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Examining house prices and rents in major Canadian cities

MAY 11, 2011

NOTE:  For more on why house prices and rents should pace each other over time, check out this article.  You may also be interested in how house prices and rents compare in other Canadian cities.

Today we turn our eyes to the change in house prices relative to rents.  The data sources are the Canadian Real Estate Association (CREA) who kindly provided me with quarterly house price data going back to Q1 1980, and the Rented Accommodation Subindex of the Consumer Price Index.

For today, we will examine changes in rents and house prices in Vancouver, Calgary, Edmonton, Winnipeg, Ottawa, Toronto, and Halifax. 

Before examining the data, let's review why rents are an important determinant of the value of housing (both investment housing and residential housing). 

 

Why rents matter

Interestingly, it was the house price to rent ratio and the house price to income ratio that alerted some economists to the severe overvaluation in the US housing market (precious few as those economists were).  It is worth examining why this ratio is an indicator of potential house price overvaluation and why it applies to both residential and investment housing.  With permission, I am going to include some sections from a great post made by Jesse over at his blog:

To understand the price-rent ratio, we can first go back to basic finance math and look at the “net present value” (NPV) of a stream of future cash flows. Cash in the future is normally worth less than today and such is discounted at the “discount rate”, sometimes referred to as the “cost of capital”. For example if I promise to pay you $1000 today or $1000 a year from now, you will put less value on the future $1000 because you can invest today’s $1000 and receive, say, 2% interest risk-free, so my future $1000 is only worth around $980 (1000/1.02). If you are skeptical I am capable of paying you back on time (or at all), you will further discount my $1000 by some amount. If I’m the Canadian government you probably won’t discount much beyond expected inflation, if I’m the Greek government or some Joe of the street you are probably discounting a lot. If you can recoup the money by liquidating collateral put up by the debtor, the discount rate decreases. We can sum multiple discounted cash flows from different payment periods together and get its NPV. NPV is the price an investor would be willing to pay for an investment given the risks involved.

For a property, this series of discounted cash flows is simply revenue (rents) minus expenses (maintenance, taxes, management fees, and capital replenishment) from future payment periods. The revenue and expenses have some variability and risk inherent in property – there is no real way of avoiding it. As a result property will always have a higher discount rate than risk-free. However with property, as a bonus of sorts, revenue and expenses tend to increase roughly with inflation. (Well not quite; as a building ages it depreciates and has higher ongoing maintenance expenses, while the rent will slightly lag inflation – older buildings rent for less than newer ones.) As with any investment we sum the cash flows to get NPV:

NPV = (R-E) + (R-E)(1+i)/(1+d) + (R-E)(1+i)^2/(1+d)^2 …. + (R-E)(1+i)^N/(1+d)^N

where R is the rent, E is expenses, i is the rental inflation rate (which normally but not necessarily tracks CPI), d is the discount rate, and N is the final payment period. Assuming N is large, using simple math this reduces to:

NPV = (R-E)/(d-i)

Notice the denominator d-i for a moment. Remember d is the discount rate, which includes future inflation expectations and risk. In other words, d-i is what we can call an inflation-independent measure of risk. (Again this is a bit of a lie but not much of one.) This number is also referred to as the “cap rate”.

(You may also note that E does not include financing expenses. For the purposes of this analysis, assume we use our own money. Besides, anyone we borrow from or invests with us should be doing the same calculations we are.)

The analog for cap rate in other investments is the price-earnings ratio and the principle is the same (P/E => 1/caprate). With so-called growth investments, the expenses are front-loaded and a potential boon from revenues is pushed out and often heavily discounted, meaning their price-earnings are higher. Property investment will tend to more closely match the price-earnings of utilities like gas, electricity, or water. (Property is, after all, a utility in its own right.)

Misuse of price-rent

Price-rent ratio metrics are an approximation. There are some deviations that can and do exist, some substantial. We hear stories of properties with 1000:1 price-(monthly) rent in parts of Greater Vancouver. When using price-rent to value a property it’s important to take into account its highest and best use. For example, a small house surrounded by larger more affluent houses (or condominiums) is likely going to be re-developed. Its value will be based on comparing various DCF scenarios and choosing the highest one. An underdeveloped piece of land is akin to a call option. In this scenario there are definite grounds for a higher price-rent (though maybe not 1000:1!) because an owner can sell today for today’s best use.

