July 13, 2013
Title: Is it better to rent?
Subtitle: Continued high real estate prices are forcing some Canadians to look at alternatives.
Despite fluctuations in some regional markets, housing prices in Canada, which edged higher in May, continue to show impressive strength by international standards. Many have used the word “bubble” to describe the situation. For example the OECD and the influential The Economist magazine have both noted that based on the ratio of selling prices to rents, Canadian homes are 64 percent overvalued.
If that is true, it would make more sense for housing consumers, particularly those affected by the Harper Government’s latest round of tightening mortgage standards, to rent, rather than buy.
But how reliable is that estimate? Douglas Porter, chief economist at BMO Capital Markets isn’t buying any of it. Porter points out, that straight price-to-rent comparisons don’t tell the whole story because they ignore the impact of cheap money. “Lower interest rates increase the present value of future rents,” he wrote in a recent note to the bank’s clients. “All else being equal, (this) should lift the current underlying home value and price-to-rent ratio.”
Evaluating whether Canada’s housing sector is overvalued is not easy. True, house prices here are doing just fine relative to our US neighbours, where (despite a recent uptick) they tanked in dramatic fashion, following the 2008 financial crisis and ensuring recession. Real estate prices in many other major western economies are hurting too.
The substitution effect
However Canada’s raw materials rich economy has led experts to judge it by different standards, in part due to the incredible advantages that they bring. As a result of those resources, international investors want to put money here, workers want to live here and people the world over want to buy from us. These factors create sustained demand for Canadian housing.
Employment, much of it resource-driven, which is one of the key drivers of real estate prices, has also been strong here. According to Statistics Canada, the Canadian economy produced 242,000 new jobs during the past 12 months. The average number of hours worked went up too.
On the other hand, real estate asset prices, which, with the exception of the odd stumble, rose fairly steadily here during the past decade, can’t go up forever. Even at today’s extra-cheap interest rate levels, at some point new homebuyers, mostly the young and immigrants can’t keep up. That forces those who need housing to turn to rents. Economists call this transition from one product or service to another the “substitution effect.”
Low interest rates change the outlook
Porter’s arguments make sense from the renter’s point of view as well. Lower mortgage rates increasingly reduce renters’ incentive to fill landlords’ pockets each month, because they reduce the cost of mortgage payments if they buy a property.
Porter however concedes there some is froth in some markets. That’s particularly true in Toronto, where he suggests that renting may be a prudent option for young professionals who plan to be there for the next five years.
However the veteran forecaster won’t go much further. “Wealth creation from homeownership will be nothing like that seen over the past decade,” he notes. “Canadian home prices are not cheap versus rent, especially in Western Canada. But the bubble mongering is way overdone.”
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