While exuberance in the housing market can be a good thing, it can also spell trouble if not handled with caution. When a market becomes severely overheated, it qualifies as “overly” exuberant and it can lead to what is commonly known as a housing bubble. Such is the case in Canada, where new highs are being reached, prompting the use of a housing index that’s little known to the general public.
Broadly used in the banking world, the Exuberance Indicator measures “explosive episodes” in the market. Back in the day, when a housing crash was never strong enough to cause any catastrophic damage, there was no need to measure exuberance in real estate. However, after the US housing crash of 2008, which sent the world’s largest economy reeling, assessing exuberance became a widespread practice, especially in the case of highly vulnerable markets, like the Canadian one.
The Exuberance Indicator was first published by the Federal Reserve Bank of Dallas and it quickly became a trusted source for housing information even for foreign markets. Data provided by the Dallas Fed is also included in white papers produced by the Bank of Canada and the Government of Canada.
Reading the Exuberance Indicator
Overall, the exuberance indicators look at two sets of numbers: home prices and critical values. When a market is deemed exuberant, home prices deviate from the fundamentals, which are determined by looking at real house prices, price-to-income ratios, and price-to-rent ratios.
When even critical values are exceeded, a market becomes “overly exuberant”. This generally happens when buyers pay a premium on a commodity, a behaviour which, according to Better Dwelling, is driven by herd mentality. A market becomes highly vulnerable to a housing correction if the imbalance stays there for five quarters.
Canada’s Exuberance Indicator over the Years
Source: Efthymios Pavlidis et al., The Federal Reserve Bank of Dallas.
Overall, the Canadian real estate market has been through three episodes of exuberance.
The Late 1980s
While the late 1980s brought an increase in home prices, it was restricted only to Greater Toronto real estate, which also suffered most losses after the subsequent crash. Overall, national values did not even reach the critical threshold.
From 2003 to 2008
After a long period of stability, prices went up dramatically, reaching unprecedented heights from 2003 to 2008, way above the critical values. However, Canada managed to avoid a severe housing crash, by artificially lowering interest rates from over 4% to an all-time low of 0.25% over the course of one year. Lower interest rates made it more advantageous to borrow than save, encouraging buyers to take out loans and invest in property.
The first quarter of 2015 saw a new phase of exuberance that continues today. Housing prices in Vancouver rose by a whopping 59%. While artificially lowering interest rates is still an option, it might not be the best course of action. With household debt levels having already reached an all-time high, a further increase would only slow down the economy, states Stephen Punwasi from Better Dwelling. The more money people allocate towards paying off their debt, the less they spend consuming goods and services, and, as we all know, the economy is dependent on consumer spending.
How Is Canada’s New Episode of Exuberance Going to End?
While it is clear that Canada is going through an episode of irrational exuberance, caused by an artificial increase in home prices, it doesn’t necessarily have to end in a housing crash, says Better Dwelling. Finding the right solution can be a laborious process, and lessons from the past will always provide a good starting point for further action.