House prices and rents: Why they should track each other and why it should concern us that they haven't
OCTOBER 01, 2011
This is part 1 of a two-part series. Part 2 can be read here.
Why wouldn't house prices go up?
In early 2011, Jesse and Jillian, both in their early 20s, made the decision to purchase their first home after renting the same house for the past three years. “It was a no brainer for us,” Jesse tells me in an email. “It was either keep renting and throwing our money away, or buy and start building equity. ” At the time, they had been renting a 2 bedroom bungalow in a small Ontario town.
“How much has your rent gone up over the past few years,” I asked.
“Not much at all. We pay only 5% more today than we did three years ago,” he replied.
“What about house prices?"
“They’re up quite a bit. A few houses we were watching a few years ago would probably sell for 20% more today.”
“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?”
It’s a great question. 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 US real estate. This proved to be a remarkably prescient warning as the market peaked barely one year later, then began its unprecedented decline. What tipped them off to the existence of a housing bubble in the US? 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 is that? There are two main reasons why rents and house prices tend to move in tandem. The first is more of a ‘common sense’ reason, while the other delves more into the theoretical ‘value’ of a residence.
Why do rents determine fair value of a home?
The 'common sense' approach:
Let’s deal with the ‘common sense’ reason first. 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. If you take any one of those factors, you’ll immediately see that it should affect both prices and rents equally, and history tells us that this is overwhelmingly the case.
Consider just rising population amid a relatively stable supply of residences. This creates demand for dwellings in general. Since any population is made up of both renters and owners, and since comparable dwellings are in demand by both, the price of the house rises. However, so too does the rent that a landlord could charge on a comparable house since the demand has also risen. You can immediately see why the same factors that push house prices higher also drive up rents in a normal market. 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. Has credit been cheap and readily-available in Canada? You bet! And growth of credit in Canada has been nothing short of shocking, despite claims about our 'conservative' banks.
The second factor is what economists call the ‘ownership premium’. When people look favourably upon real estate as an asset, the price of houses can move beyond what rents would imply. Said another way, when there is a cultural shift towards owning a home, and an associated stigma towards renting, it can drive house prices higher than rents. Is this cultural shift underway in Canada? It certainly seems so. Our home ownership rates have risen across all demographics, and we now have the highest proportion of home owners in our country’s history. 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 point for now is not to argue whether or not this is an accurate perception, but rather to simply note that this notion of housing as a means to riches is a new and prevailing mentality that is difficult to quantify entirely, but can certainly be seen in some of the graphs in this post on mass psychology and the real estate market.
The 'theoretical' approach:
The second reason that house prices tend to move in tandem with rents is a more theoretical one. Before discussing that, let’s start by noting that numerous studies and surveys have explored the motivation behind why individuals chose to purchase their current home (see the work of Case and Shiller in the US, or the RBC home ownership opinion polls or CAAMP polls in Canada). They consistently indicate that one of the primary motivations for home ownership is the investment aspect of residential real estate. In other words, real estate is viewed as both a residence and an investment. And as discussed above, it is increasingly viewed as an investment. Because of this, housing is considered a consumption expense and an investment asset.
The Capital Asset Pricing Model, which is used by countless analysts to determine the intrinsic value of a number of assets like stocks and bonds, suggests that the present value of an investment asset is the discounted sum of its future income stream. Said plainly, the ‘value’ of any asset is determined by the money that it generates, discounted to reflect inflation and an expected return. Don’t let that confuse you. If you'd like more detail on that topic, please see this post, and particularly the contribution from Jesse who writes the Housing Analysis blog.
The main point to understand is that a house is ‘worth’ either the sum of its future rents (for the investor) or the sum of the rents saved by the owner of the house, discounted for future inflation and an expected return. Therefore, as noted in that same Federal Reserve Bank of San Francisco paper discussed above, “The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house.” Simply put, the true value of a home should be determined by the monetary benefit it produces (or could produce) to the owner given its best use. These benefits include primarily rental income and owner equivalent rent (what the owner saves by not having to rent). You can immediately see why as rents rise, they raise the value of comparable homes.
