Friday, June 03, 2005

When the bubble bursts

Housing markets go through cycles. And the Canadian housing market has been on an upcycle for some time now. The risk of the bubble bursting is greater than some people think.

First, the run up in house prices has been driven largely by low interest rates. Any significant uptick in interest rates will have an immediate impact on affordability and will signal that the upcycle is over.

It is at this point that speculators will desert the market. Sellers, previously waiting for even higher prices, will rush to market realizing it is now or never, while potential home buyers will no longer feel the pressure to get into the market before it gets away from them. If interest rates do rise, then some sort of correction is all but inevitable.

Second, affordability in Canada is not all that good at present, despite protestations to the contrary. According to the Royal Bank’s latest Housing Affordability Index, the median household in Canada would be ineligible for a mortgage, on the basis of income, for a standard 1,200 square-foot bungalow, assuming they could come up with the 25% down payment in the first place.

Finally, I find it rather curious that Royal Bank now sees fit to expand its affordability index to include condos and townhouses, as if to prove that the market is still affordable. Nevertheless, our mythical median household would still be priced out the market for a 1,000 square-foot townhouse in Toronto and Vancouver. With their large mortgage portfolio, this attempt to massage the numbers to show the market is still affordable can only be interpreted as yet another sign that the market is peaking.

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