Housing bubble a mixed bowl of fruit

Daniel Smyth

November, 2010

A housing bubble occurs when buyers speculate on or anticipate a sudden and dramatic increase in sale prices in the near future.

Buyers are then more willing to pay asking prices in the hopes of purchasing a home before prices substantially increase. This causes a surge in the average sale price in the short term. A bubble is really defined when prices dramatically reduce – as fast as prices increased, they decrease, as happened in Montreal in 1989.

There are three fundamental factors associated with a housing bubble: family income, interest rates and population growth. As income increases or interest rates decrease, one is able to afford a more expensive home. However, if population growth is greater than construction, prices will increase.

It is important to compare apples with apples and not consider a mixed bowl of fruit. It is not the price of a home relative to family income that is critical, but the affordability ratio, which is associated with a monthly mortgage payment and expenses relative to the family income. A mortgage payment at four per cent vs. seven per cent produces a more affordable ratio.

In 1989, a buyer who bought a home for $100,000, with a mortgage description of 90 per cent, a 25-year amortization and a five-year term, could afford a $270,000 home in 2009 based on the average income increase and reduction in interest rates. Considering the real-estate market increase, this 1989 home would be worth about $240,000 in 2009.

Twenty years ago marked a period in Montreal’s real-estate history where the average home price spiked. Beginning in 1990, the average interest rate increased over the next two years by just one per cent; between 1992 and 1996, the average home price declined four per cent.

It is not expected that interest rates will increase by more that one per cent by the end of 2011. Furthermore, a poll conducted by the Canadian Association of Accredited Mortgage Professionals stated that 85 per cent of buyers would be unaffected by a one-per-cent increase in interest rates. The Bank of Canada has said the overnight lending rate will not increase for some time.

If house prices were to drop, it would probably be because of a cyclical pattern and would recover quickly. The drop would not be a result of a bursting bubble.