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Deconstructing Canada’s housing market valuations

Real estate reporter Tamsin McMahon dissects seven ways to measure the Canadian housing market – and explains why some assessments are better than others.

Is Canada’s housing market in a bubble? The question has lingered for years – ever since national home prices managed to defy a global real-estate correction. Observers, both domestic and foreign, continue to issue dire pronouncements about the health of the Canadian housing market. But those predictions vary wildly, with some saying the market is overvalued by as much as 60 per cent, while others say it could be undervalued by almost 10 per cent.

Of course, examining the housing market is a fuzzy science. Every analysis uses its own idea of how to measure the “fair value” of real estate. Some compare home prices to incomes, while others look at interest rates or population growth. One analysis even compares house prices to the value of Canadian exports.

Deutsche Bank

Analysis: Housing market is overvalued by 60 per cent

Most recent date measured: fourth quarter of 2014

How they measure it:

When Deutsche Bank’s chief international economist, Torsten Slok, came out in January with a warning that Canada’s housing market was roughly 60-per-cent overvalued, he set off alarm bells across the country. He also sparked fierce criticism of how the bank measures Canada’s housing market.

Deutsche Bank bases its estimates of overvaluation on two measures: house prices compared to incomes and house prices compared to rent. If house prices rise faster than people’s ability to pay for them, it can raise the risk of a correction. The same goes for rent: If it costs more to buy a home than what someone could pay to rent it, house prices are probably too high.

By the end of last year, Deutsche Bank was reporting that Canadian house prices were roughly 34-per-cent overvalued when compared to incomes and a whopping 90-per-cent overvalued compared to rent. The bank averages the two numbers to estimate total overvaluation.

Critics have pounced on Deutsche Bank’s analysis because of the data it uses to judge both incomes and rent. The main source of the data is the Organization for Economic Co-operation and Development. The organization compares house prices to a measure of income called “market income,” which looks at how much people typically earn in the labour market. By that measure, prices do appear roughly 30-per-cent overvalued. But market income ignores other important sources of income, such as government transfers and investments, says Toronto-Dominion Bank economist Diana Petramala. When house prices are compared against all sources of income, they’re closer to 8-per-cent overvalued.

Deutsche Bank’s Canadian rent figures also come from the OECD, which gets its rent data from a figure that Statistics Canada uses to estimate the effect of rent on the consumer price index. Statistics Canada has warned that its rent index doesn’t necessarily reflect actual market rent, and many critics have pointed out that the measure tends to dramatically underestimate growth in rents. Another problem with comparing house prices to rents, Ms. Petramala says, is that house prices have been growing most rapidly among single-family homes; but most new rentals, particularly in major cities, have been condominiums, and condo prices have been growing at a much slower pace. (The Economist magazine, which in their April 15 issue said Canada has one of the world’s most overvalued housing markets, uses a similar measurement.)

Bank of Canada

Analysis: Housing market is overvalued by about 20 per cent

Most recent date measured: third quarter of 2014

How they measure it:

Canada’s central bank released its own measure of house-price overvaluation in December, when it warned that prices could be anywhere from 10 to 30 per cent too high. The Bank of Canada’s model compares the level of house prices to the level of per-capita after-tax income and 10-year government-bond rates, which it uses as an approximation of mortgage rates. Both house prices and incomes are adjusted for inflation.

The more house prices move away from the underlying fundamentals of per-capita income and interest rates, the more the central bank considers home prices to be overvalued. Since Canada has experienced just two significant housing corrections over the past 40 years (the central bank defines a correction as a price decline of at least 10 per cent over a minimum of one year), the Bank of Canada studied home prices in 18 Western countries and found that its model had some ability to forecast house-price corrections. It found that over a six-year period – from three years before a correction to three years after – prices typically started out about 10-per-cent overvalued and peaked at 20-per-cent overvalued before falling by an average of 20 per cent.

