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Real Estate Market Due for a Correction? by Ravinder Tulsiani

There is a lot of speculation and fear about the bubble in the marketplace. While bubble concerns are visible in some marketplaces in the US and perhaps Vancouver, is there a cause for concern for the rest of Canada?

The Normal Market

Similar to the stock market, real estate market also has a cycle. First, there is the annual cycle of certain months being slower months than others – winter is slow time, summer is usually more active time for buyers and sellers. Second, demand & supply, interest rates will cause occasional adjustments in the marketplace.

It is important to note that a “Bubble” is not part of the normal market cycle. It is an artificial rise in demand – which is unjustified by fundamentals usually fueled by speculation, misinformation and greed.

What is a Bubble?

In the dot com era, technology stocks were trading at extremely high price-earning ratios, which were not supported by market fundamentals – that is, the stock valuation had a weak correlation to the profitability of the company; rather it was based on expectation (speculation). People expected dot com companies to be the waive of the future and were willing to finance it, these companies had no real income or collateral to back up the equity loans they were taking out. While some dot com companies made it big, like Amazon and Google, the vast majority failed. The technology bubble burst due to one simple reason, all of these companies came out at the same time causing an excess of supply with no corresponding rise in demand for the products it offered. Buying and trading was being done almost solely on dreams of future cash. That is the basis of almost all, if not all, “bubbles”.

What about Real Estate Bubble?

In contrast, real estate is a basic need – everyone needs a place to stay. It has a finite supply – land is scarce since no one is making anymore of it. In addition, artificial barriers introduced by government (greenbelt, conservation land, farm land) cause land to be even more scarce and push the demand up for other available land for development purposes.

Population is on the rise largely due to immigration, demand is boosted for real estate around business hubs (like Toronto, Vancouver, Edmonton, Montreal). Since land is more expensive in these areas, developers will likely address the higher density issue by building up (high rise condos) in these areas. And since the vast majority of people prefer a single family home and builder’s are expected to build less of it in these areas, these types of homes will also see a rise in price.

To sum up so far, a bubble is fueled by artificial demand unjustified by fundamentals (normal supply and demand) – people begin to buy and sell based purely on speculation with no current market justifications for the higher demand. Real estate has a consistent rising demand and a limited supply which is unexpected to change anytime soon.

It’s all up for Real Estate?

Does this mean that the housing prices will not fall, absolutely not. As part of normal real estate cycle, prices will occasionally adjust to reflect the current supply and demand situation of the market.

Let’s first look at the crash of the 90′s to see if similar fundamentals are visible in today’s market place.

Crash of the 90′s

Over 30% of the people buying in the Toronto area in the 90′s were investors, with consistently rising interest rates, these investors could no longer afford the financing costs which caused them to either sell or be foreclosed on by the banks, which caused an excess supply of properties (especially condos) in the marketplace; the excess supply caused the prices to fall. The falling in prices caused investors who had crystallized their losses recently to stay away from the market place (further lowering demand). And end buyers noticed the falling trend and decided to wait a little longer hoping that the property values would drop further and properties could be picked up for a bargain. This waiting game lasted years.

Last year, only 19% of the condos in Toronto were rental units (according to CMHC’s Housing Market Outlook from the second half of 2005) and vacancy rates are dropping. This is because more people are buying for themselves and not on speculation. So even if the rental markets slowed and vacancy rates started to rise, the real estate market is not likely to be flooded like they were in the early 90′s.

Affordability

A major factor that caused the adjustment in the early 90′s was the interest rates. In May of 1990 the interest rates were a whopping 14.21% (according it CMHC), making mortgage payments $11.89 for every thousand dollars of your mortgage. This would make a $400,000 mortgage cost $4,755.97 per month. You can currently get a 5-year mortgage at a rate of about 5.25% or $5.96 per thousand dollars on your mortgage. This means that a $400,000 mortgage today will cost you $2,383.67 per month. That means that the effective cost of owning a house is half the amount that you would pay back in 1990 and yet the average price is only 5%-10% higher now than it was in 1989.

Conclusion

The adjustment in the early 1990s was a response to too many speculators and excessively high interest rates. In the late 90s and until now there has been another adjustment to account for the housing markets being under valued in the 90s and consumer attitudes changing to acknowledge that homes were affordable again. Now as prices are starting to reach a level where affordable houses are affordable, we are likely to see prices moderate with slower increases in price and the occasional peaks and valleys that represent a normal market.

About the Author

Ravinder Tulsiani is a published author who has written about personal finance, real estate, self-help and online marketing.

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