Bankrate.ca

 

March 22, 2012

 

Title: Is housing overvalued?

Sub-title: Canadian real estate continues to appear pricey by many measures.

 

When the fox asks for limits on the expansion of the chicken population you know something is up. That applies to the residential real estate market too. So when a noted financial services expert says that housing prices are getting out of hand, and that measures are needed to make sure that the situation does not worsen, it’s worth taking notice.

 

“There is a consensus across economists that sustained low interest rates (have) led real estate in Canada to become overvalued,” writes Craig Alexander, senior vice-president and chief economist at TD Bank Group, in a recent note its clients. “The debate is about how much overvaluation is present.” Alexander however notes that a rapid fall in house prices is unlikely to occur, as the two major causes that would trigger this – a rapid rise in interest rates or unemployment – are unlikely to happen anytime soon.

 

Whether Canadian residential real estate is overvalued by 10 to 15 percent as Alexander believes, or whether the market is in for a 20 to 25 percent correction as others have predicted, there are numerous signs that prices are getting frothy.  

 

Signs of overvaluation

Cynics would say that an asset’s true “value” is what you can sell it for today. By that standard, residential real estate is doing just fine. The market is relatively liquid, and prices are trading at, or near, all time highs throughout much of the country. However when prices are assessed relative to rents and to Canadians’ borrowing capacity things look a little different. For example Alexander notes that Canadians’ debt-to-personal income ratio is now 150 percent, up 6.1 percent from year-ago levels and is slated to rise to 160 percent by next year, the same level reached in the United States and the UK prior to their recent roubles. Rents too are at extremely low levels compared to what it costs to buy a similar property.

 

While neither the Canada Mortgage and Housing Corporation nor the Canadian Real Estate Association commented on possible housing market overvaluation in their latest performance forecasts, the timidity of their calls says a lot. CREA expects average selling prices of resale homes to remain basically flat over the next two years, falling by 1.1 percent in 2012 and then bouncing back by 0.9 percent in 2013 to $362,300. The CMHC too expects activity to be tame, with housing starts to remain at basically the same level this year as in 2011.

 

Overvalued … but affordable

That said, despite the overvaluation and households’ high levels of indebtedness, affordability increased slightly during the past quarter say two experts, due in part to recent modest declines in the weight of ownership costs in some markets. “There is only modest affordability stress being exerted on housing demand in Canada at the moment,” note Craig Wright and Robert Hogue, of RBC Economics in the financial group’s latest housing trends and affordability report. “Vancouver continues to be the major exception. The proportion of a typical household income (there) that would be allocated to cover the costs of owning a home is extremely high.” In short while things appear to be rosy now, when interest rates costs are at historically low levels, what happens if they rise back up remains an open question.

 

Alexander suggests further moves to tighten up lending criteria, similar to those the Canadian government has already made, to prevent things from getting out of hand. “One option would be to shorten the maximum amortization on mortgages from 30 years to 25 years,” says Alexander. “Another would be to introduce a minimum interest rate floor on all income tests, say 5.5 percent, when qualifying for mortgages. It would not change the interest rate at which buyers transact, but it would ensure that individuals would be assessed against their capability to meet their financial obligations in a higher interest rate environment.”

 

The challenge for TD Bank Group is that if the Canadian government enacts those measures it would presumably mean less mortgage lending for them over the short-term. The bank and other Canadian financial institutions as whole, would presumably make up for the profit loss by having a healthier lending portfolio over the long run. However in this day an age of instant gratification when an expert says anything that may hamper his company’s short-term profits, for the sake of its long-term health (such as Alexander’s comments about residential real estate possibly being over-valued), it’s worth taking seriously.  

 

Because foxes generally prefer to eat a chicken or two right away, rather than waiting a bit, and eating the whole flock a little later.

 

Peter@peterdiekmeyer.com

 

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