Americans are in the midst of an unsustainable real estate bubble that will rattle Canada if it bursts, a leading economist warned Wednesday.

British Columbia‘s lumber exports will be undermined and Canada‘s economy in general will suffer if U.S. consumers pull in their horns, said Patti Croft, chief economist for Vancouver-based Phillips, Hager & North Investment Management.

However, cracks in the U.S. market will not necessarily affect Canadian real estate prices, unless the catalyst is rapidly rising interest rates.

“I think the U.S. Federal Reserve and the Bank of Canada will be pretty cautious in raising rates, very cognizant of the high degree of debt and leverage and certainly not wanting to set off any kind of collapse in the housing market,” Croft said in an interview.

She was commenting on a recent PH&N study that shows the U.S. real estate market is exhibiting signs of a continent-wide bubble not evident in the Canadian market.

VANCOUVER SUN Source: Phillips, Hager and North Americans’ ‘home ATM’ will run out of cash

Signs include real (after-inflation) house price gains in markets in every U.S. state, coupled with high valuations and “very buoyant” investor optimism.

“House prices continue to rise at a very rapid pace and we just don’t think it is sustainable,” Croft said.

U.S. consumer debt is at record highs because consumers have taken advantage of falling interest rates and rising house prices to use their homes as cash machines — drawing down home equity to finance other purchases. Home equity withdrawal now stands at a record 2.5-3.0 per cent of U.S. gross domestic product.

“Home prices need not decline nor mortgage rates rise for this source of consumer spending to dissipate quickly,” the study states. “If house prices decline, the headwind to the U.S. economy would be quite significant.”

The study says Canadians have not run down the equity in their homes to the same degree and, while real house prices have increased in Canada since bottoming out about 1995, the gains have been neither as large nor as pervasive as in the U.S.

Croft says there are no signs of a broad-based bubble in Canada, despite localized bidding wars and surges in the ranks of real estate brokers in markets like Vancouver, Kelowna and Toronto.

Further evidence of irrational real estate exuberance in the U.S. comes in a survey from the American consulting firm Spectrem Group showing that 63 per cent of baby boomers plan to finance their eventual retirement by selling their primary residence.

“The reality is that people’s homes are a big part of their assets and their net worth, but to count on the appreciation in your house value to pay for your retirement may be rather wishful thinking,” Croft said.

“There are some myths in real estate and one of them is that real estate always increases in value. In Calgary, Edmonton and Winnipeg, real house prices today are actually lower than they were in 1980, which is phenomenal.”

Despite recent gains in the Greater Vancouver real estate market, Canada Mortgage and Housing Corp. recently noted that average annual returns for the past 10 years are a mere 1.77 per cent because prices were flat or losing ground from 1995 to 2000.

Croft noted that bubble markets in the U.K. and Australia are cooling after aggressive interest rate hikes, while the end of house price appreciation in the Netherlands has created “a deep downturn” in the economy.

She anticipates more moderate interest rate increases are unlikely to cause a correction in the U.S. or Canada before the end of 2005 or early in 2006.

“Ordinarily what causes the housing market to ultimately correct is an inversion of the yield curve — when short-term interest rates rise above long-term interest rates — and that may not even occur in this cycle because both central banks are acutely aware of the degree of leverage in the economy. Look at how indebted the U.S. consumer is and how they have relied on their house as essentially a cash machine.”

Short-term borrowers and those with variable-rate mortgages would be hurt the most by higher short-term interest rates. While 85-90 per cent of U.S. mortgage loans are at fixed rates, PH&N says higher rates will still bite, particularly for recent buyers who have shown a marked preference for floating-rate products.

Croft said home prices could rise in Canada next year “but not at the rate they have and certainly not economy-wide.”

She noted young people of home-buying age are spending more time in the family nest because they can’t afford to enter the market, and higher interest rates will fuel that trend.

As for the effect of the 2010 Olympics on Vancouver‘s market, Croft said studies in various cities across North America show there may be a short-term bump up in the value of real estate but it is not sustained.

“Some people may be hoping or counting on the Olympics but if you think about it, you have got 50,000 people coming to a city over a three-week period, why would that create a permanent increase in real estate value?”

© The Vancouver Sun 2004