Some people are predicting a crash in the Canadian housing market because price-to-income and price-to-rent ratios have gone up a lot. But these ratios omit mortgage rates, a key determinant of prices. A better guide, in my view, is the housing affordability index published by Royal Bank of Canada (RBC).
RBC's measures at the national, provincial, and city levels show the proportion of median household income required for mortgage payments, property taxes and utilities on various types of houses at going market prices. By including mortgage rates (and other costs), they offer "a much more realistic measure of the ability of households to afford housing than the crude price-to-income ratio ….," says Wikipedia.
RBC's affordability indicators currently show only modest overvaluation in Canadian housing at the national level. This does not jibe well with the world view of the housing-crash prophets. The latter either ignore the indexes, or reject them on two grounds (as far as I can see).
Their first complaint is that the measures, calculated since 1985, overestimate affordability by using 25-per-cent downpayments when 5 per cent is the norm today (which comes with higher mortgage payments). While a 5-per-cent downpayment may be true of first-time buyers needing mortgage insurance, it's not true of the large group of homeowners who buy a house to relocate. They have a lot of home equity to bring to the purchase of a property, and this makes a downpayment of 25 per cent a reasonable approximation of the market, says Robert Hogue, an economist with Royal Bank of Canada.
Their second complaint goes as follows: the affordability measures are inconsequential since they will soon be shooting up anyways when interest rates inevitably rise from their current lows. One problem with this view is that it assumes interest rates go up in isolation. If the past is a guide, they typically rise when the economy is in a cyclical upturn. This means income and employment will also be rising, which partially or wholly offsets the impact of rising rates.
Another problem is the assumption that policy rates will be going up soon. In fact, with year-over-year inflation in consumer prices decelerating to 0.8 per cent last month, the Bank of Canada pushed back the date for increasing its lending rate to 2014. But even this target could be pushed back further, if the economy is not growing strongly by then.
The RBC indexes aren't perfect. Indeed, a case could be made that they actually underestimate affordability. Of note is the use of posted, fixed mortgage rates. "Our use of posted mortgage rates, as opposed to market rates leads to a significant underestimation of affordability," Mr. Hogue reports. The underestimation has increased as rate discounting has deepened.
The price-to-income and price-to-rent ratios are performing a useful function of signalling heightened risk and alerting policymakers to consider such preventive moves as mortgage-lending restrictions. But it seems to me the affordability measures are more useful gauges of current stresses in the housing market – and hence, likely to be more timely indicators of major changes in trend.
READERS: What factors do you consider when trying to figure if the housing market is overvalued?