Real Estate Market Bubble

12 min readMay 7, 2021

Abstract:

Toronto’s real estate market is arguably in a bubble. The research paper defines what a housing market bubble is and what are its causes and effects on the economy as a whole. This study aims to analyze how to combat a bubble and what role policymakers must play to neutralize its effects. Also analyzing key history lessons learned from previous market crashes. Finally detailing how to hedge our portfolio to protect from the repercussions of the market bubble bursting.

Introduction: Real estate market bubbles

Housing bubbles usually start with an increase in demand, in the face of limited supply, which takes a relatively extended period to restore and increase. Speculators pour money into the market, further driving up demand. At some point, demand decreases, and at the same time supply increases, resulting in a sharp drop in prices — and the bubble bursts.

International Monetary Fund (IMF), states that housing bubbles may be less frequent than equity bubbles, but they tend to last twice as long

Its main drivers are:

Low-interest rates
Rising economic prosperity
Manipulated demand & Speculation
Unusually high levels of investment
Excess liquidity
Deregulated real estate financing market
Extreme forms of mortgage-based derivative products

Market Psychology

According to the latest Mortgage Professionals Canada survey (taken in Jan/Feb 2020), expectations for home price gains are the highest in at least a decade, while expectations for mortgage rate changes are the lowest in at least a decade.

Circumstances leading to a bubble

Traditionally, housing markets are not as prone to bubbles as other financial markets due to the large transaction and carrying costs associated with owning and maintaining a house, which discourages speculative behavior.

However, a rapid increase in the supply of credit leading to a combination of very low-interest rates can bring borrowers into the market and fuel demand.

A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.

Interest rates and housing market correlation

Given that most home sales are financed through the borrowing of money in the form of mortgages, the housing industry is profoundly affected by changes to these rates.

When interest rates are lower, people are generally more willing to take out a mortgage than when rates are higher, as doing so will cost them less than at another time.

Consequently, the sales of homes rise as more consumers can take out a low-cost loan. Consumers with existing mortgages may attempt to re-finance their mortgage, meaning they trade their current loan for another, cheaper one. In periods of low-interest rates, more houses are often built as demand rises, and development companies can borrow money at a cheaper rate to finance the construction.

There seems to be a close correlation between the cost of a mortgage and the interest rate, but the correlation might not be present between the interest rate and the prices homes are being sold.

Meaning low-interest rates can raise demand for houses, pushing up the prices of houses, if the price gets too high, demand can cool, causing house prices to plummet.

Adjustable-Rate Mortgages

Not all mortgage rates are fixed at the time that the loan is taken out. Through an adjustable rate, the interest rate of the loan may change as often as every month. Most adjustable-rate mortgages have their rates tied to an index of financial securities, one that changes with the movement of the market.

Repercussions of bubble bursts on the Economy

A real estate market bubble bursting could cause the property prices to crash down, leaving borrowers with mortgage loans that could exceed the market value of their property. This could lead to several negative consequences, such as increased debt, bankruptcies, reduced access to housing, and a decline in economic activity.

Housing bubbles don’t only cause a major real estate crash, but also have a significant effect on people of all classes, neighborhoods, and the overall economy. They can force people to look for ways to pay off their mortgages through different programs or may have them dig into retirement accounts to afford to live in their homes. Housing bubbles have been one of the main reasons why people end up losing their savings.

When the bubble bursts the risk is realized throughout the system and the losses are suffered by homeowners, mortgage lenders, mortgage investors, and property investors.

The bottom line is that when losses mount, credit standards are tightened, easy mortgage borrowing is no longer available, demand decreases, supply increases, speculators leave the market, and prices fall.

Toronto Real Estate Market

The supply of housing can also be slow to react to increases in demand because it takes a long time to build or fix up a house, and in highly developed areas there simply isn’t any more land to build on. So, if there is a sudden or prolonged increase in demand, prices are sure to rise.

Months of Inventory: Number of homes available for sale at the end of a given month divided by the sales in that month.