A piece of land expected to be redeveloped (or simply to have its revenue outpace inflation due to significant income growth) at some point in the future, but is not occurring today, is akin to a growth investment, where the market is assuming future cash flows will increase significantly some point in the future. This may or may not be rational and the premiums placed on these properties are speculative.

An important consideration for residential real estate, unlike other investments, is that it is not just investors who are active in the market. Owner-occupiers who prefer to own will be willing and able to pay a premium over rental value for a property, a so-called consumer surplus. In the case where owner-occupiers are heavily active in a market an investor either tags along for the ride, hoping to sell at a higher price in lieu of a low cap rate, or simply sits on the sidelines or invests in better returns elsewhere. Canada’s ownership rate has increased from 64% at the turn of the century to close to 70% today. If one believes the newly-minted Canadian owners place a premium on ownership, this will tend to have driven marginal prices higher. At some point, however, there are no more marginal owner-occupiers buying and we’re left with the “sidelines” investors requiring rental value without the premium.

 

Where Canada stands and what it implies:

It's first worth noting that the aggregate price/rent ratio in Canada is at an all-time high.

house price rent ratio canada

In fact, back in 2008, the OECD released house price and rental data for a number of countries. When compiled, it gave us the following graph. Note that Canada is the light blue line and at that time was second only to Spain in terms of our house prices versus the rent they would fetch.

oecd price rent ratio

 

None of this is particularly new. In fact, in a 2005 paper by the OECD, they recognized that massive, anomalous rise in price/rent ratio across Canada. With the exception of a brief dip in 2008-2009, we know that in the time since 2005, prices have far exceeded rental growth.

What does this imply for future price movements?  To answer this, we'll turn our attention to a remarkably prescient paper written by John Krainer and Chishen Wei of the Federal Reserve Bank of San Francisco back in 2004.  For reference, the US market peaked barely a year after this paper was published.  Krainer and Wei argued that the price to rent ratio is important in determining future movement of house prices.  Interestingly, they argued that when the price to rent ratio is too far out of whack, the bulk of the movement to realign the ratio occurs via a change in house prices rather than a change in rent.  In other words, when the price/rent ratio is at historic highs, as it is in Canada, it is likely that the realignment will come by falling or stagnant house prices rather than rapidly rising rents. 

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.

How true that wound up being.  As the chart below shows, the US is closing back in on its long-term price-to-rent ratio trend line.  We know that it has done this largely through falling house prices.

 

What about rent control?

Some Canadian provinces, most notably Ontario, Quebec, and Manitoba, have rent controls.  Others have less strict rent controls such as BC, while others are largely hands-off when it comes to setting rent increases, like Alberta.  I will say that I am not a fan of rent control.  For some interesting reads on how rent control is poor economic policy, check out these papers and editorials:

Rent Controls:  Do Economists Agree- Econ Journal Watch

Reckonings; A Rent Affair- Paul Krugman in the NY Times (Hey....the guy doesn't always get it wrong...)

How Rent Control Drives Out Affordable Housing- CATO Institute

While rent controls have arguably suppressed rents relative to house prices, there are two things worth noting:

1)  Rent controls have existed in Ontario since the mid 70s and in Manitoba since the 80s.  BC also has a measure of rent control while Alberta has no rent control laws.  As we will see in a minute, the major cities in all of these provinces, those with and those without rent controls, have seen house prices far outpace rents, particularly since the mid 2000s.  In the case of Winnipeg, a city with strict rent controls, house prices and rents tracked each other nearly perfectly until the early 2000s, then experienced a massive divergence thereafter.  Clearly there is another macro factor at play.  It is much more likely that house prices across the country have been buoyed by policy at the national level rather than at the provincial level.  Loosening of CMHC mortgage requirements, the removal of the CMHC insurance ceiling, and a falling interest rate environment are much more likely responsible for the divergence between house prices and rents.

Along this same line, it's worth noting that in provinces where strict rent controls are in place, they prevent the realignment of the price/rent ratio through rapidly rising rents, leaving stagnant or falling prices as the only possible means of realignment. 

2)  In the US, there are fewer examples of strict rent control states, but one glaring example is in California.  Despite this, house prices have fallen significantly in that state as well.  

