A real quick way to tell if there’s a bubble, of any sort, is to compare the price of the asset, versus the cash flows it generates. A stock’s “P/E” ratio is a classic example wherein you compare the stock price (p) versus that of the earnings (e).
Housing is no different in that you can compre the price of a house to the rents it generates, resulting in a similar “House Price to Rents Ratio.” The following chart is from the OECD and has indexed the House Price to Rents Ratios for both the US and Canada to 100 (to adjust for any international discrepancies).
I cannot claim to have studied the Canadian housing market as much as the US, but I found the figures surprising.
Are you saying that a house in Canada is getting more rent than it’s sale value would suggest it should? I don’t know what that means.
I am not sure how this affects me … average guy who owns a home.
What? What?
Splain?
Me not economist or banker. Me dumb shit, work hard, pay off mortgage long time ago.
I am serious, I don’t know what that graph means.
I think it means that even though you are paying 10 times as much for a house today, you cannot charge 10 times in rent.
What people always fail to understand is that a house is not an investment, it is a place to live. Sometimes it looks and acts like an investment for a while, but that always ends in heartbreak.
Sorry for failing to explain.
The idea is that price to earnings or price to rents should more or less remain the same.
ie-the market will on average (at least here in the US) pay $16 in stock price for $1 in earnings. The Dotcom bubble ended up where people were paying $60 in stock price for that same dollar in earnings.
The concept can be applied to house prices. If a house generates say $500 a month in rent, then its price should, more or less, be the same multiple of that rent. But if house prices go up faster than rents, that’s a sign of a bubble. Why would house prices go up for any other reason than rents going up? Therefore, when you see the house price to rents go up, it’s a sign of a bubble because we’re paying more in price for the same amount of rent.
Thanks Kevin.
I think it means that in Canada if a home rents for $1,000 per month it would have a market value of about $190,000 (graph is at 190). In the USA a home renting for $1,000 would have a market value of $130,000. If I’m wrong, my apologies.
As somebody who does have fleeting knowledge of the Canadian market, this makes quite a bit of sense.
The P/E ratio on an investment property in Canada has been stagnant for one reason: increasing supply of available rental properties.
Canada remains in a relative housing boom, and many people are moving out of the rental market into the first-time buyer market and this has weighed heavily on the rental market, keeping average rents flat, and even putting downward pressure on the rental market as landlords have to become more competitive to get tenants.
I don’t interpret this is a *bad* sign for the Canadian economy. This is actually an envious position for us to be in. It’s a problem the Americans should love to be having right now.
Addendum: the Canadian market is looking more along the lines of heading towards a “soft landing” as supply is starting to catch up with demand.
To view easing P/E on rental properties as a sign of economic trouble, simply because of an increase in supply is short-sighted.
While it’s less-good for the owner of the property, the decreased cost of living (despite increased average wages in Canada) is better for the overall economy in terms of that persons broader spending.
Unlike the United States, I think it’s a good thing that we’re not hedging our entire financial system on RECM. As we can plainly see, it’s not as sustainable.
In Manitoba rent controls are messing up the graph.
http://moxargongroup.blogspot.com/2008/09/xran-xplains-credit-crunch.html
Greetings puny Earthlings, Xran here, simplifying the complicated, after they’ve been complicated by the simple.
The economy is in the news a lot these days, so I’ve decided to break down the credit-crunch / sub-prime mortgage fiasco to its simplest elements. I have to admit, like all economic issues, it’s not as cut and dried as people believe. So this is a big one.
Let’s take a very simple and straightforward example:
say that you bought a house with cash for the sole purpose of renting it out and therefore making money on it. If you charge $1,500 a month rent, that is, $18,000 a year and buy a house for $180,000, it will take you 10 years to recoup your investment (I’m keeping it simple so I’m not taking into account the other payments you have to make like taxes and the fact that you’d almost certainly have a mortgage).
However, if you bought the same house for $360,000 it would take you 20 years to recoup your investment – unless you doubled the rent to $3,000.