As we can see from the graph GTA’s housing market is following a similar trend from back in 2013- 16 ( competitive market ). We are currently at a similar one-month inventory level.

The next graph from the Regional Real Estate Board portrays a similar trend through the monthly series average price and suggests we might see a similar normal distribution that occurred during the 2016–17 housing bubble.

Consumer polling conducted by Ipsos in the late fall of 2020 suggested that “condominium apartment is the logical entry point into the ownership market for many households”.

This pie chart suggests that there is an excess demand for real estate specifically in the Toronto region compared to its neighboring towns.

Canada Mortgage and Housing Corporation released a report suggesting that wealthy foreign parents are buying condos for their kids or just for hedging purposes. This claim can be supported by the Q1 2020–21 year-over-year stats below.

Potential measures to control a market bubble

We will list potential measures to cool of the Canadian housing market fire while discussing some of the benefits and drawbacks of each.

Bank of Canada Interest rate Manipulation:

BOC could potentially raise interest rates or back down from its commitment to hold policy rates at near zero until 2023, which has been one of the main drivers for the surge in home sales and prices across the country.

Meanwhile, interest rates impact more than just the housing market and are a harsh tool to use when the economy has yet to return to the pre-pandemic levels of activity, and tightening credit conditions (liquidity) will prolong the recovery. Furthermore, a higher interest rate would likely strengthen the Canadian dollar resulting in a reduction in export competitiveness and making imports cheaper.

The real estate bidding process

Implementation of a system where buyers must open bidding among agents to keep the sale prices from settling well above the price of the next willing buyer and to create an appropriate benchmark for other properties in that location.

To implement this measure, it would require for it to be passed by the appropriate provincial real estate associations which could take time.

Speculation tax

An addition of a unique capital gains tax on the sale of residential real estate purchased from the day of the sale with the rate falling to zero over five years of holding the asset.

This could potentially filter out the speculation and alter the market psychology. A similar concept was used in Ontario in the 1970s, and it weakened the market overnight.

This measure would have a moderate impact on the user demand and specifically on the longer duration second properties.

History of Bubbles

Throughout history, all bubbles have revolved around speculation in something or the other, whether it was tulips, new technology, IPO’s est.

During a bull run, investors rationalize overpaying for assets to keep prices moving higher. The problem arises when the interest rate rises.

History teaches us that an unexpected surge in interest rates has repeatedly led to poor investor outcomes. Hence there exists an inverse relationship between the interest rate and the S&P 500, a surge in corporate leverage (liabilities/assets) promoted by weak economic growth negatively affects corporate profitability and financing activities.

US Real Estate Crisis

The U.S. market crashed in 2008 because of defaults on consolidated mortgage-backed securities and subprime housing loans that banks offered to anyone who asked, irrespective of credit score. Thus, American homeownership rose exponentially because of people with low credit scores and problems with debt being approved for subprime mortgages.

As prices rose and people expected a continuation of that, investors who got burned by the dot com bubble of the early 2000s and needed a replacement in their portfolio started investing in real estate. From 2004–2006, the Federal Reserve raised the interest rate over a dozen times to slow this down and avoid serious inflation. The ensuing 2007 banking crisis and the 2008 financial crisis produced the worst recession since the Great Depression. The plummeting price of real estate and the widespread defaulting on mortgages crushed Lehman Brothers and they applied for bankruptcy which was the largest bankruptcy filing in U.S. history at that time.

Canadian Housing Market

When evaluating Canada’s current housing metrics, we found that the home price-to-rent ratios, home price-to-income ratios, or how much the household sector was overexposed to residential real estate numbers are higher now than they were during the U.S. housing bubble. This is a result of record-low interest rates and soaring demand for housing during the COVID-19 pandemic which has pushed real estate prices to new heights. The average home price in Toronto was up 15 percent year-over-year, hitting $1,045,488 in February, while Vancouver home prices rose nearly seven percent over the same period, with an average home selling for $1,084,000. These key metrics are pointing to deteriorating conditions that are comparable to the US housing crisis.

