Bank of Canada Governor Mark Carney is going to be in Vancouver on Wednesday June 15th to deliver a speech on the country’s housing market. There is a lot of interest as to whether or not the housing market is overvalued so I thought I would take a look at housing prices and markets using the most recent CMHC annual report (2010 Housing Observer) I was able to dig up, which has average housing prices by major urban centre as well as an assortment of other data for the period up to 2009.
A potential measure to examine the sustainability of the housing boom borrows the concept of the price-earning ratio from stock markets. A price earnings ratio is the ratio of the price of an asset to its earnings flow. The lower the price earnings ratio, the less you are paying for an asset relative to what you can earn from it. In the case of housing, a very crude P/E ratio can be constructed by taking the average residential price and dividing it by the average annual rent for a two-bedroom apartment (a two-bedroom rent is what was available in the report). Crude of course because people usually buy a house to live in rather than earn rent but I suppose there is always imputed rent. Rent is a measure of the potential cash flow from the housing asset. What the P/E ratio does is relate the market valuation of the worth of the housing asset to the actual income or return that the asset can generate. If market valuations of housing prices are related to the income flow, then the ratio should stay constant but if prices become disconnected from income, then the ratio should change fairly dramatically. Declining P/E ratios can represent undervaluation while rising P/E ratios can represent overvaluation.
The results for Canadian urban centres between 2002 and 2009 are presented in the accompanying figures. The first figure presents the Housing P/E ratio for 2002 and 2009. The second figure shows the percentage change in the housing P/E ratio between those two years. The results? Well, everyone’s housing prices went up quite a bit in terms of valuations but the lowest housing P/E ratios are in Moncton, Windsor and Thunder Bay. I suppose one of the side benefits of having a depressed economy is more reasonably valued housing. The highest housing P/E ratios in 2009 were in Vancouver (42) and Victoria (40) (making Vancouver a suitable place for pronouncements on housing markets by The Bank of Canada Governor) followed by Montreal (34) and Toronto (30). Other cities with a ratio higher than 25 include St. John’s, Quebec City, Sherebrooke, Oshawa, Hamilton, Kitchener, Guelph, Saskatoon, Calgary and Edmonton. Places like Halifax, Winnipeg and Barrie were below 25 but still above 20. When you look at the percent growth in the Housing P/E ratio, Winnipeg and Regina have exhibited the highest growth rate over the 2002 to 2009 period. Vancouver, Victoria, Quebec City and St. John's have not been far behind.
It would appear the increase in housing prices has become a pretty broad-based phenomoenon affecting smaller as well as larger urban centres. Does all this mean anything? Maybe not. After all, this is only a crude estimate of a residential P/E ratio and many factors affect prices and rents in the housing sector. Moreover, the housing market is not the stock market. However, in stock markets, a P/E ratio in the 17 to 25 range is often considered a sign of overvaluation. At values of 25 plus, there may indeed be a speculative bubble. Based on these figures, there does seem to be overvaluation in a number of housing markets. It will be interesting to see what Mark Carney says.