While commentary in the news media continues reviving arguments that Canadian home prices are overvalued (see: beating a dead horse), let’s review one metric cited as evidence: the home price-to-rent ratio.
Most commonly, the ratio measures average residential sale prices as a percentage of annual rents. The argument put forward by news media is that home prices are “fairly valued” when the ratio is equal to its long-term average. By extension, the percentage by which the ratio is above its long-term average is the percentage home prices are overvalued.
So where are we now?
The Canadian home price-to-rent ratio in 2013 stood far above its long-term average. Does that mean Canadian homes are headed for a drastic correction? Hardly.
Even during the 2008-09 economic recession, the national average home price in Canada dropped less than 15% from the time it peaked until it bottomed out.
Recall that the recession led to massive job layoffs and caused consumer confidence and spending to plummet. A fundamental deterioration in economic fundamentals is required for home prices to drop.
Current economic fundamentals are supportive for the Canadian housing market. Mortgage interest rates have fallen, which has buoyed home prices while keeping mortgage financing affordable and attractive for many homebuyers and investors. The increase in condos available for rent from non-tenant investors has helped contain rent increases. The existence of rent controls in some provinces also handicaps the overall growth rate for rents.
Additionally, choices available to renters and homebuyers affect their willingness to pay. Aside from a handful of features and amenities, the number of differences is limited for units of a similar size and location, which constrains their variation in market rents. By contrast, REALTORS® know that prospective homebuyers have a myriad number of considerations in mind when searching for a home in a particular price range – and that when they find “the one,” it can be difficult to pass up. This is especially true if it is located in area where prices have been trending higher and are expected to continue to do so.
The difference in the length of time that buyers and renters expect to live at their address also has implications for their willingness to pay. Barring mortgage financing issues, homebuyers may be more flexible than renters regarding their willingness to pay when they find their perfect home. In part, that’s because they generally expect to live there on a longer-term basis. By contrast, rental agreements accommodate many renters’ intentions for shorter-term residency due to leases being subject to annual renewal (or, in some cases, termination by the tenant with one or two months’ notice).
The bottom line is that claims about an imminent home price correction should be analyzed on their merits. It is worthwhile to consider the reasoning that underlies such claims. Claims that are based on a ratio often fail to bear scrutiny because the ratio compares two things that possess important qualitative and market differences.