 

Rents and price in major cities:

With all of that as a background, let's see how some of the big cities stack up.  What is depicted in each graph is the change in house prices and rents with Q1 1980 set at 100 for each variable.

vancouver house price rent

 

calgary price rent ratio

 

edmonton house price rent ratio

 

winnipeg house price rent ratio

 

toronto house price rent ratio

 

house price rent ottawa

 

montreal house price rent ratio

 

halifax price rent ratio

 

What are the implications?

Cheers,

Ben

 

Added:  Check out the follow-up article about house prices and rents across the provinces and house prices and rents in other Canadian cities.

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Ben Rabidoux
By Ben Rabidoux

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29 Comments

  • Sams Mango said:
    • 2 years, 11 months

    I want to add one point that I have made before, rents and house prices need to be adjust for interest rates. For example, each asset has it's own sticky-ness up and down, so we need to normalize this with interest rates. Today, I can buy a home, but i also will demand a lower rent as my cost of providing that shelter have also gone down. 10 years, the home would have been cheaper, but my monthly carry via high rates would have demanded a higher rent, over time that would look weak on a graph.

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  • Torquemaster said:
    • 2 years, 11 months

    Any list that has Citigroup (who by the way just finished a 10 for 1 reverse split) is not a very good list.

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  • John in Ottawa said:
    • 2 years, 11 months

    Some people will grasp at any straw to ensure data doesn't get in the way of preconceived notions. "Please, don't confuse me with the facts."

    The stock split is irrelevant to their strength, although I was surprised to see them on the list. Don't forget Citigroup is tax payer owned for the most part. It just goes to show what a good bail out can do.

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  • John in Ottawa said:
    • 2 years, 11 months

    I rented for three years in Ottawa before I built my home at the lake. The house in Ottawa cost $2,300/month rent. The house at the lake is a similar value, but my monthly is about half. Of course, I tied up a lot of capital.

    In a place like Ottawa, my decision to buy or rent would be based on how I want to use my capital and what flexibility I want. Right now, ownership is the answer because there is no way I could rent anything similar on the lake.

    On another note, we had a discussion a few weeks ago about the strength of Canadian banks. Some readers wished to think, but provide no supporting evidence, that Canadian banks are in dire straights. Well, here is the situation reported by Bloomberg. Canadian banks dominate the list of the top 20 strongest banks. We are all there.

    If things get tough in Canada, at least the banks are going into the fray from a position of strength.

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  • Mandelbrott said:
    • 2 years, 11 months

    Looking at it from the denominator, how have rental rates behaved in the US during the correction in housing prices? Slightly lower, stable or maybe even slightly higher?

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  • John in Ottawa said:
    • 2 years, 11 months

    Rents in the US dropped because so many homes came on the market, couldn't be sold, and became rental units. Rents have just started going back up again, but with the double dip in home prices, rents may have to follow prices down again.

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  • jesse said:
    • 2 years, 11 months

    Contrary to popular belief, rents in the US did NOT plunge significantly with massive shadow and real inventories (is that correct use of "shadow" John? :P ). Instead they kept pace roughly with core CPI, which has kept pace with incomes. There was some mild weakness in headline rents, but true weakess was taken up by incentives and other concessions offered by landlords instead of absolute rental rate drops.

    Things may be changing on this front, however. CalculatedRisk has been closely following the US residential investment market and it looks like rents are going to be increasing faster than core inflation over the next year, if not longer, in part due to partial absorption of inventory and the slow rate by which shadow inventory is being leaked onto the market. This will increase core CPI slightly but more importantly will help speed up the return to the long-term average for price-rent ratios.

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  • John in Ottawa said:
    • 2 years, 11 months

    Jesse, do you read what you write? I said "dropped," not "plunge significantly." The facts are over on CR to verify, but then you verify it in your post.

    Then you say "did NOT plunge significantly with massive shadow and real inventories," but go on to say later, "will be increasing....in part due to partial absorption of inventory"

    To your credit, you got the correct use of shadow.

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  • jesse said:
    • 2 years, 11 months

    John, my comments are directed towards Mandelbrott. Apologies for the confusion if you thought I was refuting your comments. If I disagree with something you write I will quote it directly.

    US rents fell, but not significantly. CalculatedRisk sees rents starting to increase even with continued high inventory levels.
    http://www.calculatedriskblog.com/2011/04/forecast-rising-rents-to-slow-...

