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The 'soft landing' thesis: Valid, but highly unlikely

NOVEMBER 18, 2010

It's getting increasingly difficult to dismiss outright the notion that real estate in Canada is extremely pricey based on measures of fundamental values. I have yet to receive an intelligent response from the bull crowd addressing these fundamentals. At best we hear anecdotes ("endless rich Asian investors"), non sequiturs ("a correction hasn't happened yet, therefore it won't"), and other arguments that contain an element of truth, but ultimately hold little water when considered rationally ("immigration will save us", "they're not making any more land", "our banks/consumers are more prudent", etc)

Perhaps the one very valid argument often thrown around is the idea of a soft landing in real estate. Consider this point raised by a commenter from a previous post:

"I’m merely trying to float the idea that prices might go sideways and prices may not collapse at all or decline very much in the centre of Toronto and Vancouver. All the reasons I stated above (inheritance, inter-generational wealth transfer, wealthy immigrants -ed.) may play a part. But those reasons are either a) discounted altogether by you or b) met by a defensive scoff or c) challenged by your pathetic machismo when faced with an alternate point of view which we’ve seen ad nauseum on every other bear blog."

My pathetic machismo aside, let's consider the scenario posited by the bold, anonymous poster....hey, it's easy to have machismo when you hide behind an internet pseudonym.

The 'soft landing' thesis has certainly been suggested in the Canadian media:

Housing achieves a soft landing in conservative Canada

A soft landing or something worse?

....just as it was in the US back in 2004-2006

Housing to make a soft landing

A soft landing for housing

Of course this proves nothing other than the fact that when an economist on either side of the border whose income relies on preventing a housing crash tells you that a housing crash is highly unlikely, consider the source.

Definitions

So how do we determine the likelihood of a real estate crash vs the likelihood of a 'soft landing? Let's start with a couple definitions.

Here's how I would define a 'crash' in an asset market: The price decline roughly mirrors the rapid price increase in both duration and magnitude.

This is a common feature of asset bubbles: They are roughly symmetrical in shape and duration. Consider the following examples borrowed from Chris Martenson's excellent primer on bubbles:

A 'soft landing' on the other hand involves a similar rapid rise in asset prices followed by a plateau in gains while fundamentals catch up.

It's important to note that virtually all economists today will fall into one of these two camps. It is exceptionally difficult to find an economist who believes that the price increases we've seen in real estate are sustainable into the future as they have massively outpaced income growth and inflation.

VREAA's examples:

If house prices in Canada are in fact in a bubble, and the price movement mirrors the movement in prior bubbles, what might that look like?

Some possible scenarios were explored in an interesting post by VREAA, where the author used technical analysis to examine potential future price movements in the Vancouver market, arguably the most overextended market in Canada, if not the world. The author recognized the inherent difficulties in examining price movement in real estate using TA, though it provides some interesting scenarios to consider should the price movements mimic those of bubbles in the past. The tricky part is knowing where the real estate bubble started, which would then become the resistance point.

I won't re-post the entire content, though I do suggest you check it out for some interesting insight.

Now this doesn't prove one way or the other which way the market is likely to move, though I do think VREAA is absolutely right that IF the Vancouver market is in a bubble (it is!), it will very likely return to its support level in a symmetrical manner.

Empirical Data

Enough of my opinion or the opinion of other bloggers. What does the empirical data say?

Interestingly, the research I read, and I read quite a bit, suggests that soft landings are exceptionally rare when asset prices move significantly out of line with fundamentals.

To wit:

"First, we emphasize that the real estate price peaks which are currently under way in many industrialized countries (one important exception is Japan) share many of the characteristics of previous historical price peaks. In particular, we show that: (i) In the present episode real price increases are, at least for now, of the same order of magnitude as in previous episodes, typically of the order of 80% to 100%. (ii) Historically, price peaks turned out to be symmetrical with respect to the peak; soft landing, i.e., an upgoing phase followed by a plateau, has rarely (if ever) been observed."

Similarly, an article published in the journal Urban Studies in July 2010 had the following to say:

"A systematic deviation of a price from its fundamental value over a sustained period of time, on the other hand, can only be the result of speculation. Such deviation is thus called a speculative bubble." (pg. 1727)

"History tells us that the faster and larger the bubble inflates, the more likely it will burst in the less benign way" (pg. 1728)

This comment follows a discussion on 'soft landings' versus 'crashes'. The 'less benign way' referred to here is in reference to market crashes.

If interested in referencing this article, here is the full reference:

Xiao, Q. (2010). Crashes in Real Estate Prices: Causes and Predictability. Urban Studies, 47(8), 1725-1744.

Key Implications:

While it may perhaps still be debated whether or not the real estate market in Canada is in a bubble, it is become increasingly difficult to debate the fact that prices are straying significantly from measures of fundamental value. How they will realign with these fundamentals is certainly up for debate, though it is worth noting that significant overvaluation in real estate markets seldom corrects itself by remaining stagnant.

That being the case, I would put the odds of a Canada-wide stagnation in house prices at an absolute maximum of 25%, with the odds of a sustained increase over the next few years at 5%, and the odds of a significant correction over the course of a few years at 70%.

Pricier markets like Vancouver, I would weigh those odds much differently. I see the odds of a stagnation in prices at less than 10%, a sustained increase over the next few years at less than 5 percent, and a significant correction at well over 80%.

Cheers

Ben

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Ben Rabidoux
By Ben Rabidoux

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12 Comments

  • Will said:
    • 3 years, 5 months

    Hey Ben - I really like your blog!

