A Closer Look at Canada's Decline in Real Estate Prices

John Pasalis in Toronto Real Estate News

For the past couple of months I have been cautioning our readers against making any big conclusions about Toronto’s real estate market based solely on changes in average prices.  Toronto has seen a big decline in the number of sales of high end homes this year which has been exaggerating the decline in prices.  For more on this read my previous posts Toronto Land Transfer Tax Exaggerates Housing Price Decline and Making Sense of Toronto’s Real Estate Decline in October.

At a national level, economists from TD Economics noticed that national average prices were being skewed down because of steep declines in sales in British Columbia, where average home prices are the highest in Canada.  Last month TD Economics published a report titled A Different Look at Canadian Home Prices where they introduced the TD Home Price Index as a more accurate way to measure changes in national prices.

I invited one of the authors, Economist Grant Bishop to answer a few questions about their report.

John Pasalis:  Hi Grant, thank you for taking the time to answer a few questions about your report.  Can you start off by explaining why Canada needs a Home Price Index?  What’s wrong with using average prices to track national house prices?

Grant Bishop, TD Economics: National-level average prices are distorted by swings in sales volumes across different markets.  By applying consistent weights, an index strips away these market-specific swings and is a better indicator of the value of housing nationwide.

Presently, house prices at the national level are reported as an average across all properties sold in the month, quarter or year.  The problem is that the average house price is reported as representative of the average value of the housing stock.  It is only a measure of those houses sold; not those that never went on market.  Certain high-priced or low-priced markets may experience relatively high or low sales volumes in any given period.  The number of sales is highly variable between cities and over time.  Sales volumes can thereby generate unrepresentative swings in observed house prices. 

An aggregate measure at the national level should provide a consistent picture of how home values are changing over time.    The index should be representative of the stock of housing rather than just those houses that are sold.  An index that removes the effect of momentarily hot markets is necessary to remove the distortion from these temporary high sales volumes. 

As a stylized example, consider two cities each of 100 homes.  In city A, all houses are worth $200K.  In city B, all houses are worth $100K.  The average value of housing is then $150.  However, consider a period where 30 houses are sold in city A at $200, and 10 houses are sold in city B at $100K.  The observed average price is then (30 x 200K + 10 x $100K)/(30 + 10) = $7000K/40 = $175K.  Because more houses were sold in the higher value city A, the average price was distorted upwards.

As a more concrete example, from the 1981 census, Vancouver constituted 9.3% of all owner households in our 24 city sample.  From the 2006, census Vancouver constitutes 10.5%.  Despite interprovincial migration, a given city’s proportion of homeowners moves relatively slowly over time.  Compare this with sales volumes: In July 2007, Vancouver represented 8% of all national sales.  By July 2008, Vancouver’s sales were down to 5% of the national average.  Vancouver is a high-priced city and its lower sales volumes diminish its weight in the national-level average, distorting this measure downwards. In contrast, an index ensures constant weighting so that the national-level measure better represents the price of the overall stock of housing.

As a macroeconomic indicator, home values are very important.  Canadians hold around 35% to 40% of their wealth in their principal residence.  Home values then have a substantial impact on households’ decisions to spend, work, and invest.  It’s important that we’re consistently gauging this indicator.  Moreover, even though people buy houses locally, not nationally, the impact of such reported swings can create misperception about the value of one’s own home, inducing more pessimism or optimism than is warranted.

CREA’s [Canadian Real Estate Association] average of house prices is certainly not wrong. It measures what it measures.  However, as a measure of the value of housing, we contend that an index with constant weights is a more consistent gauge.  An average of sales is prone to swings in different markets and thereby misstates the actual average value of the stock of housing.

John Pasalis: How does the change in average prices reported by CREA compare to the change in TD’s Home Price Index?

