house purchase and don’t feel pressured to rush in; consider saving and waiting a few years. Ask yourself if you can service your mortgage under a scenario with interest rates 2 to 3 per cent higher than currently, especially in three to five years or when you may need to renew your mortgage. Consider your horizon: Don’t equate speculative short-term flipping strategies with long-term home ownership.

It is extremely difficult to know why or when a bubble of any kind is about to burst. Perhaps the recently announced rule-tightening related to government-insured mortgages could be a catalyst. Remember that it was more than three years before the bursting of what we now call the tech bubble that Federal Reserve Board Chairman Alan Greenspan made his famed cautionary speech about “irrational exuberance” in stock markets. As Mark Twain noted, history may not repeat but it sure does rhyme. Let’s keep in mind that bubble rhymes with trouble, as well as rubble.

Source: Stephen Foerster, The Globe and Mail

This entry was posted on Monday, July 9th, 2012 at 10:14 am and is filed under Canada real estate news. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.