MAY 19, 2011
UPDATE: I posted this article yesterday. Today I see that RBC has released their updated housing affordability measures. The post has been updated to reflect this new data.
Housing affordability is often cited as one of the primary reasons that Canada is not experiencing a housing bubble. Despite all fundamentals pointing to a significant level of overvaluation in most parts of the country, critics of the 'bubble thesis' point to the fact that affordability, as it is defined in several common measures, is well below all-time highs. I'd like to outline seven reasons why I believe that the most commonly-used affordability measure is quite misleading and should take a back seat to measures of fundamental value widely used in empirical research. While house prices relative to rents, incomes, inflation, and economic growth are all commonly referenced in academia when discussing the possibility of a housing bubble, affordability indices are seldom referenced....and for good reason.
The most commonly referenced affordability measure in Canada is the RBC Affordability Mndex. In the US, two widely followed indices are the National Association of Realtors Affordability Index and National Association of Home Builders/Wells Fargo Housing Opportunity Index.
Let's zone in on the RBC Affordability Measure. RBC describes the purpose of the measure as follows:
Our standard RBC Housing Affordability Measure captures the proportion of median pre-tax household income required to service the cost of a
mortgage on an existing housing unit at going market prices, including principal and interest, property taxes and utilities.
Let's start off by noting the most recent measure of affordability, as of May 2011:
As you can see, the critics have a valid point. The measure has fallen from the recent highs in 2008. However, let me highlight a few reasons why this measure is not all it's cracked up to be.
1) Affordability is still stretched by historic measures.
Even if we believed that the index was a good measure of affordability, we should still not gloss over the fact that by recent historic standards, the index is still very high. The image below has the three affordability measures with a horizontal green line drawn from their current level. You'll note that the measures are still well above the average of the past 20 years.
In fact, the most recent report indicates that the measure for all three housing types are now above their long-term trends (though below the cyclical peaks in 1990 and 2008).
Notice that the average has been since 1985. Yet during this time, interest rates have done the following...
2) Interest rates will rise much faster than incomes over the next decade.
While I do think that interest rates will stay unusually low for an extended period of time, it's important to realize that this will be a function of the inflationary landscape. Regardless, it is a catch-22. If inflation rises, incomes will rise, but so will interest rates. And you can bet that interest rates will rise much quicker than incomes. From today's level of roughly 5% for a fixed rate mortgage, a rise to 6%, which could happen in a matter of months, is a 20% jump from current levels. Don't expect incomes to come anywhere near pacing that rise in interest rates.
3) The RBC Affordability Measure assumes a 25% down payment
...which is just laughable. With banks still peddling zero-down mortgages (albeit underhandedly), and with downpayment requirements a paltry 5%, we're a far cry from that level. In fact, the most recent reliable data from CMHC indicates that down payments averaged 6-7% as late as 2007.
Granted, the zero-down mortgage was 'officially' ended shortly after this, but it would be a mistake to assume that average down payments made any major jump since then. It would be interesting to see the RBC measure weight for average down payment and average house price, data which is kept by CMHC, though next to impossible to get one's hands on.
4) The measure is in pre-tax income
As tax laws change, impacting take-home income levels, the measure would be far more telling if it accounted for these changes and reported the figures in after-tax dollars.
5) The measure uses the 'standard' home
This one's a bit intriguing. As explained by RBC:
The qualifier ‘standard’ is meant to distinguish between an average dwelling and an ‘executive’ or ‘luxury’ version. In terms of square footage, a standard condo has an inside floor area of 900 square feet, a bungalow 1,200 square feet and a standard two-storey 1,500 square feet.
Why not simply weight for average house size? I could be mistaken, but I have a hard time believing that the average bungalow in Canada is 1200 square feet and the average two-storey is 1500 square feet, particularly given recent building trends.
6) The often-cited city-specific data excludes property taxes and utilities
More relevant than the Canada wide measure is the city-specific measures. These are the ones often reported in local papers. For reference, you can see these measures on page 8 of the latest report. However, as noted by RBC, "the modified measure used here includes the cost of servicing a mortgage, but excludes property taxes and utilities due to data constraint in the smaller CMAs". As property taxes have typically far outpaced income growth in most cities, this is an important element in determining true affordability.
7) The measure ignores other consumer debt
The rapid growth in non-consumer debt is not accounted for in the RBC measure. This is a mistake. What should be examined is the growth in total debt servicing costs. The growth in consumer debt is a major topic of interest on this site.
Affordability measures can be one indicator of potential housing market issues. However, they should not be placed in front of other measures of fundamental value such as rent and income growth. While the RBC measure in particular is interesting, it is not without its major flaws, a fact overlooked by some who would seek to portray the housing market as less risky than it truly is.