MAY 14, 2011
Prices and rents revisited:
Earlier in the week, we examined the changes in house prices and rents in the largest cities in Canada. We also spent quite a bit of time discussing why changes in rents are one of the measures of fundamental value when it comes to residential real estate. If you are unclear on this, I suggest you re-read the post again. It is important in appreciating the data I am going to present in this post.
Quick note: I've added to graph for Montreal now that I've accessed the historic house price data for that city.
The bottom line is that when there is a massive divergence in the growth of rents and the growth in house prices, there is always at some point a realignment. While in theory the realignment can occur through a rapid rise in rents, this is seldom the case. For starters, strict rent control in a handful of provinces prohibits this. But beyond this, it is simply not the experience of numerous other housing markets that have experienced such anomalies.
As a prescient paper written by the Federal Reserve Bank of San Francisco noted, "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."
With that said, allow me to present the provincial data. For reference, the rental data is from the Consumer Price Index rental component (CANSIM table 326-0020) while the house price data is from CREA.
Note that in every province except BC and Ontario, house prices and rents have closely paced each other before abruptly diverging in the early to mid 2000s. So what is the deal with Ontario and BC? There may well be a historic and stable premium relative to rent that buyers have been willing to pay to live in those provinces. Furthermore, rental controls may have had some impact in keeping rents subdued in both provinces, though that hardly explains why other provinces with strict rent control (such as Manitoba) have seen house prices and rents track so closely.
Let's assume that the price premium in these two provinces is permanent. Just how much of a premium buyers will be willing to pay is now the huge question. Given the parabolic move in house prices relative to rents in both provinces, it's clear that house price premiums relative to rents have increased as quickly as in other provinces. So while they two lines may never touch again, it's an exceptional stretch to believe that they won't at least narrow.
All fundamentals that we have examined thus far suggest that a level of overvaluation exists. The drivers of house price appreciation are complex and involve both psychological, economic, and monetary influences. Any one metric cannot provide a complete snapshot of the state of housing in Canada. Yet when numerous metrics all point to a significant overvaluation issue, people would be advised to think long and hard about the implications for house prices appreciation going forward. Even more importantly, it's time we begin to consider the economic repercussions of a more rapid realignment of house prices with underlying fundamentals. For more on that, check out these two posts (part 1 and part 2)
Those fundamentals have been discussed in the following posts:
And for more on the price/rent ratio and using it to determine whether it makes sense to rent or to buy, check out this post.
Oh, and by the way, here is the US experience with house prices and rents:
We know how that ended. Is it really different this time? Can our parabolic move in house prices relative to rents continue indefinitely?