If $1,500 a month is a realistic rent – i.e. that is what you can expect to get from potential renters – the increasing value of the house is not going to do you any good, because the higher the value, the lower your rate of return. Remember, you didn’t buy this house in order to sell it – you bought it in order to rent it out and give yourself a steady income.
Canada has inflated home values.
Case in point, my place is 90 yrs old, has tripled in market value since 2000.
Ever notice how stuff costs more in Canada vs USA?
I fear more for my great neighbors to the south because according to the New York Post, Wall Street was about 500 trades away from a financial Armageddon to the 8000 level.
Last Thursday, there were $500 billion worth of sell orders in the premarket.
Which would have caused a shortage of commercial paper which most companies have to have to conduct their daily business.
Which would have caused a major seizure of businesses ability to continue operating.
But I still haven’t heard any US politician say yet those magic words ‘austerity program’.
Ah well, I guess it will have to wait until after the election is over.
Cinderella, your carr – pumpkin awaits.
site test.
site test.
I am trained as an economist, and I can claim to have examined Calgary and Edmonton’s housing markets in-depth as late as 2007.
Two resources for the layperson:
1. Garth Turner. I realize it might pain people to think he imight be correct on something, but the Greater Fool blog has been a decent counterweight to the buoyant reports spewed by industry experts. He discusses some of the perils of landlords – the trap of paying a $2600/month mortgage and renting it out at $1200/month and writing off the losses against the capital gains. Garth is correct in his premise that you cannot always rely on industry data (media reports that quote mortgage brokers, real estate agents and developers) because of their incentives to push the “buy” point. Their analysis follows a familiar pattern: Is the market going up? Buy before it goes up further. Is the market going down? It’s time to buy. Is the market flat? Buy becuase you’d hate yourself if you didn’t and the market moved up. Garth has done a very good “elevator economics” style of book that can be understood by the layperson.
2. UBC’s Centre for Urban Economics and Real Estate has some useful reports, particularly their most recent one entitled: Are Canadian Housing Markets Over-priced?.
Points to ponder:
1. October 15th. I may not be up-to-date on this, but on October 15th, 2008, there will be no such thing as a 40-year mortgage. Switching to 35-year mortgages will remove a price floor (support for current prices). I expected to see a runup in Edmonton and Calgary’s housing market as this deadline approaches, but it hasn’t really materialzed.
2. Economist Michael Hudson. I have found his analysis to be very astute and accessible to people. His article entitled “New Road to Serfdom” offers an interesting take on a certain Austrian economists’ premises. He dissects the portion of the economy known as the FIRE economy, and points out the looming monster of negative equity.
3. Median income vs median house price. This is a very good inicator of the sustainability of a housing increase. We take the median income of a household in a particular city, then we assume, based on 20% down, what this home-buyer could afford to purchase. If this house price is, say, $300,000, and the median house price in the market is $400,000 and rising, then we’d say housing affordability is eroding, as it’s out of reach of what the median income earner can afford to purchase using a standardized mortgage. If, however, the median income in a region will support a house price of $300,000, but houses are selling for less than that, then it’s an affordable market.
Based on the 40-year mortgage issue, the UBC report and lagging income growth, I think house prices will come down even more. Not good for home owners, but it’s good for first-time buyers.
With inflated value comes higher property tax…
Good post Captain !
Lotsa bubbles out there – always has been.
What adds to the problem now, is low liquidity.
As a return-on-investment only, many things are a dog. But they can also act as a hedge against inflation. (To get really scared though, google ‘deflation’)
P/E – a very useful, a very telling tool when trying to predict what is coming.
ROIs
$600K house bringing in net $1500/mth; 33
$1000 acre farmland @ $45 (after land taxes); 22
$50 pet rock @ $0.0 return ; infinity
10 years ago, many Nazdaq stocks had P&Es of infinity also !