That analysis should raise red flags, since the central bank considers Canada’s housing market to be roughly around the point where corrections have tended to occur. However, the bank also found that corrections were typically triggered, in part, by central banks raising interest rates in response to inflation. In recent years, interest rates in Canada have been falling and inflation has stayed low, so the factors that might burst a housing bubble are not yet upon us.

Fitch Ratings

Analysis: Housing market is overvalued by about 24 per cent

When: Second quarter of 2014

How they measure it:

New York-based ratings agency Fitch Ratings has studied Canadian home prices since the 1980s, comparing them to what it considers “sustainable house prices” – that is, prices based on factors that have consistently driven the demand for new housing. Fitch looks at measures such as population growth and new-home construction. While others focus on housing affordability, taking into account the fact that interest rates have kept homes affordable for many buyers even as prices rise, Fitch doesn’t consider interest rates to be a significant factor in driving home prices in the long run.

Similarly, changes in the unemployment rate can have a dramatic effect on the housing market in the short term but don’t tend to drive house prices over many years. Instead, Fitch has found that the strongest long-term driver of home prices in Canada is incomes – both individual household incomes and national wealth as reflected in the GDP. The more Canadians earn, the more they can spend on their homes. “The whole idea behind this is that in the real world there’s a lot of factors that influence home prices over the short term,” said Fitch Ratings director Stefan Hilts. “But over the long term it really just comes back to the balance of supply and demand.”

International Monetary Fund

Analysis: Housing market is overvalued by about 11 per cent

When: last quarter of 2014

How they measure it:

The IMF has only recently begun studying Canada’s housing market, and its models go back only as far as 2010. Like others, the IMF factors in the rate of household formation – a measure of population growth. (A household is considered any group of people living together under one roof, whether or not they’re related to each other.) It also looks at income and employment growth along with five-year mortgage rates and inflation. Interestingly, the IMF has found that the one measure that most closely mirrors changes to home prices in Canada is something called the terms of trade, which compares the total value of Canada’s exports to the total value of imports.

For example, if the value of exports rises faster than imports, then the terms of trade increase. The terms of trade also take into account changes in exchange rates, so if the Canadian dollar appreciates, the terms of trade also improve because a rising loonie will boost the value of exports and lower the cost of imports. According to the IMF, when the terms of trade increase, Canadians feel richer and are therefore likely to spend more on housing. The opposite is true when the terms of trade are falling. The IMF puts all those measures together and compares them to actual home prices, estimating that the housing market is overvalued by 7 to 20 per cent, or a median of about 11 per cent.

Toronto-Dominion Bank

Analysis: Housing market is overvalued by about 11 per cent

When: last quarter of 2014

How they measure it:

Like the IMF, TD also considers median family income, interest rates, employment and demographics to be fundamental drivers of the housing market. Unlike the IMF, the bank also looks at demand and supply, including the number of new homes. TD’s models also focus on affordability, essentially looking at how much a typical household spends on housing and comparing that to the long-standing average, which holds that Canadians spend about 30 per cent of their incomes on housing. Low interest rates have kept housing affordable even as prices have kept rising.

But TD also builds interest-rate expectations into its models: It accounts for the likelihood that interest rates will rise, which would push up mortgage rates and make housing less affordable. If interest rates rise to more “normal” levels, then housing would be 10– to 15-per-cent overvalued, the bank says. (TD does not define “normal,” but the Bank of Canada’s all-important overnight rate has averaged about 6 per cent; it is 0.75 per cent today, and has averaged 1.8 per cent over the past decade.) TD considers home prices to be about 11 per cent above what the bank considers to be their “fair value” based on economic fundamentals.

Canada Mortgage and Housing Corporation

Analysis: Housing market is moderately overvalued, by about 3 per cent

When: second quarter of 2014

How they measure it:

Canada’s federal housing agency came out with its own way of forecasting a potential housing correction in November, when it warned that the housing market was moderately overvalued but that the risk of a correction was low.

CMHC’s way of measuring overvaluation is the most exhaustive, but it also illustrates just how difficult it can be to get reliable signals about Canada’s housing market.