Grant Bishop, TD Economics: CREA’s house price in October was down 10.9% Y/Y while the TD HPI showed a less steep decline of 4.6%. From 2002 until early 2008, the year-over-year percent changes within the TD HPI were generally consistent with CREA’s average.  Over that period, the level of CREA’s average generally exceeded that of the TD HPI.  For instance, when house prices peaked in May 2008, the TD HPI records a $340,046 price while CREA reports $345,362.  However, the greatest – and most important - difference has been during the post-2007 period of deceleration and decline.  But turning points are when accuracy counts most.  With house prices now in a year-over-year decline, it’s critical to gauge the magnitude of the fall consistently.

John Pasalis: The TD Home Price Index does not control for unit-type shifts (e.g. changes in sales volumes of high end homes vs. starter condos).  If you could take unit-type shifts into account, what impact do you suspect that would have on the Index.

Grant Bishop, TD Economics:  Using repeat sales to control for quality across time is an important feature of the S&P/Case-Shiller index that is used in the United States.  The TD HPI strips away the distortion caused by sales volumes in different markets. However, we agree that controlling for unit types and quality is key.  Given the downturn in the market, it is likely that we would see a lower decline if controlling for unit types.  Specifically, higher quality homes will likely be held off market to a greater degree and new homeowners will likely look down market.  This would mean that the average price from observed sales would be biased downwards.

We do project a movement towards higher density and lower cost units.  In a large centre like Toronto, this has both cyclic and structural elements: Over the downturn, income growth will stagnate and younger cohorts especially will look towards cheaper options.  Retiring boomers are prone to downsizing.  Although the latter may buoy the luxury condo market, their new condo will likely be cheaper than the single-detached that they’re cashing in.  Of new housing, we project a more rapid fall in singles construction than in multiples.  Overall, the near-term trend should be for “hamburger rather than steak”.

In the data, we see Toronto overall sales declining year-over-year (-22% in August and a further -7% in September), but these were led by declines in sales of single-detached units (-24% in August and a further -9% in September).  Townhouses and condos sales have also declined year-over-year but not quite to the degree.  As well, although there’s a decline in price story as well, the proportion of Toronto homes selling over $500K have declined from 18% of sales to around 14%.  Indications are that those who can wait to sell are doing so.

John Pasalis: What do you feel is the key take away message from your report?

Grant Bishop, TD Economics: Firstly, Canada needs better housing data, and consistent measures of prices.  Homes are very important to families, and housing plays a large role in the economy.
Secondly, especially in a period of high volatility, it’s important to measure indicators consistently.  Any statistic can be biased by its measurement and is key to consider what is really being measured.

John Pasalis: What’s your outlook for Canada’s real estate market over the next year?

Grant Bishop, TD Economics: Over the coming year, we forecast a price decline of -6.1% nationwide under our base-case forecast and a -10.7% under our pessimistic scenario.  The greatest declines will be seen in the overbuilt markets of Western Canada where the shock to commodity prices will markedly depress income growth.
Between our base-case and pessimistic forecasts, the devil’s really in how credit turmoil is resolved and plummeting consumption rebounds stateside.  Canada is being buffeted by the three C’s (credit, commodities, and cross-border trade) and this is going to cause stagnation in income growth for Canadians over the coming year.  The high erosion of affordability shows that prices had disconnected from incomes and this is now being reined in rapidly.  In the long-run, house prices can’t exceed what people earn, have saved, or banks are willing to lend on the basis of their future earnings.  We expect prices to return to a more affordable level that is more in line with income growth and interest rates.

John Pasalis:  What’s your outlook for Toronto’s real estate market over the next year?

Grant Bishop, TD Economics:Our forecasts for Ontario are for a decline of -4.5% under a base-case and -9% under a pessimistic scenario.  By sales, Toronto comprises 40% to 50% of the province’s real estate market.  The province and its major city are going to feel severe strains from the downturn in exports and a sagging manufacturing sector. However, the GTA should nonetheless fare better than the outer Golden Horseshoe, where there are signs of oversupply.  Affordability in Toronto is within reasonable limits but prices will nonetheless feel some significant downwards pressure.

