In recent years, news stories have declared Canadian home prices are headed for a sharp correction. Virtually all of them have predicted a sharp drop in home prices to what some economists say is their “fair value”.
What do they mean by “fair value”? The definition and the predicted price correction have their origins in math and a belief system.
Let’s first focus on the math that they use to define “fair value”, which involves average price, income and a long-term relationship between the two. Specifically, they define this “fair value” as what the average price would have to be in order to get the ratio between it and income back in line with its long-term average.
The growth in average price and incomes can and often differ. Whereas income tends to grow in a fairly steady upward trajectory, average price tends to grow more slowly or quickly depending on the phase and alignment for economic and housing market cycles. For example, incomes grew steadily in the mid-1990s while home prices remained stable; by contrast, price growth reawakened and outpaced income growth early in the new millennium, and has grown at roughly the same pace from 2010 to present.
At any point in time, you can measure how far average price is from its value that would return the ratio to its long-term average. The percentage difference between the two is what they use as the predicted price correction. According to this line of reasoning, if the ratio exceeds its long-term average, prices will irrefutably drop so that the ratio is returned to its long-term average. It’s easy to calculate the percentage difference because it’s the same as the difference between the current ratio and its long-term average.
Price corrections are, by definition, inconsistent with price stability. However, if the ratio is above its long-term average, wouldn’t stable home prices cause the ratio to return to its long-term average over time as income continues growing?
To believe that prices can only go up or down ignores their potential for holding steady. While it can be difficult to change ingrained beliefs based on rational arguments, next month I’ll discuss the origins of those beliefs and why predictions of an impending correction for Canadian home prices based on them are wrong.