The USA has many strengths that will get it through the Alan ‘low-interest-rates-to-save-dot-com-bubble’ Greenspan bog;
– High per capita productivity (20% higher than Canucks)
– Lots of oil (just have to start drilling)
– A relatively low-cost country. (think of how many road miles per capita Canada has to maintain vs the USA.
– A military power house.
– A high ratio of wealth producing entrepreneurs to artsy-fartsies.
– Lotsa Patriotism (not counting George Soros and Al Gore)
“. . .many people are moving out of the rental market into the first-time buyer market and this has weighed heavily on the rental market, keeping average rents flat, and even putting downward pressure on the rental market as landlords have to become more competitive to get tenants.”
That hasn’t been the case in Saskatoon, where rental properties have been being converted to condos en masse because the P is a lot more attractive to the building owners than the E from rental. This has been pushing rental costs up alongside housing. Until very recently anyway.
“In Manitoba rent controls are messing up the graph.”
xiat That’s true but also canada has a lot more immigration than the USA combined with rent controls house prices can fluctuate when immigration drives demand crazy, rentals cannot.
“With inflated value comes higher property tax…”
Hard Right not just that but land transfer tax too….
Generally exaggerated stories of rent-gouging landlords notwithstanding, the rental of residential property is more closely controlled by the general state of the economy than the sale of residential property. The reason is simple. Paying the rent comes 100% from the renter’s present cash flow. While there may be minor exceptions, one cannot habitually borrow next month’s rent on a regular basis, or for standard interest rates. However, when that renter goes out to BUY a residence, the money he spends is based on his expectations of future earnings, heartily inflated by the loans officer at the local mortgage company. Placated by the thought that he is paying himself rent, or similar doublespeak, the new purchaser generally pays at least as much in mortgage payments as he paid in rent. The graph shows that on average, residents of the US get a better deal when they buy a house than do Canadians, because the house that they buy with the money they were paying in rent is less expensive.
Without resorting to nit-picking about how Canadian housing standards are oh-so-much higher than American standards (they’re not, really), the cost of a house in Canada is significantly higher than the cost of an equivalent house in the US. And the gap is widening, as can be seen by the tendency of the two lines on the graph.
Keep yourself entertained by looking at American housing websites and then compare them to Canadian sites – take Portland versus Vancouver, for example. Don’t compare old tenements versus new view properties in widely disparate areas of the country- find similar houses of similar age in similar circumstances. And when you convince yourself that the disparity is real, remember that Americans get to deduct the interest on their mortgage from their income tax calculation, while Canadians don’t. That’s not such a big deal when interest rates are low, as they are now, but when the current recession is over and things pick up again, interest rates will increase, and Americans will be even better off than their complacent tax paying Canadian bretheren.
I live in a house which was listed (but did not sell) for 930,000. At 10% that would imply a rent of $93,000 per year, $7750 a month. Mercifully we pay less than 1/3 of that implied rent. Was the house over-valued at 930K. Well the market thought so. And given how slowly houses are selling in Victoria, to clear the market I suspect house would need to be priced around 650K. But renting is still looking more attractive than buying.
Had me worried for a while until I calculated the P/E for the house we just bought to rent out and got 153. Fortunately I like in a place where (at least for the moment) there is a shortage of rental housing and the gross ROI would be 7.8% on our recent purchase. Throw in tax deductions for a rental property and right now it’s looking very good. Of course that might all change in a few years but the interior of BC looks to be fairly safe now.
“A real quick way to tell if there’s a bubble”
Canada has by far the highest population growth in the G8, and that’s not counting the hundreds of thousands who join the waiting list every year, they need housing too.
Put two and two together here, kids: there will be no housing “crash” in Canada, if by “crash” you mean houses are once again affordable to the average Canadian.
“Crash”. Geez, what’s next? If the price of food plummets 20% are we going to call that a crash too? Maybe consider getting a job or transacting business or something if your house isn’t appreciating fast enough.
