Tom Davidoff Knows About RE Cycles

We recently [2 Dec 2011] posted a quote from a CTV interview with Tom Davidoff, of UBC’s Sauder School of Business, and an e-mail exchange that followed. We have since found a very sensible and informative article published by Prof Davidoff regarding the California housing bubble, reproduced below. We aren’t aware of him writing a readily available analysis of Vancouver’s market, and would greatly appreciate seeing an account of his thoughts in this regard, given his experience with the US RE boom and bust.
We suspect that, given his expertise, he could enrich and inform the online dialogue regarding our market. We’d welcome him posting something of this nature here at VREAA, but it’d be just as good to see it elsewhere on the web, or in a local paper, or publication.
Is Vancouver RE in a ‘bubble’? What are the estimated risks of price corrections? How much could prices correct? Is it different here? If so, why?
– vreaa


Why this housing bubble was different
Jon Lansner Interviews Tom Davidoff
The Orange County Register, 6 Mar 2010

Tom Davidoff, is an assistant professor at the Sauder School of Business University of British Columbia who has studied real estate cycles — including California’s wild home-price rides. We asked him to help us understand what’s happened …

Us: What made this housing bubble different?

Tom: We can compare the boom and bust cycle in housing in the late 1990s and 2000s to that in the 1980s. The increases and decreases were much sharper this time than the 1980s. This time around, I think it was more clear that there was a bubble. Where I disagree with some people is that it wasn’t the coastal areas like Orange County that made it clear — at least, after the fact — that there was a bubble. In the 1980s, the big price gains were in areas like the coasts where it’s hard to add new supply (there was an earlier oil boom and bust in some energy industry areas like Houston. Those “oil patch” markets are elastically supplied and I would guess the bust in prices was predictable). The problem with using prices in areas where it’s hard to add new supply to judge whether or not we’re in a bubble is that it’s hard to say what the right price of a home is in those markets, even relative to rent. Was there a bubble in the 1980s? In hindsight, hard to say yes, as if you bought a house in 1989 in New York or San Francisco and held it for 15 years you made out like a bandit.

In markets like Las Vegas or Phoenix, or arguably most of the Central Valley and Bakersfield, in the long run you can build lots of new supply, and the location of new homes isn’t much worse than the location of existing homes. You don’t have the same downtown or ocean premiums in those markets. So when prices get far away from the cost to build new homes in markets where it’s not hard to build new homes, you start to suspect over pricing. Like a lot of other economists, I personally didn’t suspect an impending bust probably until sometime in 2006. My problem was that I was too focused on the coastal markets. I wondered about Las Vegas, but felt like there was a world in which prices in places like Boston and coastal California were justifiable. I wish the Cassandras, who deserve credit for prescience, had been griping about Las Vegas instead of San Francisco. I think any economist who really gave prices in the relatively easily supplied markets serious thought would have been very worried as early as late 2004 and certainly mid-2005.

Another difference is where the bad loans were. In the 1980s, I think largely because of tax laws and regulations, the bad loans and excessive pricing was largely on the commercial and rental residential side. In the 2000s, exotic owner occupied residential loans were also a problem.

Us: If this bubble was different, will the recovery be of the unexpected variety, too?

Tom: The recovery may be fast or slow. I can believe that we are at a bottom, and I can also believe that there will be a continuing wave of mortgage defaults on both the residential and commercial sides that could certainly lead to price declines of 10 percent or more in many U.S. markets. The massive number of owner occupied homes with mortgages much larger than current market prices, and even market prices in the foreseeable future, is different from anything at least since the Depression. In the long run, barring very rapid global warming, prices should not be below replacement cost in a lot of the “sand” markets where they currently are. So price below replacement cost would usually be a good signal for time for prices to start rising. The potential for mass defaults and an attendant second dip in lending and GDP makes that argument harder to swallow.

Us: Are bubbles a quasi-natural economic occurrence that are going to happen in real estate every so often?

Tom: “Bubble” is a tricky word. In markets where it’s hard to replace the existing stock, like the coasts, people will always value homes in large part based on what other people think they are worth. That means that prices can fluctuate a lot even without anything changing in the real economy. So I suspect coastal U.S. prices will continue to look like a roller coaster. Ditto stocks like google, masterpieces of painting, etc.

Getting prices to move like that in places like Phoenix requires that both buyers and lenders are not motivated to consider the likelihood of huge losses. I hope we don’t see the lack of discipline in owner residential lending that allowed the giant bubbles in markets that should be disciplined by supply for a long time. Between the legitimate benefits to financial innovation and the political power of financial institutions, I suspect it won’t be too long before the next crazy price increases arise in some asset class. A guess is that it won’t be housing next, but housing will surely have another turn. By the logic of Willie Sutton, the money to be made in housing finance is too tempting to be ignored.

Us: What policy changes could prevent such economic distortions in real estate, if any?

Tom: I don’t think price volatility on the coasts requires much “economic distortion.” The problem in the real “bubble” markets of the 2000s was that both owners and lenders had the incentive to ignore the very real possibility of large losses. Both parties had valuable default options that left downstream investors and taxpayers on the hook for losses, so that only the upside mattered. For now, the market is probably self-policing. Once investors are no longer spooked, it may be necessary to (a) limit or tax high risk loans or (b) do a lot of work to make sure downstream investors are aware of risks and (c) force financial institutions to pay for the “too big to fail” burden that they place on taxpayers.

