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For rent sign in this undated file photo. (iStockphoto/Jay Spooner/iStockphoto/Jay Spooner)
For rent sign in this undated file photo. (iStockphoto/Jay Spooner/iStockphoto/Jay Spooner)

the economics of housing

Does it make more sense to rent or buy? Add to ...

In the first of his weekly columns for Globe Investor's new month-long Home Buying site, housing bear Ben Rabidoux looks at whether now is better to buy or rent.

Not too long ago I received an e-mail from a young couple in their early 20s who had just made the decision to purchase their first home after renting a house for the past three years.

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“It was a no-brainer for us. It was either keep renting and throwing our money away or buy and start building equity.”

At the time, they had been renting a two-bedroom bungalow in a small Ontario town. Their rent had gone up by about 5 per cent over three years, while local housing prices had appreciated by 20 per cent or more in the same period.

“Does it concern you at all that house prices have risen so much faster than rent,” I asked.

“Not at all. Our town is growing. People want to live here. Small town, nice people, close to the water ... Why wouldn’t house prices go up?”

Their experience has been mirrored in most cities in Canada. House prices over the past decade have substantially outpaced rental growth. You can see the pattern in these charts comparing rent and home price increases in major Canadian centres:

Vancouver

Calgary

Toronto

Ottawa

Montreal

Halifax

The same pattern is widespread even in most smaller communities

Should it concern us when we see house prices rising much faster than rents for a prolonged period of time? Interestingly, in 2004, the Federal Reserve Bank of San Francisco released a report warning of a serious overvaluation issue in U.S. real estate. This proved to be a remarkably prescient warning as the market peaked two years later, then began its unprecedented decline. What tipped them off to the existence of a housing bubble in the U.S.? Believe it or not, it was the fact that house prices had grown so much faster than rents for a prolonged period of time.

Why do rents determine fair value of a home?

We need to step back and look at the issue of home prices in a completely different way. All of the usual factors that people tend to associate with rising house prices, namely rising population, income growth, limited supply, and the general desirability of a particular city or area, should affect the price of renting a home as well as buying a comparable home.

Let’s consider just rising population amid a relatively stable supply of residences. This creates demand for dwellings in general, pushing up house prices, along with the rent that a landlord could charge. But not every factor drives them up equally. In fact, there are two main factors that can cause the value of a house to rise faster than the rents that a comparable dwelling would command.

The first factor is cheap and readily available credit. Since houses tend to be bought on credit, but rents paid out of income, when credit is cheap and readily available, it can, for a time, push house prices up much faster than rents. But this is not sustainable in the long run as ultimately even house prices are constrained by the growth in the incomes that support mortgage payments. With interest rates hovering near historic lows and with mortgage debt at all time highs, it’s easy to see that this fact is at play here in Canada.

The second factor is what economists call the "ownership premium." When people look favourably upon real estate as an investment, the price of houses can increase faster than rents for a time. Said another way, when there is a cultural shift towards owning a home, and an associated stigma towards renting, it can cause people to make irrational financial decisions such as purchasing a home when an equivalent home can be rented for substantially less than ownership costs. This is particularly the case in Canada’s larger cities.

Our home ownership rates have risen across all demographics, and we now have the highest proportion of homeowners in our country’s history (roughly a 70/30 split). At the same time, surveys by RBC and the Canadian Association of Accredited Mortgage Professionals (CAAMP) have consistently shown that people view home ownership as the best way to build long-term wealth. Home ownership is consistently rated higher than investing in stocks, bonds, or mutual funds as the best way to build wealth. The notion of housing as a means to riches and renting as “throwing your money away” is a relatively new, and in some cases, dangerous mentality.

In many cities, it makes far more sense financially to rent a dwelling and build your equity by saving the difference between your rent and your ownership costs. Unfortunately, it is phenomenally difficult for many prospective new buyers to think logically about this due to the prevailing stigma against renting and the pressure exerted by well-meaning friends and family to “stop throwing money away on rent.” As I like to remind people, the majority of new buyers are still renters; they’ve just gone from renting space to renting money.

The growth in prices relative to rents tells us that unsustainable factors are at play. Temper your expectations! A decade of house price appreciation like the past is exceptionally unlikely and the chances of significant price corrections are high and rising, particularly in places like Vancouver and the Toronto condo market.

Analyst and strategist Mr. Rabidoux covers Canadian macro economic trends with a focus on housing and consumer credit. He also has a website, TheEconomicAnalyst.com.

For tips, stories, videos and live chats about what's going on in the real estate market, check out the Globe's Home Buying section for daily updates.

Follow us on Twitter: @GlobeMoney

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