Rule No. 1: A property bubble isn't a bubble till it pops. Whether it’s Shanghai, London, or Toronto, until the final blow-up, it's just a rising market driven by rising demand.
Just ask the people who sell real estate. They will tell you we are nowhere near a bubble. And lately we've seen a number of opinion pieces by what you might call "bubble scoffers," who are reacting to the loose use of the term that ascribes bubble characteristics to everything from bitcoins to stocks to the boom in technology start-ups.
My own prescription to prevent a bubble, a wider sense of caution, which I offered more than a year ago, still stands.
But as 2013 comes to an end, rather than join either the chorus of warnings or those of reassurance, I thought that in the spirit of the season, I would take a different stance altogether. I would like to look on the bright side. Certainly, we need some optimism.
Reason for hope
We've had another year of foreboding on global property prices from very respectable sources. New homes in big Chinese cities are up another 20 per cent despite attempts by the government to cool the market. In London, prices are rising at six times the rate of inflation.
Even Mark Carney, the Canadian-born head of the Bank of England, can't keep a lid on it. Canada comes in for special treatment. The latest of the doomsayers, Deutsche Bank, said in a Scrooge-like pre-Christmas superlative that Canadian property was the most overvalued on the planet — some 60 per cent above what it should be. Just in November it was the Organization for Economic Co-operation and Development — the rich countries think tank — that singled out Canada's property market for a potential "disorderly correction."
That sounds worrying, but it’s actually a euphemism for something even uglier. Instead of dwelling on how much many of us — and me in particular — would lose if we had a 60 per cent correction in the Canadian property market, I thought it best to don my rose-coloured glasses and borrow from the subtitle of one of my favourite movies, Dr. Strangelove.
The theme for this holiday season bedtime story is: "Why I learned to stop worrying and love the property bubble." Occasionally in economics, a rising tide raises all boats. But often it’s a lot more choppy. There are winners and losers.
'Occasionally in economics, a rising tide raises all boats. But often it’s a lot more choppy. There are winners and losers.'- Don Pittis
To the economist, observing economic cycles is like the kid gazing at waves rolling in on a beach and thinking about the forces causing their repetition and patterns. The stock trader is like the other kid on the beach who thinks she has it figured out, wades in and keeps getting her good shoes wet.
So long as you don't care about the exact moment of a peak or trough, watching economic cycles can teach you many useful things. One of the things they tell you is that the supply of new houses created by the economy does not grow in exact proportion to the growing number of households.
Peaks and valleys
Sometimes, the peaks of ocean waves are well above sea level. Sometimes the troughs are well below. The same things happen with the supply of houses. What causes the peaks and troughs in house construction is sometimes mysterious. But as someone old enough to have watched many little waves and at least three big ones, it is interesting how at the end of every big cycle, there is a glut of houses.
I remember the end of the "townhouse" boom as a kid. Townhouses went cheap and construction projects stalled unfinished. I remember two houses in Toronto's now-pricey South Kingsway neighbourhood standing uncompleted for years afterwards.
These booms followed by busts are not a uniquely Canadian phenomenon. Pictures of luxury houses surrounded by weeds are a symbol of the end of the U.S. boom in 2008. More recently, property busts hit Ireland and Spain. The subject has been well studied. As this report from the European Central Bank shows, just about every industrialized economy goes through the cycle.
As the report also shows, while Germany gets credit for low rents and a stable property market since 2008, it is no coincidence that as of 2007, the country had just gone through a seven-year property bust. Because that's what happens after an excessive boom.
As the famous graph from Canadian economic geographer Jean-Paul Rodrigue shows, after a bubble pops, valuations plunge with demand to a level well below the average expected price levels. We have seen the same thing in oil, natural gas, gold, potash.
High prices push up production, followed by a point when too much is being produced and prices fall. In the housing market, where the construction cycle of a single building can take at least two years and the product lasts decades, it is not so easy to turn off the tap. Market economists often complain that rent and price controls distort the market for property because underpricing fails to instruct the market to produce enough.
But the factors the ECB blames for inciting a boom — "including short-term interest rates, local and global money and credit developments, and the incidence of mortgage market deregulation" — can also distort a market the other way, producing too much.
And this, finally, is the good thing about a property bubble. While you may suffer personally when the price of your house falls, and while the wider economy may suffer a contraction when homeowners suddenly feel poor, the greater Canadian economy will benefit.
Here’s why: During bubbles, a country grows its housing stock, over-investing in the construction of new properties so that the supply is more than sufficient, allowing prices to fall relative to income. At the end of a bubble, finally and for quite a while afterwards, there is enough to go round.
Reason for optimism
As the ECB report says, "there has been a strong correlation between the persistence and magnitude of booms and of subsequent busts." And that's why, when I take a long view through my rose-coloured glasses, I feel good when I see signs for new luxury homes and condos. That's why there should be no restriction on building them.
Luxury homes are well made and made to last. Just like the bedraggled mansions in older parts of town I remember as I was growing up, luxury housing may not stay luxurious forever, but it contributes valuable housing stock during the downward part of the cycle.
What Canada is experiencing now may or may not be a bubble. Today, I promised to be agnostic on that point. If this is not a bubble, then we are producing just the right amount of housing to supply our needs and we can keep on doing that forever. Prices in the new paradigm will stay at the current permanently high plateau.
If it is a bubble, unfortunately for those who want to buy low and sell high, we have no idea how long it might last. Remember rule No. 1. But if you do hear the pop, think of it as a champagne cork celebrating a new era of property stability.
All the best for 2014.