19 responses to “Tom Davidoff Knows About RE Cycles

  1. Hmm, very interesting article. I think the principles he talks about could be applied to Canada, i.e. prices in coastal areas where it’s hard to create new supply versus Las Vegas (Saskatchewan!) where it’s easy and prices are becoming equally far removed from replacement costs. Also he talks about lenders and borrowers equally optimistic about the likelihood of gains v. losses. Although economists in Canada are barking about imbalanced markets the government and bank policies are still allowing 0-5% down mortgages, which might indicate that they are optimistic that losses will be nonexistent or minimal. And of course we all know that Vancouver is running out of land, so that’s why our prices are going up at such a fast rate compared to the prairies, but I think many would argue that the prairies are just as frothy.

    • Yeah, prairies are in a massive bubble, for instance, Calgary prices have gone up 0% annualized for the past 4 years! And that’s after a drop of 10 to 20%! All markets are driven by local factors. Calgary is about supply catching up with demand. Vancouver is about HAM.

  2. Very weak article. I suspect that Davidoff is one of those ‘experts’ who claim that bubbles are not visible until they pop.

  3. granite countertop

    Well that was interesting.
    So he’s not a mindless bubble denier. He’s an extremely articulate bubble denier, something I can respect.
    From this piece, and your previous conversation, I think I have a good grasp of what Davidoff thinks of the Vancouver market. He’s aware that prices are completely out of line with fundamentals, but is agnostic as to whether the prices will remain high. That’s a safe position for a scholar to take.
    I’d like to hear his thoughts on Vancouver too, but I wouldn’t recommend he give them. He’s an Assistant Professor, his #1 job is to impress the senior academics at Sauder. Informing Vancouver homebuyers about how risky their investment is may be a career-limiting move. I really wish that was a paranoid exaggeration.

  4. Ah yes the “coastal premium”. As much as that rings true in some respects, the earnings stink. I think he’s more describing a luxury premium and the analogy of a work of art is not horrible, but confusing when I look at most properties in these purportedly scarce coastal markets.

  5. Like the coastal regions don’t have their own individual market factors? You can’t use a limited Orange County perspective to describe real estate in Portland Oregon even if the latter is a “coastal” city. Supply constraints don’t necessarily mean rising prices unless someone is willing and able to pay the higher prices. Given that Vancouver is now more expensive than Newport Beach, it must be that all the super rich hedge fund managers have moved to Vancouver to buy up the limited stock of houses by paying 300% more than they cost 8 years ago.

  6. 2010 … well tche-ye-ahh … as if. care to offer any likelihood of major natural disaster on coastal jp?

  7. From Garth’s blog tonight:

    “a new survey (Ipsos Reid) has just found a quarter of retired people in BC think they’ll run out of money. Worse, 44% of everybody is worried they won’t be able to support themselves after they stop working. BC also has a negative savings rates. That means people are spending, on average, about 9% more than they earn.”

    How can people sleep at night in such a situation? Spending 9% more than they make, really?
    I don’t believe everybody in BC is in that situation (at least I’m not!), which means that the ones that are actually spending more than they earn are actually spending a lot more than the 9% of the survey… This is something I have a hard time to comprehend…
    Once this bubble burst, we’re in for extremely painful times here.

  8. Here is the journal article that Tom Davidoff’s interview above is based on:
    ‘Supply Elasticity and the Housing Cycle of the 2000s’
    Davidoff, 2011

  9. If he ever gets canned by UBC he could get alternate employment as an astrologist.

    ” The recovery may be fast or slow.”

    Way to use all that study and education to tell us something glaringly obvious.

  10. So you get hired today to UBC with $200k salary. 5 years of after-tax savings rate of 30% (35% average tax rate) nets $195k in the bank. Now you can put 10% down on 1.95mm compromise-house. Now your mortgage is 8.8X gross earnings and your after-costs asset value is worth the same as your debt.

    Nothing unusual here.

  11. Mortgage principal = 45 years of established savings rate. I’m assuming this pre-purchase family got by on $7,500/month on food (1k), car (0.75), rent (2.5), RRSP (1.25), and other spending (2).

    How many people do you know that save 30% of take-home?

    • “How many people do you know that save 30% of take-home?”
      Not a lot for sure, and even less in BC. See what I pasted last night from Garth’s blog: in BC, “people are spending, on average, about 9% more than they earn.

      “Mortgage principal = 45 years of established savings rate.”
      Anyone that thinks these RE prices in Vancouver are sustainable is a fool.

  12. “Now you can put 10% down on 1.95mm compromise-house. Now your mortgage is 8.8X gross earnings and your after-costs asset value is worth the same as your debt”.

    Yes, this is your mortgage if you choose to make a house your first purchase without rolling any other equity into it. Not many are so idiotic

    • Thanks for your help, now it makes sense. You mean the sustainable supply of RE gains that every generation brings. Each bigger than the one before.

  13. For the record, we have had a series of e-mail exchanges with Prof Davidoff, and he has kindly offered to send along a piece with his views on the Vancouver market. We look forward to seeing his analysis, and to headlining it here.

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