Irrational buyers, social stigmas, and abundant credit: Let the bubble begin!
If buyers were rational, one would expect that when house prices rise significantly beyond the cost of renting an equivalent dwelling, people would choose to rent rather than own. The drop in demand would put downward price pressure on real estate, maintaining an equilibrium between growth in rents and growth in house prices. Indeed this is the case across much of Canada and over long time horizons: Home prices are typically tethered to growth in rents.
However, participants are never perfectly rational in any asset market. This is particularly true in real estate markets where emotions, social expectations, and the intangible benefits of ownership often overshadow rational judgment. When wide swaths of the population begin to believe that house prices are an excellent investment regardless of fundamentals, or when a significant social stigma towards renting develops, deviations in the long-standing relationship can occur. Coupled with cheap and abundant credit, house prices can detach from growth in rents for a time. Once again, it’s this significant deviation from underlying fundamentals that is the most widely accepted definition of an asset bubble.
So with that in mind, let's once again examine the growth in house prices and rents in cities across Canada. For today, we will examine from BC east to Manitoba. Next week, we'll look at Ontario and all provinces east. We've previously examined this topic using the 'rented accommodations' component of the Consumer Price Index (see here and here). However, after taking some (valid) criticism for using a quality adjusted measure of rents, I'd like to reproduce these graphs using a rental index created with CMHC rental data. CMHC measures pure rental changes and does not quality-adjust their data. Unfortunately, the data only goes back to 1992. Nevertheless, we see how closely rents and prices track each other in most cities....until the early 2000s. See for yourself...
Note that rents in Victoria are now stagnating and actually beginning to decline marginally. This is bad news!
Note that rents in Vancouver have now fallen on a year-over-year basis. Once again, bad news.
Calgary has seen house prices fall from their peak and then nicely recover. The problem now is one of falling rents.
It's worth noting the conclusion of the 2004 Fed paper I mentioned above:
“The majority of the movement of the price-rent ratio comes from future returns, not rental growth rates. This will not comfort everyone, as it implies that price-rent ratios change because prices are expected to change in the future, and seemingly out of proportion to changes in rental values."
“We found that most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation.”
Those hoping that the next decade for house prices will look anything like the last will be sorely disappointed.
-Ben
45 Comments
Brilliant post Ben. I've permanently linked to it on the HHV blog under the resource links and also highlighted it for readers.... hope you don't mind me quoting you and cross-posting your Victoria graph.
Hi HHV
Thanks. Feel free to reproduce the data. Get the message out!
So if I'm buying a rental property, the only way I can gain a profit is if prices keep going up AND mortgage rates stay low AND I rent to good tenants.
It does not compute.
I kept my last house as a rental for about a year. I came to the same conculsion. Rent covered the mortgage, insurance, taxes and maintenance ... barely. So the only way I would profit was through price apreciation ... which wasn't happening. And I had to spend my evenings tracking down rent checks, calling plumbers, etc. etc.
You can make money on rental properties, just be sure that you are cash flow positive from the rent and you're all good. Or you can just invest in a real estate trust and let someone else do all the work. Stock market's tanking and my REIT is doing just fine.
Hard to compare home prices to rent when one is a free market while the other is regulated. Otherwise rent would be much higher from landlords gouging prices.
Nonsense. Are all provinces highly regulated? How does the ratio compare in the provinces that are not regulated vs the ones that are? Have rents in Ontario, for example, even kept pace with the allowable annual increases? What about in the US? Were there not some states with strict rent controls? What happened there?
I have all these answers, but you'd better find them out for yourself. It will be an eye-opening experience for you.
While we're on the topic of free markets, are you going to tell me that residential real estate is outside the realm of government involvement? Aren't you the one trying to convince everyone that the government will orchestrate a soft landing in real estate by ramping up immigration (to non-permanent residents no less)? What does that tell you about 'free' markets?
