Wither home prices?:
They are not a one way street

In the U.S. and the U.K. there is news on the home real estate front: House prices fall. For those who have seen nothing but soaring house prices in the last half decade, those three words seem like heresy. Now there is no doubt at all that inflated house prices are not much different than the prices of Dutch tulip bulbs in the 17th century and tech stocks in the late 1990s. When the price of any asset, such as a house, gets far ahead of other asset prices without reason, such as scarcity or cost of production, the market corrects the imbalance.

The correction is well under way. House prices have fallen dramatically in Chicago, Las Vegas, Miami, New York and San Francisco. In Britain, house prices in London have come off their peak. The S&P/Case-Shiller Home Price Index shows that across the U.S., house prices in June 2008 have retreated to their July 2004 level from a peak in the late fall of 2006. To see the data, visit www.homeprice.standardandpoors.com

Can Canada have a U.S.-style home price collapse? A downturn yes, but so far, there is scant evidence that we’ll see house prices crumble American-style. Surveys show that while house prices should still be rising in the remainder of 2008, there has been a softening of the market in Vancouver, where the inventory of unsold houses has risen this year, and in formerly hot markets in Calgary and Edmonton. Winnipeg’s home market is likely to be less afflicted by the unfolding global credit crisis partly because a high proportion of jobs in the city are in government, insulated from the business cycle. But this city’s economy also depends on manufacturing and agricultural exports that are bound to be impacted. So, here too, count on home prices to soften in 2009.

The decline in U.S. house prices is the most severe since the end of the Second World War, says the Royal Bank’s Paul Ferley. But Mr. Ferley does not expect comparable damage in Canada. “We did not experience the excesses and the Canadian market is less vulnerable to house price declines than the U.S.,” he explains.

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The price of housing is ultimately sustained by the ability of buyers to pay. If Canada slips into recession (defined as two consecutive quarters of GDP shrinkage) the human cost would be higher unemployment, reductions in the spending power of home buyers, falling prices of existing homes, and a downward reset of average house prices. Canada does not yet have an official recession, but the national housing market is softening, says Adrienne Warren of the Bank of Nova Scotia in Toronto. For now, she says, “the resale housing market is back to a buyer’s market.”

Declines in house prices will tend to be greatest in markets that ran up the most. The reasons lie in the peculiar character of homes. When prices rise for a long time, owners start to treat their homes as ATMs, remortgaging them to extract some cash. There is no capital gain on primary residences. Some mutual-fund salesmen and stock brokers urged their clients to borrow against their houses, buy hot funds or stocks, and reap capital gains. If the owners do as suggested, they wind up selling a low risk asset that always

pays a dividend in the form of the implicit rent the owner receives for living in his house and taking on the higher risks of the stock market and paying fees to extend the mortgage or get a second mortgage and fees for buying and holding the mutual funds. If the money goes directly to stocks, the fees are less, but the principle is the same. The owner has compromised the home as a castle and turned it into a pawn shop.

The saving grace of Canada’s house market is that, when owners have difficulty paying, lenders prefer to extend amortization rather than to foreclose. Homeowners wind up deeper in debt, but they don’t become homeless. As well, the contagion effects of U.S. foreclosures are unlikely to happen in Canada. In the U.S., whole blocks of houses have been seized by creditors, looted by criminals who rip out copper pipe and wire, then left in condition unfit for occupancy. Unoccupied houses undermine tax bases, cities have to reduce their work forces. It’s a devastating cycle of abandonment feeding further abandonment. Fortunately, it’s not the Canadian way. At least, so far.

Canada’s housing market is likely to cool until the economy reflates and the stock of housing for sale clears. The process is likely to be gentle, but we are entering what may be a prolonged buyer’s market. For first-time buyers, that’s good news. For existing owners hoping to trade up, it’s a double-edged sword, for the price of what they want to buy may also fall. The only sure losers are folks hoping to sell to get cash for retirement

Andrew Allentuck is the author of Bonds for Canadians: How to Build Wealth and Lower Risk in Your Portfolio, published by John Wiley & Sons Canada Ltd.