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  • Mandelbrott said:
    • 2 years, 11 months

    Thanks Jesse; I am in the camp that believes that housing valuations have little to no correlation with the rental market. Would like to test the theory but in order to do that appropriately one would have to consider occupancy (the inverse of vacancy), rent values, inventory and incentives/concessions all simultaneously.

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  • Joe Q. said:
    • 2 years, 11 months

    Ben,

    Bulls sometimes argue that major international cities also have continually high price-to-rent ratios, and that the numbers we see for Vancouver etc. are not so bad by comparison. This is partially true, but ignores home ownership levels in these other cities -- Vancouver has a much higher home-ownership rate (more than double that of New York City).

    City-level home ownership rates would perhaps be an interesting topic for a future post, as they are (when combined with price data) a good measure of the "bubble mentality" in a particular locale.

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  • jesse said:
    • 2 years, 11 months

    Vancouver's ownership rate is below the national average.

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  • Joe Q. said:
    • 2 years, 11 months

    Jesse, Vancouver's ownership rate may be below the national average, but is it significantly lower than other big Canadian cities? My understanding is that Vancouver is around 65-66% and Toronto may be just a few points higher. Not a huge difference, especially relative to New York, San Francisco, Paris (all in the mid-to-high 30s range) and all the other big expensive international cities people like to compare Vancouver with.

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  • jesse said:
    • 2 years, 11 months

    Now... on rent controls... one of the biggest myths around is that rent controls suppress rents. Look at the rental growth rates on the graphs. Are they rising at the rental control limit? Ummm... nope.

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  • Sams Mango said:
    • 2 years, 11 months
    Reply
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  • John in Ottawa said:
    • 2 years, 11 months

    What! No Garth??!!??

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  • Etienne said:
    • 2 years, 11 months

    I own rental properties with my father (well he owns most of them, I invest in them) and when we bought the ratio was about 6 times income. Now the same buildings are selling for 20x income. Even with the low interest, it's impossible to make money at 20 times income with maintenance fees, interest, etc, and as soon as rates go up, investors will seek for better returns and prices will go down.
    In Montreal, rent control keeps rent way low (too low in many cases). It is bad for the landlords because they could rent at higher prices (and even when tenants leave, you cannot raise back to market value). I am currently renting a home $900 that sold for $240k (22x) and moving to a rental at $1400 that is worth $320k (19x), there is no calculation that makes rent worthwhile at these ratios.

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  • Etienne said:
    • 2 years, 11 months

    I meant "that makes buying worthwhile"

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  • Sams Mango said:
    • 2 years, 11 months

    " own rental properties with my father (well he owns most of them, I invest in them) and when we bought the ratio was about 6 times income."

    If that is the case, why are you not selling them as fast as you can 6X to 22X?

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  • Etienne said:
    • 2 years, 11 months

    Because it generates revenues yearly. In his case, that's what he's after (yearly income).
    But my uncle, received offers at >$1.2M for a rental building he paid about $300k and now he's really wondering if he should sell, he's saying he won't see an offer like that for a VERY long time once it starts going down. His main concern is that half the capital gain will be taxed at full rate, and since he's generating yearly revenue, he's not sure about selling and giving a few hundred thousand dollars to the government.

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  • Samsmango said:
    • 2 years, 11 months

    Your math is wrong because you are not calculating the loss on the 800k by having your capital tied up

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  • paradox said:
    • 2 years, 11 months

    Nice charts Ben.
    It is striking to see how Vancouver and Toronto price and rent index are completely disconnected since 1986 whereas for the other cities the disconnect started around 2000.
    What is so special about Vancouver and Toronto?
    If you have been waiting for prices to align with rents before you buy since 1986, that is a very long time. Given this long time span, can we say with confidence that fundamentals really dont matter for Vancouver and Toronto and should look for other metrics to evaluate RE in those two cities?

    Also, it has been a mystery for me all those investors in the apartment buildings in BC lately. I have looked closely at many of those deals and they are selling at sub 4% cap rates and this with broker massaged figures and operating statements. Given the nature of the business, cap rates of 8 to 12% used to be the norm.
    I dont know why would anyone invest his money at an hypothetical sub 4% rate in an apartment building today when you can get 4% by buying a 10 year government bond, hassle free.
    Even if they finance and buy with OPM, I dont think they are getting interest rates lower than 4% to justify any return. It beats me.

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  • Patrick said:
    • 2 years, 6 months

    Did you really just say "fundamentals don't matter?" Could there possibly be a more obvious sign of a bubble?