Fundamentals apply in all markets. They can be muted for a time, but they can never be silenced entirely. When it comes to real estate, rents are the number one fundamental determinent of residential value. This applies to 'free' markets as much as it does to 'manipulated' markets.
What does this chart tell you Ben. http://i52.tinypic.com/33nubgk.png
Since you brought up my view about immigration and housing starts, let's see what CMHC's had to say about it in 2008 and now.
2008 http://i54.tinypic.com/smpsi8.png
Latest on rental demand 2011 http://www.cmhc-schl.gc.ca/en/corp/nero/nere/2011/2011-06-09-0815.cfm
Latest on housing starts http://www.cmhc.ca/en/corp/nero/nere/2011/2011-09-09-0815.cfm
I'm impressed by their 2 year forecasts and can't wait to see 65,000 housing starts by 2012.
I'm just posting this image for future reference. http://i51.tinypic.com/11qgthu.png
One thing to consider is that the government might actually be concerned with high immigration to support house prices. In the medium term this could lead to undesirable unrest when UE stays high. While it looks like immigration is an ingrained gov't policy for a while, they may want to precipitate a crash now because they have a fighting chance to right it before they face real competition at the polls in 2021. That means tapping the pop growth brakes a bit, for a time anyways. Canada needs to fill jobs with its citizens and residents to get UE down.
My tinfoil hat pet theory is that the government is targeting immigration geography changes to cause bubble markets to burst. We are already seeing falling immigration into Vancouver based on a change in COO mix (less you know who). But what do I know!
The government prefers foreign workers because i) they will work for less (hence the falling wages) which benefits corporations ii) if they don't hold a job they get sent back home.
The immigration model filters students/foreign workers who sustain a job from those who don't. Very clever system.
"The government prefers foreign workers"
Also because with the way EI is set up it's difficult to fill certain positions. Canada expounds the virtues of having a skilled workforce, so needs to fill the void somehow. This is similar to US or Europe, where non-locals are brought in either temporarily or otherwise to work. So Canada is in company.
At some point, though, the high UE rate needs to be addressed. That NPRs have dropped significantly recently is indication that governments are going to "get people back to work" in various jobs once slated for foreigners. This will probably be accompanied by EI or other such subsidies. (EI subsidies were nice because they were off the books, funded by worker premiums.)
The rent control argument has 2 issues, one is the appreciation cap and the other is renovation premia that are hard to monetize due to the cap. This is an issue but... Let's be very clear that ANY investor in residential property should know the rules before buying. Then to subsequently complain the rules aren't fair is ludicrous. That's like buying a sports car then complaining about the speed limit.
Rent controls in BC are CPI indexed; but only while an individual tenant occupies a rental unit. Landlords are free to jack up their rents between tenants all they want. Even with the indexing, real inflation in rents lags the so-called "limits" in place. There is only one explanation for that: it's the market setting the rents.
This is absolutely true HHV and are two major reasons why the rental control argument doesn't hold much water. Rents as measured by CMHC data are not appreciating at the rental rate cap, nor are close to any of the anecdotes I hear either online or from those friends and family I know who rent. Their rents are appreciating below the maximum because of prevailing market rates. Of the ones I know whose rents are being raised at the cap, they started out with low rent to begin with and were professionally-managed.
But I do see an issue -- a landlord who wants to renovate a suite from "barely passable" to "newly-renovated" will have constraints on raising the rent to the newer standard. It's a difficult one but is one reason why some landlords are loath to bring suites up to a better quality. We shouldn't cry a tear for them; it was their own negligence or incompetence that got them into the situation and the rules are known. There are tons of well-run and well-kept rental accommodations around and they have no trouble keeping accommodations functioning for many decades. Yes, being a landlord is hard sometimes.
Should we not be cognizant of the fact that MANY rental units in cities like Vancouver are not legal? As in, the landlords tend to hide the fact that they have renters, to avoid the regulatory scrutiny that comes with having a secondary suite (etc) as a rental unit? I'm thinking of basements suites and the like, which account for a fair chunk of Vancouver's rental units.