John Pasalis is a sales associate at Prudential Properties Plus in Toronto and a founder of Realosophy. Email John

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Comments

[dontcallmeshirley]

Hey John,

Gosh, you are persistent. Okay, we get it, mix of houses sold distorts the average. It's your blog, but fixating on this is making you appear less impartial.

You should have asked the economist what the value of an illiquid asset is (ie. no buyers) and also how to account for house mix being distorted by houses moving around in the price brackets (eg. a house that would have fetched $700k in a bidding war last year goes for $500k today - Tuesday).

And you know what, maybe TD economist can also answer how TD appraises a house when they front the mortgage.

Cheers!

[Guru]

Its funny how all these experts are pointing out these flaws in housing price declines when real estate prices are coming down, but did not mention the same problems when the real estate market was exploding.

If a 10% decline is really a 5% decline after taking into account the relative weight of BC and other high priced locations, well that means that the reported 20% gain was really only a 12.5% gain when the market was booming.

Please take into consideration who these experts are working for and what there angle is when reading these articles.

[Eduard]

Considering average sold price in my mined is less important than accepting median sold price statistics as the true scale of market pulse. Why is it that we don’t see more of that view?

[dontcallmeshirley]

Putzing around with the math of average price is a red herring.

The important question is how much longer can sellers hang on for?

Unemployment, lack of credit (everyone saw the Scotiabank news right?) and stock market losses will pressure sellers.

How much longer will they have sufficient cash flow to carry properties?

[John Pasalis]

@dontcallmeshirley
I hear you, I have not balanced the art of writing for both new readers and subscribers. I can appreciate how this is starting to sound a bit repetitive.

wrt. illiquid assets: real estate has always been a relatively illiquid asset. The fact that there are fewer buyers today means that it is just going to take a little longer to sell. I suspect you'll see more buyers in the new year.

@Guru,
I'm not sure maybe some economists didn't look into this because housing sales were relatively normal across Canadian cities. One city wasn't skewing the data either up or down.

But even if you are correct and the data was skewed up and a 20% increase was really a 12.5% increase, that's positive news for our real estate market.

@Eduard
I'm not sure why most of the real estate boards and associations report on average prices.

[Brendan]

John,

First off, great blog, I love how you take on some of the baseless TREB propaganda. However, to the point that more buyers are going to somehow appear in the new year, I struggle to figure out what basis you have this for happening.

In order to purchase a house a buyer needs to have job security, savings and a mortgage. All of those things have been put under immense pressure over the past 6-12 months.

Markets are down in excess of 40% (or even 50% depending on the day) which has destroyed most buyers down payments. Credit has tightened making it harder to secure a mortgage (actually it is just harder to secure a mortgage you can't afford, how novel!). Lastly, most organizations are looking to cut back, or at least freeze hiring and wages making many individuals less than certain about their future income streams.

I am surprised that the massive decline in global stock markets doesn't get more attention when it comes to the affect on buyers purchasing power. It has affected retires and pensions, so one can only assume it would affect savings of those looking to purchase real estate as well.

[John Pasalis]

Brendan,

Glad to hear you enjoy the blog.
There are a couple of reasons why I think there are going to be more buyers in the spring. I talk to and hear from a lot of buyers who tell me they are going to wait till the new year before they start looking again. Second, sales are historically low in the fall and they usually pick up in the spring.

One of the biggest factors driving the slow down in the real estate market is low consumer confidence. I think Canadians can handle news about a recession, but all the negative news surrounding the credit crisis and fears of another great depression really hurt consumer confidence. If credit markets continue to remain stable then consumer confidence will improve which will in turn have a positive impact on real estate sales. If US banks start falling like dominos again, all bets are off.

