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Property Bubble or Just a Cooling Period?

Property Bubble or Just a Cooling Period?
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The Canadian housing market has "lost touch with fundamentals" according to a report by research firm Capital Economics. In the report released on June 29, the authors suggest that the Canadian housing sector has become an asset bubble nearing the point of bursting. The prediction is for a 25 per cent decline in property values over the next three years.

There is no question that some parts of the country have realized significant property gains but as noted in the table below, not all regions are experiencing the same phenomenon. Vancouver is definitely in bubble territory. Toronto? Most likely, but Halifax and Calgary have actually seen prices fall since the beginning of the year.

The national average has gained almost nine per cent in less than half a year and under normal circumstances, would probably be considered a bubble. However, the number is inflated due to the outlandish 25 per cent gain in Vancouver and other parts of British Columbia. There are unique reasons for the pressures in housing prices in B.C.'s coastal cities that simply do not apply to the rest of the country so the national average can not be taken strictly at face value.

Canadian House Price Increases

* As of May 31st, 2011

Despite the price increases, demand remains high with over 197,000 new starts recorded in June. This is a slight increase over the May result and also marks a gain on the 189,000 new starts recorded in June of last year.

One reason for the sustained demand for new properties is the exceptionally low mortgage rates still available for new home buyers; a fact Bank of Canada Governor Mark Carney alluded to recently when discussing the state of the Canadian housing sector. Carney declined to invoke the "bubble" term when describing current conditions choosing instead to centre his comments on concern over the high level of debt held by Canadian households. The governor made it clear that the age of ultra-low interest rates is coming to an end and those with heavy debt loads may have difficulty addressing higher interest costs.

What Happens When Interest Rates Rise?

While we cannot say with certainty when the interest rate hawks will once again take over the Bank of Canada, be assured, rate hikes are coming. We only need to look at our history to confirm how quickly interest rate policy can change -- so for those not old enough to remember the late 1970s and early 1980s, here is an interest rate refresher.

Following the recession and stagflation of the 1970s, central banks pushed interest rates to record highs to fight out-of-control inflation. By 1981, lending rates had eclipsed the 20 per cent barrier while mortgage rates rose to an eye-popping 18.5 per cent. Compare this to the 4.3 per cent fixed rate on a five-year mortgage available from any Canadian bank today. Now consider the plight of current mortgage holders managing their present low-interest mortgage payments but with little capacity to absorb an increase should lending rates spike.

For instance, a five-year mortgage for $250,000 at 4.3 per cent costs roughly $1,550 a month -- an increase to seven per cent would force the monthly payment to $1,923. A jump to 10 per cent would push the payment to $2,380 a month.

The current Bank of Canada benchmark rate is one per cent but is expected to rise later in the year. While we're not likely to reach the highs of the 1980s this time around, a lot can still happen during the time most homeowners have a mortgage.

If interest rates appreciate slowly and in step with salary increases and the pace of economic recovery, there is no reason to expect a significant property value depreciation. However, should the Bank of Canada find it necessary to raise interest rates at an accelerated pace, the increased interest costs could lead to a reduction in demand leading to a possible over-supply of properties on the market.

Under this scenario we could expect prices to stabilize and even decline. However, it would take a significant interest rate adjustment -- on the scale of the situation experienced in the 1980s -- to drive property values down by 25 per cent or more. For areas that have experienced the greatest gains such as Vancouver and Toronto, a little cooling of an over-heated market may not be a bad thing.

Scott Boyd is a currency analyst and a regular contributor to the OANDA MarketPulse FX blog.

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