Rent isn't regulated in Calgary. Lo and behold, they've gone down.
Explain that.
Hi Ben,
Thanks - really looking forward to seeing the data on ONTARIO housing prices.
DELETED!
Hey @therealgarth, do you know how to do a cash flow analysis on residential real estate? If you do, show us an example from any of these markets Ben has highlighted where you can cash flow positive using current rental rates, property values, and interest rates. Show me a SFH that cash flows positive in Vancouver and I'll buy it today.
Take a hike, Appraiser. At least comment from a different computer or something. Make it a bit of a challenge...
LOL - thank you Ben - great analysis and data as usual.
Appraiser - Thank you for some good humour and laughs at your expense. You are CLUELESS.
For all the intelligent readers here - a VG link with very depressing news that correlates to what Ben has posted here. Enjoy...
http://www.chrismartenson.com/blog/economy-on-ropes-going-down
Every day is a challenge for Appraiser
I am ready to cheer up on the Appraiser's side - as more and more Appraisers keep happily buying overpriced RE with the goal of renting it out, they are going to definitely drive the price of rent down - supply versus demand, with 70% of the population owning a home already, there are not that many renters in Canada, so ...Go, Apprasier, Go, get few more properties, keep buying!!!
And I would suggest not to pay any respect to a low rental vacancy official data - most of the rental stock is going unreported now - at least in Richmond it is. We already saw the huge influx of the rentals since the spring when the demand for buying the RE started to decline. We were looking to rent and to buy at the same time and it was fascinating to see the same property listed now for rent on a Craiglist that we recently saw on the MLS and it was taken off the market after being there for the long time. They obviously did not have any liberty to ask the good price on a rental market since there was an oversupply (and they won't be able to use the allowed increase % by the same reason).
Anecdotal evidence, but a friend of mine was out hunting for rental condos in Toronto, after having split up with her partners. She found a very modern building (almost new, actually) near Lakeshore. The real estate agent showing the suite stated that it would be 2700 per month. She laughed, and eventually negotiated it down to 1900. That's a good reduction. The owner is certainly not having his carrying costs paid for, since the unit is valued at 500k.
Next I'm going to break the story on how the government and private sector is getting into the landlord business by going after social welfare and senior pensions. More to come soon...
And it all starts with hundreds of friendly advertisements promoted across the country like this.
http://i51.tinypic.com/fjhy5v.png
http://i51.tinypic.com/ftzwia.png
Looks like an unofficial IPO to me.
By the way, which one is your bank? http://i52.tinypic.com/fksg7a.png
And my favorite chart of them all showing the CMHC Ponzi Scheme collapsing. Time for the tax payers to feed to machine.
http://i56.tinypic.com/b96tls.png
Greg, I appreciate you enthusiasm, but you need to start your own blog and quit filling this comment section up with these links that have little or nothing to do with the conversation at hand.
Perhaps, in your own blog, you could also explain the significance of the many graphs you post here, since you tend to lose me and, I'll venture to guess, most of the other readers of this blog.
At the very least, could you condense your posts? You are currently making about 1/3 of comments on this site.
No problem Ben. I won't post here anymore. I'm sure you'll enjoy your active bloggers like the last GDP post.
Hey, I enjoy your posts Greg. I can't speak for Ben but I don't think he wants you to leave. Appraiser on the other hand is another story..........
Just structure your comments like this - introduce your point of view (hopefully how it relates to Ben's post), prove it with graphs and possibly summarize graph in plain English, explain why the graph matters, then hammer it home with a conclusion. That's being effective and helping people understand what you are trying to say. As it is now, I find your thoughts are very scattered. Just organize what you're trying to say and that would help me understand.
I think you do have some good points, and I tend to believe you more with your immigration point of view. Not to the same degree as you, but I think it's a valid (and overlooked) point.
Just my thoughts
Greg - please come back!!!!! Your posts are way ahead of their time. The others just don't see it yet. Please come back.
