What’s with house prices in Vancouver?

“Nah, I’m going to keep renting until the bubble pops, then I’ll buy a house on the cheap.”

A friend of mine said that when I moved to Vancouver in 2002.  Looking at what the Vancouver real estate market’s done since then, the joke appears to be on him.

Despite a swoon in 2008, it seems neither Credit Crunch, global recession, banking collapse nor sovereign debt crises are enough to topple the might of Vancouver real estate.

Yet, according to a November 2011 release from RBC Economics Research, owning a bungalow in Vancouver requires 91% of the median pre-tax household income.

So … was my friend right but his timing wrong?  Or is my realtor right and the market fundamentals in Vancouver justify these prices?

I decided to learn a little more about what makes a bubble.  The following is an amalgam of findings described by Ferguson (2009) and Reinhart & Rogoff (2011).

1. Kickoff – Something happens to create new profit opportunities
2. The Rise – As prices rise, more people pile into the market
3. Mania – “Hot” money enters the market, driving prices beyond what party-poopers would call the “fundamentals”; rationalizations abound as to why the fundamentals don’t apply.
4. The unthinkable – Something happens to kick the legs from under the market.  It turns out the fundamentals did apply and prices collapse.

Why I think we’re in a manic phase

So, how would you identify a “fundamental” price for housing.  The Economist gives it a go in a recent article where they conclude Canada’s housing market is over-valued.  Given Vancouver has some of the least affordable housing in the country, it stands to reason that it is overvalued too.

Moreover, RBC Economics Research maintain that for a house to be “affordable”, no more than 32% of household pre-tax income should go towards housing.  Recall that a house in Vancouver requires 91% of pre-tax income of the median household.

That means Vancouverites do not have the financial means to bid housing prices to their current levels.

“The fundamentals don’t apply here” crowd would have you believe that Vancouver is special.  We have the nicest weather in Canada and plenty of outdoor amenities, which drives up demand as people flock to live here.  But, we have space that’s restricted by the ocean, mountains and US border, limiting supply.  So, prices are high because we have high demand and low supply.

But here’s the thing.  It is not possible for the people who flock here to live to bid prices up to their current level because they do not have the income to do so.

This leads to an interesting question.  If the people who live here don’t have the means to bid prices to their current level, then why are they at their current level?

That’s where “hot money” entering the market comes in.  A recent article in The Province suggested what many Vancouverites are thinking – rich Chinese investors are bidding up the market.  But, as the article shows, the evidence for this is anecdotal at best.

Anecdotal or not, my sense is we do have a lot of foreign money bidding up the price of our real estate.  For several years I have been fortunate to know and work with several Chinese businesspeople.  Let me add my anecdotal evidence to the fire by saying what I’ve learned.

One Chinese businessman told me the super-rich in China are keen on getting their money out of the country (hmm, wonder why?).  For several reasons Canada is a popular destination.  According to him, many political and industrial leaders have bought homes in the richest areas of Vancouver for a variety of uses:

1. Residences for their family
2. Investment properties
3. Or they sit empty

On a personal note, I know of two houses on my block that have been bought by Chinese owners that now sit vacant – immaculately maintained, but vacant.

Additionally, I have worked with Chinese businesses who’s strategy seems to be:

1. Travel to China
2. Come back
3. Buy a hotel (or warehouse/land/apartment blocs/etc)
4. Repeat

Reinhart & Rogoff note that bubbles can persist far longer than any rational person thinks is possible.  For Vancouver real estate, as long as businesses can buy hotels on their return trip from China our housing prices will defy the “fundamentals”.

Consequently, I believe the event that pops the bubble will take place in China, not in Vancouver, and it will be something that causes China’s supply of money to run dry.  Then, the only demand will come from people who live here and prices will collapse to a level that they can actually afford.

References:

Ferguson, N. (2009).  The Ascent of Money.  New York, NY:  The Penguin Press

House of Horrors, Part 2.  (2011, November 26).  The Economist.  Retrieved from:  http://www.economist.com/node/21540231

Olivier, C.  (2011, November 14).   Is It Time to Curb Foreign Real-estate Buying in Vancouver?  The Province.  Retrieved from:  http://www.theprovince.com/business/time+curb+foreign+real+estate+buying+Vancouver/5703433/story.html

Reinhart, C.M., & Rogoff, K. (2011).  This Time is Different:  Eight Centuries of Financial Folly.  Princeton, NJ:  Princeton University Press.

Wright, C., Hogue, R.  Housing Trends and Affordability, November 2011.  (2011).  Toronto:  RBC Economics Research.  Retrieved from:  http://www.rbc.com/newsroom/pdf/HA-1125-2011.pdf