With respect to your concerns about the impact the stock markets might have on real estate sales, that's a tough one. I looked back at our last market crash in 2000 and interestingly enough sales in Toronto actually started to pick up after the market crashed. Sales reached record heights in 2002 just as the TSX hit its lowest level. I'm sure the market crash is going to have some immediate impact on our market and on consumer confidence, but I don't know if there is always a perfect correlation between stock market performance and real estate sales.

[dontcallmeshirley]

Hey John,

Preaching a message of hope will not end the current stalemate between buyers and sellers.

I would suggest that you, and all realtors, have a crucial role in breaking the stalemate.

How? Educate your sellers. Tell them the landscape has changed and that buyers are not "holding out"

Simply, there is now less cash flow out there to throw at a house purchase.

Buyers have gotten murdered on their mutual funds. Those will not come back because the stocks that make them have either disappeared (Lehman Brothers etc) or fundamentally changed (AIG etc).

Lots of lenders have written off hundreds of billions of dollars, they will be tight with future lending until they re-coup those losses.

Get that message out there, get sellers to set aside their pride, drop asking prices, and voila, you'll have a real estate market again.

You have to burn the other end of the candle to get this pig moving again.

Cheers!

[lipstickonapig]

First of all, I'm very impressed with the quality of the comments on this blog - there are some real insights here, especially the first post.

Second, people that benefit from a strong real estate market will obviously be biased when reporting on that market - go figure; so let's stop being so suprised when real estate agents say things aren't as bad as they appear, unless they have some thoughful and factual analysis to back it up!

Third, and this is for John to answer, why is there so little attention being paid to the fundamental value of real estate? If I buy a house now and I pay fair value for it, I am less concerned if the broader market falls 10% or even 20% in the next two years...all assets including houses have price cycles that follow their long-term mean. A recent WSJ article stated that the long-term (ie. 100 year) average home price should increase by inflation plus a percent or two; meaning if long-term inflation is around 3% you should expect to earn about 5% on your home year over year over the long term. Home prices should always revert to their mean. Take a look at what happened to the average home price for the GTA in the years 1986, 1987, 1988, and 1989; they increased 27%, 36%, 21%, and 19% respectively. Way higher than the long-term mean of 5%. This was driven in part by a period of high inflation and immigration. Reversion to the mean demanded that house prices "correct" for this period of abnormal price appreciation and as could be predicted, house prices in the GTA declined over the next seven years by an average of 4%. So if you take an average of the two periods, you get 6.6% year over year increase which is still higher than the mean but can be expected given the structural shift in demand resulting from immigration patterns. So what about today? From 1997 to 2007, home prices in the GTA have increased 6% year over year. This is slightly higher than the long-term mean of 5% but not by much. So on a fundamental basis house prices in the GTA don't deserve to go through a large correction as they did back in the early 1990s...there is a big difference between a fundamental price correction and a decline in prices due to consumer sentiment. The current state of the real estate market is more related to the latter than the former. If you take a normalized Toronto home price from 50 years ago and grow that home price by 5% until today, our current home prices are only slightly above that trend line and by no mean represent a bubble. And if you think the long-term average price increase should be 6% and not 5%, we are actually under the long-term trend and one could argue Toronto real estate is fundamentally undervalued! The bottom line is there is a big difference between fundamental value and market value. John, how about some fundamental analyis instead of the "less buyers in the Winter" analysis?

[chris]

You make good arguments, but let's look at macroeconomics:
- oil prices have been devastated
- commodity prices have fallen
- auto sector is near bankrupcy.
- US economy in shambles.

Who will suffer most? Ontario, BC, Alberta. Prices still need to adjust to the reality that Canada's export will be weaker, and that the job market will not support demand for homes.

[chris]

You make good arguments, but let's look at macroeconomics:
- oil prices have been devastated
- commodity prices have fallen
- auto sector is near bankrupcy.
- US economy in shambles.

Who will suffer most? Ontario, BC, Alberta. Prices still need to adjust to the reality that Canada's export will be weaker, and that the job market will not support demand for homes.