How Housing Prices Work and When to Buy

Why?

If you live in Alberta and you're lucky enough to still have a job you might think the current real estate market presents a buying opportunity. Because I work in finance I'm often asked about my opinion on when the best time to buy is and where I think prices are going. Obviously, real estate markets are hard to predict because there are many factors at play but if you understand how these factors impact price I think you'll have a much better chance at making the right decision.

The Basics

Like almost everything else in the world real estate prices are based on supply and demand and can be graphically shown using a chart like the one below.

Basically, where the willingness to supply new houses meets the demand to purchase those houses you have an equilibrium. If you then draw two lines across and down from that intersection you will find the price where the market is balanced and the quantity where that market is balanced. This is the basic approach to determining the equilibrium price in any market and real estate is no different.

Now, an astute reader might look at the supply and question why it would go up with price. The reality is that there is only so much land in any city and even if the city can expand almost infinitely (like Calgary or Edmonton into nearby prairie) that land becomes less and less desirable as it gets further from the jobs and entertainment that most cities have concentrated in the center. That is definitely true and the way economists usually represent this is to increase the slope of the supply curve. What this does it recognize that it's hard to increase supply and therefore it requires more money to increase the number of houses than a flatter curve. In the case of Calgary (the city we're going to use for all our examples because I live here) I think a chart like the one to the right is probably more representative of the overall market than the original.

Demand

Now that we have a framework for looking at how prices change we can start looking at the factors that might change our diagram. In this section we're going to focus on the demand curve. In my mind there are really two categories of things that change demand:

• An actual increase or decrease in the number of people wanting to live in the city.
• A change in the amount the people of this city can afford to pay for a house.

In the case of Calgary, for most of the city's recent history there has been more people coming to the city than leaving which would effectively shift our demand curve to the right. What this looks like and how it impacts price is shown in the next diagram.

So as you would probably expect, having more people moving to your city will increase the price of housing and it will also start to increase the quantity of housing. For those of us living in Alberta this is a very familiar story.

Changes in Affordability

Beyond actual changes in demand though there are lots of things that can change 'how much house you can afford'. When you're in a city that is growing and the supply curve is relatively steep I would argue that this measure is actually the key influencer of prices. In fact, because most major cities are growing and there tends to be constraints on space I would argue that this is the biggest single factor in determining housing prices in most places.

So if how much house someone can afford is the key to pricing how do we calculate what someone can afford? The most obvious factor is income. Most buyers have mortgages and to pay for those mortgages most people have jobs. The next most important factor is the size of the mortgage payment. Mortgage payments are calculated based on the amount of the mortgage, the amortization (years to pay off the mortgage) and the interest rate. Of these factors, the most significant tends to be the interest rate. In general, most Canadian buyers choose the maximum term of 25 years for their amortization so unless the maximum gets changed (like it did in 2012) it isn't really a factor. The mortgage size on the other hand has a big impact on the payment but it varies with the house price so it's not so much a factor as what we're trying to solve for. Therefore, the only factor left effecting the mortgage payment size is the interest rate. It's also a key factor because it's pretty volatile.

To demonstrate how good these two factors are at tracking changes in housing prices I've done a little math. Basically, I've gone to Statscan and pulled off the historical earnings numbers for Calgarians from 1986 to 2016 and I also grabbed the average posted rate for a 5 year mortgage (Canada's most popular mortgage term) from Statscan as well. Using these I wanted to come up with the maximum mortgage size a Calgarian could afford and I planned to use the total debt service ratio to calculate this. That said, the total debt service ratio includes a few things that I don't want to estimate (property taxes and other debt payments) so I'm simply going to assume that the maximum mortgage payment a Calgarian could get is 30% of their annual income (a Canadian can normally qualify for a mortgage as long as their total debt service ratio is below 40%). Now that I've done that I indexed the mortgage size I calculated so that 2007 was 100 (just like the housing index) and plotted this index against the housing index. What you see below is that our new 'Max House Index' matches really closely (R squared of 0.9) to actual changes in housing prices (data again from Statscan).

What you can also see is that there was clearly a run-up in price above our index from 2005 to 2007 but now that the 'bubble' burst it's clear that the fundamentals weren't driving those price changes. In fairness to the market back then oil prices were on a dramatic run at the time and there were probably expectations that this rise in oil would result in higher wages and therefore higher prices. Of course, we now know that oil prices would drop dramatically in 2009 and that wages wouldn't rise rapidly but it certainly 'felt' like it could have happened at the time.

Another observation from this time period is how much our index jumped in 2009. This jump was entirely because of a drop in interest rates (wages were actually down) and was because the Bank of Canada was trying to create a 'soft landing' for the housing market. In Calgary, this definitely worked as prices came back to our index in the years after 2009 but because interest rates were lower the market was able to get back to 'normal' without the massive drop that would have been required if the rates were at 2007 levels.

What Does This Mean?

When you take this all together I'm hoping you can see that wages and interest rates are usually the biggest factors in determining housing prices. There can be periods of time where lots of people try to move to a particular city which will raise the price and there can be times when home builders create too much supply and end up dropping prices but over long periods of time the key factors are the income of the people living there and the prevailing interest rates. Using this knowledge we can now start to forecast future changes in price.

Calgary's Forecast

Looking at where Calgary is relative to the index today and the future of earnings I don't believe the market has hit bottom yet. Prices tend to be 'sticky' on the way down which means it takes people longer to drop their prices when the market is declining than it does for them to increase when the market is going up (big surprise, right?) and right now you can see this in action as the gap between prices and the index is slowly growing. If fundamental factors don't change though the market will eventually have to start coming back to the index and the bigger problem is that there isn't much to suggest that will happen in the near term.

So when should someone buy? While I don't know exactly when interest rates will decrease or wages will increase (that's when prices go up) I do know that the price of oil is a key driver of employment and wage growth in the city of Calgary. So what I suggest to anyone who is considering buying real estate right now is to wait until the price of oil rebounds (and I obviously think it will at some point). Once oil has been above $70/bbl for a month or two it should be there for a while and that will be a clear signal that wages are at least going to level off in Calgary and prices will stop decreasing.

Other Cities

While I won't pretend to be an expert on the real estate markets of other cities in Canada I can do the same analysis that I did with Calgary. For the curious, the index comparison charts of other major Canadian cities are below.

While I think most of these charts speak for themselves I do want to make one final comment on the Vancouver market. As you can see from the Vancouver chart it is completely different than the charts for the other cities. The relationship between what the people of Vancouver can afford and the price of their houses seems to be way less strong than all the other cities. In my opinion, this means that we are either experiencing one of the longest sustained real estate bubbles in history or there are totally different factors driving this real estate market. Obviously I'm leaning to the latter of these explanations but I haven't done the research to show what those are and I'll refrain from speculating. That said, if those outside factors were somehow removed from that market I can almost promise a very big drop in prices.