"explain why the graph matters"
There it is. No offense, Greg, but just posting a link to a graph is not a good way to start a discussion. Explain it to people.
I think you are overreacting Ben. I find Greg's posts very informative.
I don't think it's too much to ask that a bit of an explanation accompany each link and that perhaps several links can be put in the same comment. Pretty reasonable.
I too enjoy your posts Greg but I find the request made by Ben to stay on the discussed topic very reasonable and not at all offensive - otherwise the discussion gets unreadable, there is nothing to be offended about Greg, minimal moderation is always needed to keep people with the broad interests like you on topic - what is appropriate for the own blog is a big overkill for the collective discussion of the narrow subject...
Olga - I think that Greg is trying to fill in some of the "missing" pieces that, if they were included, would paint a totally different picture. He's trying to "broaden" the conversation.
Greg sees the big picture. He stands back and looks down on something, not up. I'm sure he would agree that he may not see it all, but he's certainly getting way, way more than most are.
Please come back, Greg. You are very informative and I, along with everyone else, am learning a lot from your posts.
Ben, is it that you don't want Greg to comment as often, or that you just want him to preface his links with more dialogue, or that you don't like where he's going? Which is it?
"is it that you don't want Greg to comment as often, or that you just want him to preface his links with more dialogue"
Bit of both. I think it's reasonable to ask Greg to gather his thoughts and post one or two lengthier, coherent posts, preferably related to the topic at hand, rather than 10 small posts often with only a hyperlink and little or no text.
I'd assume everyone here enjoys a good discussion. Ben is right. A series of hyperlinks does not add to readability nor enhance a discussion, no matter how interesting they may be. It's not an unreasonable request to ask for more of an explanation with each link and/or lengthier, less frequent posts.
Greg, my school-aged son has a friend he likes to play with. This friend packs up his toys and goes home any time he doesn't get to play what he wants. Don't be like that. Any good website makes requests of its readers and moderates discussion to some extent. You have in the past led some discussions down some interesting paths that were unrelated to the topic. Nothing necessarily wrong with that, but if you find you have a message you want to get out and are consistently leading discussions away from the post topic, you may want to take Ben's advice and start a blog. You evidently have a following.
Don't be so quick to offense. You are, after all, a guest here.
It is the followers who dictate the leader, not the other way around. You are correct, Jimmy: Greg definitely has a following, and that's because he speaks of things no one else will touch, no one else will look at, things the government and vested interests know about, but the public is not privy to. His comments for the most part ARE on point, but just in a more expansive, investigative way.
History is chock full of people who did speak up, were right all along, but who were labelled "conspiracy theorists" and, no, they were not all neat, tidy and polite about it. Often the greatest truths are messy because people do not want to look at them. Instead they attack the messenger.
Why is it the government is hiding so much from us? Are we, the taxpayers, not entitled to know what is going on? Do you think it's because we can't handle it, or is it because TPTB KNOW what would happen if we found out the ugly truth? Opacity is there for a reason; it's to hide something.
Jimmy, you compare Greg to your son's friend who packs up his toys? Greg has been taken to task many times here on his posts, and yet he has not backed down. He has continued to reiterate his views, backing them up with more statistics and links. He has not folded when he didn't get his own way and he has not been quick to take offence.
There was an absolutely brilliant blogger on a site I often visited. People came to hear what "Black Swan" had to say. He got frustrated with the host because the host refused to see that the people running the government, even when the evidence was CONTINUALLY put right in front of him, did knowingly look the other way, failed to prosecute, changed laws in favor of certain Wall Street banks, etc., etc. He finally left in disgust, and it was a loss to the site (whose numbers dwindled down to nothing) and to the others who visited the site. Greg was trying to turn some stones over to see what was underneath. If others don't want to listen, then that's their problem.
Greg, I hope you would consider it your calling and start your own blog (I would, except I don't know enough yet). Your site would be deluged with people.