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  • Absinthe said:
    • 2 years, 11 months

    Interesting articles linked: neat to see the data. I've worked in rental in BC, and the current system here seems reasonable to me - inflation + percentage raised cap per year but no final rent cap, vacancy decontrol, application for extraordinary increase in a bunch of circumstances. According to the linked data, Toronto with a similar system is hitting the bell curve of a healthy market.
    That seems to me the best of both worlds - with business planning (if they neither buy nor build in the middle of a bubble), a landlord here can gentrify & maintain a margin on a rental, but destabilization of the business side as has recently happened doesn't extend to the entire economy or cause immediate hardship on renters. It's speed control rather than market control. People will move around, but have a larger planning window overall, which allows the reaction to work through to employers and community services.

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  • jesse said:
    • 2 years, 11 months

    David Altig from some place called the "Federal Reserve Bank of Atlanta" seems to like price-to-rent ratios too! Way to hit the nail on the head, Ben. I hope Canadian policymakers are looking at similar graphs to the ones presented in this post.

    http://macroblog.typepad.com/macroblog/2011/05/just-how-out-of-line-are-...

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  • Bangkok Investor said:
    • 2 years, 9 months

    Most banks in Canada and the UK (and I suspect many other countries) will lend at 4x income max. I'd guess the average Canadian family income is 90-100k for lower middle class (the majority). That means 400k mortgages max. In Vancouver and environs that will buy you a 2-bed condo in a wood-frame building. A reckoning is coming - people are deluding themselves to think otherwise. Nice graphs by the way.

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  • Tommy said:
    • 2 years, 7 months

    Very interesting graph. The way I interpret the out-of-whack price/rent ratio in Toronto and Vancouver is that those two cities have a distinctive advantage over other Canadian cities: Immigration. When you have tens of thousands of new immigrants coming into a city, the real estate value will continue to go up (provided that there are jobs to support the high growth). In reality, most local Vancourites and Torontonians cannot afford million+ condos/bungalows. Many of those high-priced properties are bought by foreign investors who treat Canada as a second-home (or vacationing destination). When high-priced properties keep selling, they somehow make the lower prices properties seem too cheap. So the overall prices trend up. This pattern of immigration and real estate prices is indicative in the last 10-15 years. Ever since the Chinese government has allowed immigration in early 2000, the price of Vancouver and Toronto real estate just keeps going up and up. Oil-rich Middle-Eastern immigrants also seek opportunities to invest in Canada where it is politically stable and commodity-rich.

    On the flip side, I see the growth of other Canadian cities (Alberta, Manitoba and Saskatchewan) as a result of a combination of inter-provincial migration (locals who seek else where for more affordable housing and higher wages), real jobs creation in resources sector (oil/gas, potash, mining etc) and Doppler Effect from other high-priced Canadian cities (investors seeking values else where due to reasonable fundamentals in cities like Edmonton, Calgary and Winnipeg where income is more in line with property values). Sometimes it just makes sense to sell a $500K bungalow in Vancouver (a few years ago btw) and move to another city where a person can make similar income (or even better).

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  • Ben Rabidoux said:
    • 2 years, 7 months

    Thanks for the comment, Tommy

    The belief that the rise in house prices is directly attributable to immigration is quite common. The missing piece in all of this is the role of supply. After all, strong immigration coupled with strong building activity to satiate demand really shouldn't drive house prices above inflation.

    Check out these posts:
    http://www.theeconomicanalyst.com/content/superficial-appeal-population-...

    http://www.theeconomicanalyst.com/content/revisiting-population-growth-d...

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  • guest said:
    • 2 years, 3 months

    I don't find the use of a Price/Rent ratio really informative in a market place of competing investments.

    More meaningful, using the same source data is a calculation of the rent YIELD. Calc numerator as excess yearly costs of renting over costs of ownership (include insurance, taxes, arbitrary allowance for r&m. The denominator is the cost of property including transfer taxes and ignoring financing (assume all done in cash).

    Since the 1980's investment yields have fallen, and fallen and fallen. The safe 'return' from home ownership should quite correctly have fallen in lock step (ie prices rise). The Yield would give you a comparable measure. The Price/Rent does not.

    A published Yield measure would also trigger purchasers to do their own calculation. This forms the basis of rational mortgage decisions. http://www.retailinvestor.org/realestate.html

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