“The term “bubble” refers to a substantial and sustained mispricing of an asset, the existence of which cannot be proved unless it bursts.” - UBS
Last week UBS released its 2017 Global Real Estate Bubble Index. At the top of the list was none other than Toronto, followed by Stockholm, Munich, Vancouver and Sydney. And at the bottom of the list was Chicago – a city that UBS feels is undervalued.
Here is the full list of index scores:
The UBS index is a weighted average of the following five sub-indices:
Price-to-income
Price-to-rent (fundamental valuation)
Change in mortgage-to-GDP ratio
Change in construction-to-GDP ratio (economic distortion)
Relative price-city-to-country indicator
If you look at their price-to-income benchmark in isolation, Toronto drops down to the middle of the pack along with Geneva and San Francisco. Hong Kong, London and Paris sit at the top with the most unaffordable housing.
Still, UBS credits “an overly loose monetary policy”, foreign demand, tight zoning, and rental market regulations for the eroding housing affordability in Toronto and Vancouver.
One of the challenges, of course, is that the capital flowing into real estate is not all local – it’s also global. And many cities around the world are seeing high price-to-income multiples, perhaps because of that.
So exactly how much decoupling from local fundamentals should now be considered reasonable in our globalized world? And to what extent is this a result of “superstar economics?”
Here’s an excerpt from the UBS report:
The economics of Superstars explains why, in some professions, show business for instance, “small numbers of people earn enormous amounts of money and dominate the activities in which they engage.” By analogous reasoning, prices in the most attractive cities are expected to outperform average cities or rural areas in the long run. Hong Kong, London and San Francisco are exemplars of this theory.
The intuition is that the national and global growth of high-wealth households creates continued excess demand for the best locations. So, as long as supply cannot increase rapidly, prices in the so-called “Superstar cities” are supposed to decouple from rents, incomes and the respective countrywide price level.
I guess this is one of the reasons why bubbles are proven after the fact. If you would like to download a copy of the full UBS report, click here.
You can’t have an Easter dinner in Toronto right now without somebody bringing up the topic of our “crazy” real estate market.
Below is a chart from Bloomberg showing the year-over-year change in home prices in the Greater Toronto Area since 1990. It also shows the historical average (in blue) and how in March 2017 we hit 4 standard deviations above that. Home prices rose 33% in March compared to a year earlier.
If I were a realtor, I’d probably tell you that the market is hot hot hot. Now is the time to sell because you’ll get some absurd number above your asking price and now is the time to buy because prices are going nowhere but up. Don’t miss out.
I would like to try and be a bit more nuanced than that. Here are 3 thoughts:
1)
There’s no question that low rates / cheap money is one of the root causes of the real estate valuations we are seeing today. But frankly I have no idea when or if that will change. There is an interesting argument out there that capital is no longer scarce. Our economy is going through a fundamental shift, which is why real estate is not the only asset class seeing these sorts of valuations and growth figures.
2)
There are a number of global factors which are helping to cement Toronto’s position as an alpha global city and destination for human capital. Think Trump, Brexit, and so on. I agree with Richard Florida’s argument that our real estate market will see more – not less – pressure going forward. Here is a snippet from a recent interview with Florida in Toronto Life:
I think Toronto is going to get an even bigger influx of the creative class. With the rise of Trumpism, more and more people who might otherwise have gone to the United States are going to come to Canada. We’re going to see American tech companies invest more and more in Toronto. And if we think the housing affordability and economic divide we see today is bad, it’s going to grow ever more gaping.
3)
I believe that there are always opportunities in the real estate space, but that you have to be disciplined, focused on fundamentals, and willing to do things that others won’t. What bothers me is when I hear people say things like: “Real estate only goes up. You can never go wrong.” I started my career pre-2008 and lived in both the United States and Ireland. I saw what down looks like.
Fred Wilson (New York VC) wrote a post on his blog this morning called The Bubble Question. In it, he talks about how everyone asks him whether or not there’s a tech bubble, which he has been asked for the past 4 years now. It reminded me of the debates that are also happening in the real estate community (particularly in Canada).
The thesis of his post is this:
I learned in business school that the multiple of earnings one should pay for a business is roughly the inverse of interest rates.
In other words, as interest rates drop, people are willing to pay more for the business or asset in question. And it’s because they can’t find the yields anywhere else.
The same phenomenon, you could argue, is also happening in the real estate space. Typically, income producing real estate assets are assessed using capitalization rates (or cap rates), which is defined by the Net Operating Income (NOI) of the property (revenue - expenses, but excluding financing costs), divided by the price of the property.
The real estate equivalent of what Fred is talking about is cap rate compression. When cap rates drop it means you’re paying more for the same amount of yield (or NOI). One of the reasons that might happen is because people are anticipating that the asset will appreciate. But it could also be because interest rates are so low that investors will take whatever returns they can get.
So you could argue that the market is just responding to the macro economy. And since the feds are probably waiting for global growth to pickup (before raising rates), one could argue that the status quo is just going to continue. Ideally, it’ll continue until robust economic growth is able to take the place of cheap money.