The graph that is missing would be "discounted home prices" = price/avg mortgage rate, relative to rent prices. House prices mean nothing on their own. House cost, ie. Financing costs due to interest rate levels, need to be considered. We are in the era of low interest rates, just like Japan has been for over 10 years. House prices are too high only if interest rates rise, increasing financing/opportunity costs.
Actually, "discounted home prices" = 1mortgage interest expense / avg mortgage interest rate.
Buying makes sense if:
1- interest expense (and maintenance, insurance costs, etc.) Are lower than rent expense,
2- you also have the cash to pay the principal amt of the loan,
3- you're buying for a certain level of time beyond short term, ie. Less flexibility than renting gives you, and also maximizes eventual home value increases in the midterm
So, the trick then to knowing if to buy or rent is predicting the interest expense over the life of your loan, assuming you will be fine living in the same home for the midterm, and that you will have the monthly cash to pay back the principal amount of the monthly mortgage payment.
To know what house you can purchase can be reduced in very simple terms to:
house price = (rental expense of the house you want + maintenance + insurance) / avg mortgage interest rate
The numerator looks simple, but you need to estimate the maintenance, depending on the state of the home. Insurance can be quoted very precisely from several companies. Most importantly, the Rental Expense needs to be increased on a yearly basis by the expected inflation rate (say 3 to 5%). In other words, the rental expense will very likely increase in major Canadian cities.
The mortgage interest rate is tricky given the volatility over the term of your mortgage (until you pay it all off, say 20-30 years).
Looking at the following web page, you can see that using Prime as an indicator, we are all near lows since 1975
http://www.canequity.com/rates/prime_rate.stm
Mortgage rate historical values
http://www.canequity.com/mortgage_rate_history.stm
So, one can´t fall into the trap of thinking that one can buy a home based on the monthly payments, and more importantly interest expense amounts, based on current low interest rates, since in the next 20 years, they will most certainly have increased and decreased, perhaps over several economic cycles.
A good calculation to ensure you stay above water is to use the 10 year fixed mortgage rate at your bank to see if you would be able to stay above water comfortably. Depending on your appetite for uncertainty, one can then get a variable rate mortage, closed, if possible, thereby getting the lowest rate for 5 years, while putting away any extra cash you would be saving given the alternative 10 year fixed mortgage rate. In other words, you base your ability to purchase a home on a 10 year fixed rate, but save by getting a 5 year variable closed rate, and you put away any savings.
Based on today´s rates, a 10 year fixed rate is at 6.75%, and a 5 year variable closed rate is at prime + 0,1% = 3.1% (checked a major bank website). By saving 3.65% and putting it away for the future, you save a lot by staying at the lower rate, but basing your maximum home purchase value on the 10 year fixed rate (which is more than double the expense amount at today´s rates). Over the life of the loan, in today´s low interest climate, you will most likely save money, since the break-even point with both types of mortgages would require the variable closed rate to be above above 6.75% over the next 10 years, which means that prime rates would be at about or above 6% (which implies an economy at full capacity, and high inflation that needs to be in check, including the US economy).
Getting back to the subject of this thread, having calculated the purchase price of a house you can afford based on a higher 10 year fixed rate mortgage, but actually paying the lower 3.1% variable closed rate (and saving the rest for the future), you can now see if the rent expense is lower, equivalent, or higher than the actual interest expense over the life of the mortgage - remember, rent expense can increase to 50% or more over the next 10 years, depending on the market you want to live in.
In my view, this is the best way to find out if the homes are overvalued or not based on rental expense. Again, it is clear that your cash flow requirements will be higher (due to the fact that you will owning the home as you decrease the principal amount of the loan, and you should also save for a rainy day).
Good luck and happy analyzing your next home purchase!
So in grossly simplistic terms, what is the crude price/gross monthly rent ratio in these cities - on similar homes, of course. Take a median home with ?three bedrooms and a typical 2-bed condo. How would the price and rent compare? I have the number of 200 in my head as a reasonable upper limit in a healthy non-bubbly market.