Some key differences between the two countries to keep in mind:
Our primary residence mortgage interest is not deductible here in CDA. It is in the US and may have encouraged higher leverage rates and higher demand for homes.
We are a net commodity exporter – especially energy – the US is not. the ramp up in commodity prices has been good for housing demand in CDA and bad for the US – and it mirrors much of the two lines on the graph above.
…
A rising tide lifts all boats – and a receding tide lowers all boats. the US housing price pullback is starting to affect pricing north of the 49th, first in the commercial and residential investment market and then in the retail CDN market. the recent pullback in commodities will hurt the CDN R.E. market (it already is in AB) and help the US – 30 states last month saw R.E. prices move higher.
Message of the graph: Now is not a good time to buy investment/rental property in CDA.
But renting is still looking more attractive than buying. Posted by: Jay Currie at September 22, 2008 3:13 PM
If, and only if, the rate on return on invested funds (not required for leverage/mortgage) exceeds capital appreciation of the house. Typically, that amount is pretty much thought of as 8%.
Homeownership, while weaker than gold, is an inflation hedge.
Seeing some of the other comments in here reminds me of the Captain’s other posting about financial education, and lack thereof.
What is the meaning of “indexed the House Price to Rents Ratios for both the US and Canada to 100”? This confuses the whole issue for me.
“A real quick way to tell if there’s a bubble”
Canada has by far the highest population growth in the G8, and that’s not counting the hundreds of thousands who join the waiting list every year, they need housing too.
Put two and two together here, kids: there will be no housing “crash” in Canada, if by “crash” you mean houses are once again affordable to the average Canadian.
“Crash”. Geez, what’s next? If the price of food plummets 20% are we going to call that a crash too? Maybe consider getting a job or transacting business or something if your house isn’t appreciating fast enough.
The difference being is there were/are 10 aunts and uncles in our parents generation, 3 or 4 brothers and sisters in our generation and 1 or 2 kids in the next generation. As the baby boomers start to retire (5,500 per day turning 65) they are all going to want to “downsize”. Will the 3 or 4 of us (this generation) be willing/able to buy 10 of our aunts and uncles homes for a million dollars, and rent them out to our 1 or 2 kids for $3000 a month? somewhere this does not add up- our only saving grace will be …..immigration.
“Correction” does in no way equals crash. However, what has happened here (US) is not necessarily the rule for all other markets. That being said, the conservative approach to a surging market is to hedge one’s bets, or in this case, be financially prepared for a potential down tick in housing values.
Markets do go up AND down, just be sensible and lay off that need for another home equity loan for the new Jacuzzi, it won’t pay you back.
By the way, if you think US banks have it bad, in Europe the weighting of one Belgian bank is worth almost 3 times their GDP, if it were to lose it’s 35 to 1 leveraging.
More later, there’s a reason to keep your powder dry, this is one of them.
The major difference is that in Canada, your “principal residence” (sorry, only one per household) is totally “off sheet” for tax purposes, whereas in the USA it’s “on sheet”.
In plain English, in the US, if you buy a home today and sell it a few years later for more money, you will face capital gains tax, although you may be able to defer it by buying a new home immediately. Because a principal residence is capital-gains-taxable in the USA, related expenses (property tax, mortgage interest, insurance, blah blah blah) are tax deductable. In Canada, your principal residence is not normally subject to capital gains, and therefore there are no corresponding tax write-offs.
This means that in Canada, homes are a tax-free investment that is effectively equivalant to a “growth stock”. I.e. you buy today, without any expectations of high dividends (==rental income) and hope to sell in the future for a tax-free capital gain. Note that if you buy and sell every year or two for a profit, the tax authorities may audit you, and decide that you’re really running a business, and you may be taxed as such. The “line in the sand” isn’t always clear.
To take the comparison further, homes in the US are like “mature stocks”, which have low P/E ratio, while homes in Canada are “growth stocks” with high P/E.
What it comes down to is that you’re comparing apples to oranges. They may both be classified as fruits, but they are quite different.