In March 2017, months of double-digit year-over-year price increases culminated in a 33 percent gain. It brought the average cost of a house or condo in the Greater Toronto Area to $916,567, a $228,000 increase in a single year.

Toronto’s 2016–17 Housing Bubble

We find that we are experiencing buyer behavior like 2016 and early 2017, particularly in the condo market, which appreciated 15 percent last year. The lack of inventory is a key driver for the creation of this bubble. Irrational exuberance generally refers to periods when people’s motivation for buying a home and the price they pay is driven by a belief that prices will keep going up forever.

An example of this is when investors pay high prices for homes that can’t be justified by the rental income they could expect to generate and accept a negative monthly cash flow because they believe that this will be offset by the house being worth 10 to 20% more in a year.

Another example is when home buyers are led to overpay for houses out of a fear that if they don’t buy a home today, houses will appreciate $100K more in six months, out of their financial reach.

Both of these are examples of the motivations that drove investors and buyers during Toronto’s 2016/2017 housing bubble, which led to prices rising by over 30% per year. But when the rate of appreciation in house prices moves above the band and continues to move further and further away from the historical trend — as it did in 2016/17 and like it’s doing today — then this explosive growth in the rate of change in house prices is a trend that is typically indicative of a housing bubble. Another big difference with today’s suburban housing bubble is that the acceleration in house prices has been far more rapid than it was in 2016.

One way to see this is to consider how many months it took for house prices to appreciate by single digits to over 30%. In 2017, it took 25 months — this year it took just eight months.

Below is a chart showing the 2-month change in average house price for suburban houses between November and January since 2007. You’ll note two outliers in the trend (aside from last month). The decline in 2009 was during the financial crisis and the 5% increase in 2017 was leading up to the peak of Toronto’s last real estate bubble.

When comparing average sale prices in January 2021 on a year-over-year basis we see that average prices in Toronto’s suburbs were up by over 30% in Durham, Halton, and York regions and by 29% in Peel Region. Prices in the City of Toronto were up a more modest 15%.

Hedging Strategies

There are various strategies we can leverage to hedge our portfolios if we are predicting a market crash due to a bubble.

Diversification

There is a wide range of investments and different asset classes each with its level of risk that we could diversify such as stocks, bonds, cash, real estate, derivatives, cash value life insurance, annuities, precious metals, renewable energy projects, and even cryptocurrency.

Cash

When indicators are suggesting that there is uncertainty in the market, most professional traders and hedge funds try to liquidate to cash or cash equivalents.

If you manage to get out quickly you will be able to enter at a lower price with more variety of options as we discussed earlier when the market is competitive there are lower levels of inventory to choose from which could limit our potential gains.

Guaranteed Investments

If you are a short-term investor, bank CDs and Treasury securities are a good bet.

If you are investing for a longer period, fixed or indexed annuities or even indexed universal life insurance products can provide better returns than Treasury bonds. Corporate bonds and even the preferred stocks of blue-chip companies can also provide competitive income with minimal to moderate risk.

Fixed-rate mortgage

It may cost more initially but in the long run, it locks in the interest portion of your house payment, and over a typical 30-year term, most homeowners will ultimately pay more in interest than they do in principal. Furthermore, a fixed-rate mortgage typically acts as an option. If rates go down significantly, you can refinance at your option but if they go up your costs don’t.

Conclusion

I believe Toronto real estate market is at its most competitive state right now and generally, we have seen an enormous amount of demand in the real estate market for which some credit could be given to Covid-19 and the pandemic as it changed the priorities of many households. As people started working from home it created a need for bigger living spaces but post-pandemic, we might start seeing a decrease in demand. The Royal Bank of Canada (RBC) released a statement that said they expect to see home resales decrease by 30% following the pandemic to a 20-year low.

On the other hand, lower interest rates and a bounce back in employment rates and immigration will help boost real estate sales once more.

So, it is not entirely clear when or if the bubble will burst but we need to keep a close track of some of the metrics mentioned in this report to predict future outcomes.