    I personally believe that the "soft landing", or "rich investor", "inheritance", etc arguments are pulled out of thin air. Rich investors, whom we can assume are probably quite business savvy, are not going to keep an entire country afloat. What's keeping the real estate market afloat is a combination of social pressure to buy a house and the fear of continued rising prices, as we've seen over the past few years.

    My wife and I fell in the same trap a few years back and are very happy to have come out with only a small loss. We're now happily renting, or so I thought. Buying a house is still a weekly conversation, even though our lease won't expire until late next year. The weird thing is, she is completely understanding of the fact that home prices will most likely be down next year, and discusses this with her friends, who seem to agree. Yet, despite all this knowledge, she still wants to buy a house.

    It seems that the potential of loosing a fair chunk of changes (again) or being stuck in a home that you want to move out, but can't, because you can't pony up the funds required to repay your loss (again) is perceived as a small price to pay for calling a place your own - real estate associations and msm sure have done a great job of brainwashing an entire generation!

    But back to the article... Prices always return to their inflation-corrected historical average, unless there is a significant change in the environment. So yes, Canada has departed from this rule, and is likely to fall back to the average again at some point in the future. However, a change in environment (deductible mortgage interest) could be introduced which alters this rule. I don't think it's likely, but it could.

    One thing is for sure, incomes are not going to catch up to home prices any time soon, so demand will dry up eventually...

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  • DancinPete said:
    • 3 years, 5 months

    Hi Ben,

    One question I've ha:. If part of this housing collapse is going to be fueled by boomers selling their McMansions and downsizing, what is the impact of this increased demand for the houses/apartments they're downsizing into? Do you see a glut of McMansions dropping in price as the next generation can't move up and the boomers can't get out, but an increase in demand for smaller more sustainable housing?

    I'd also like to add an anecdote about the Rich Asian Investors (tm) leaving when their investments turn sour. I've met a few of these types of buyers ( I live in the lower mainland) and I'd classify them not as investors, looking for a return, but immigrants looking to get out of China..... at any cost. I, too, doubt that there's enough of them to make a serious impact on the overall housing market, but I don't think they're all here just looking to flip property.

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  • jesse said:
    • 3 years, 5 months

    An asset bubble requires perpetually increasing capital to sustain it, even if prices stay flat. This is because other investments with better income streams will start pulling capital away.

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  • Dave said:
    • 3 years, 5 months

    Great blog. I just discovered this by accident. And a very interesting post, as I had been pondering the same question in relation to Australia. ie Can we somehow engineer a soft landing? I doubt it very much.

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  • Toronto said:
    • 3 years, 5 months

    The real questionn is how do we take advantage of this. Rather than waiting for a correction while we rent after selling our houses is not enough. I'm thinking of opening a collections agency or perhaps a debt councelling service which will excel when it all goes down. Any other ideas?

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  • Grrr said:
    • 3 years, 5 months

    Here's my reasoning why a soft landing isn't possible.

    As interest rates were falling and lending practices were loosening (40/35 year ams, lower down payment requirements), housing prices began to move up more rapidly than normal. This generated interest from investors who began buying inventory to resell. Regardless of whether they flipped a month later after doing nothing, or held for a longer period of time while renovating, this activity represents increased demand and absorbed supply. The increased demand pushed prices up even faster and attracted more investors (and infomercials, books, etc.) Increasing prices also attracted more builders. The increase demand from investors was met by new supply coming on line.

    But what happens if prices simply level off? Obviously investors will lose interest. The demand they represented will vanish and the supply they absorbed will come to market, either pushing house or rent prices down. Even small drops in prices will chase more investors out of the market. Also, even as the markets cool off, it will take time for builders to readjust and slow building. They will be an additional source of oversupply.

    It's not just the investors that will cause prices to fall. Some average buyers will decide to delay their purchases in a flat market. After all, at a time when renting produces better cash flow and prices aren't going up, why not wait to buy? But waiting to buy represents delayed demand which put downward pressure on prices.

    So why can't we have a soft landing; a flat market? Because the market dynamics just don't work that way.

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  • Retired in Victoria BC said:
    • 3 years, 3 months

    The current Conservative policy is driven by the desire not to lose the next election so they have tipped toed around the issue of irresponsible lending and they are not prepared to increase interest rates. They hope that if the market does fall precipitously before the next election they can they say they did take steps to cool the market. This in spite of the fact they let lenders run amok and make vast profits with the backing of the taxpayer through CMHC. The problem with all rational real estate analysis it cannot predict the market to the extent that it is affected by short term political decisions. I think the fall out will come principally after the next election and in the first year of the next Government.

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  • Ben Rabidoux said:
    • 3 years, 3 months

    Perhaps. I would point out that it’s not the conservatives who have failed to raise interest rates. The BoC is not affiliated with any political party, despite the governor being appointed.

    Also, as per today’s mortgage change announcements, the government does not seem particularly inclined to support the housing market at all costs.

    That being said, I do agree that there will be a significantly different tone out of Ottawa should the conservatives gain a majority.

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  • Katya said:
    • 2 years, 6 months

    Someone raised the issue of the impact of demographic changes on the (typical suburban) housing market. The link will take you to an important paper by the Joint Center of Housing Studies at Harvard University, which explores this topic in some depth and sees the slow but inevitable sell-off of "typical family houses" as the major long-term trend beyond our shorter-term bubble worries. More big houses on the market for fewer young buyers, especially fewer young buyers with the kind of funds and income needed to buy these houses at their current (high) prices. This is expected to yield an (inevitable) softening without some kind of intervention. Again, a slow but steady shift; it's hard to fight demographics. It is good news for certain kinds of condos (not tiny downtown core) and for bungalows (the latter of which already are showing their relative value). Here is the link to the report:

    http://www.jchs.harvard.edu/publications/remodeling/w11-4_masnick_will_b...

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