The agency studies three different models to come up with its estimates of where home prices should be. One model compares home prices against factors that have traditionally driven demand for housing: inflation, after-tax income, mortgage rates and population growth.

Another model studies factors that can influence home prices in major cities, including land values, construction costs and urban population growth.

The third model looks at housing affordability. It compares current prices – what people are actually paying – to where prices should be based on how much typical households could afford to pay for a home if they spent 30 per cent of their income on housing.

CMHC has added a fourth model that combines some of the elements of the other three. It then maps all four models onto three different measures of actual house prices – the Canadian Real Estate Association resale house price index, the Teranet-National Bank house price index and Statistics Canada’s new housing price index – giving it 12 possible ways to measure overvaluation.

The resulting range is dramatic. In its most recent forecast, last fall, CMHC’s models predicted that house prices could be anywhere from 13-per-cent undervalued to 16-per-cent overvalued – an average overvaluation of about 3 per cent. It compares all of its measures to a threshold of 8.5 per cent, the point at which CMHC can reliably say the housing market is overvalued. If its highest estimate goes above that threshold, it signals a moderate risk of overvaluation; if the average of all of its models also rises above the threshold, there’s a more serious risk.

Overvaluation is just one of four factors that CMHC looks at when it studies the risk of a housing correction. It also looks at what it calls “overheating,” which is when home sales rise faster than new listings. It adds in rapid price growth, which may be a sign of speculation in the market. It also studies overbuilding, which is when developers respond to strong demand and rising prices by flooding the market with new homes. In the past, CMHC has found that combinations of at least two of these four factors correspond with spikes in claims for its mortgage insurance.

Canadian housing market economist Will Dunning

Analysis: Housing market is undervalued by about 9 per cent

When: report published last March

How he measures it:

When economist Will Dunning issued a report last year saying that Canadian home prices might actually be significantly undervalued, it sparked a flurry of hate mail from housing bears. A former CMHC analyst who now serves as the chief economist for the Canadian Association of Accredited Mortgage Professionals (he did this particular analysis on his own, not on behalf of that organization), Mr. Dunning devised his contrarian assessment using a very different measure of the housing market than the typical mix of market fundamentals used by most economists.

He looked at something called the capitalization rate, or “cap rate,” a measure popular among commercial real-estate investors to assess the value of their investments. At its most basic, a cap rate measures the return on a real-estate investment by comparing how much an investor can earn in rent on a property in one year to the underlying value of the property. For example, a 3-per-cent cap rate means that 12 months of rent – minus expenses like property taxes – is equal to 3 per cent of the value of the building. Cap rates move in the opposite direction from real-estate prices: When cap rates fall, prices rise. Investors like falling cap rates because it means their property values are going up. Using cap rates makes it possible for people to compare real estate to other types of investments that pay a yield, like bonds.

Cap rates also do something else that Mr. Dunning considers important: Over the past 15 years or so they have usually tracked mortgage rates – that is, if mortgage rates fall, cap rates fall too. The correlation between the two is strong proof that the housing market tends to set prices based on the cost of carrying a mortgage. When mortgages become more affordable, home prices go up. The change is gradual, however, with Mr. Dunning finding that it takes roughly six years for cap rates to fully reflect changes in mortgage rates.

This is the basis for why Mr. Dunning believes housing is still undervalued in Canada: Even though they’ve been falling, cap rates are still much higher than interest rates, a sign that the housing market has yet to fully price in the rapid drop in mortgage rates since the 2008 financial crisis. In essence, his analysis suggests that Canadian homeowners haven’t taken full advantage of today’s record-low interest rates. Prices should be roughly 9-per-cent higher and would need to rise as much as 25 per cent over the next several years to fully reflect falling mortgage rates. It’s a controversial analysis, in part because so many economists have been warning that falling mortgage rates are precisely what have pushed home prices up to unsustainable levels.

Data for Fitch Ratings incorrectly indicated Fitch undervalued the housing market in a 2014 report by 24 per cent rather than overvalued it by the same amount.