Is Canada’s Real Estate Market Overvalued, And Does It Need a Correction?

At this point, it’s probably safe to say that most Canadians with any vested interest in the real estate market, have some awareness of the growing home prices nationwide. But the question that many analysts have asked is whether we can describe Canada’s current market conditions as being in a bubble. Essentially, some analysts and observers believe that the real estate has reached a limit, and that a “correction” (or “crash,” significant decline) in prices is inevitable. If home prices continue to climb the way that they have, it may one day reach a point where the bulk of Canadians will not be able to afford a home, unless wages and salaries are also increased to compensate.

Fears that Canadian home prices are overvalued were reinforced as recently as today. Susan Pigg of The Toronto Star reports on the recent data released by the Canadian Mortgage and Housing Corporation (CMHC), which stated that house prices across the country are 3-4% overvalued, with the biggest risk of a severe price drop happening in the “high risk” cities of Regina and Winnipeg, which is being blamed on the combination of escalating prices coupled with the over-construction of units, causing a surplus. Toronto was categorized as “moderate risk” of a correction due to annual price gains that have been more than triple the rate of average salary increases (the CMHC uses a metric that compares home prices to annual incomes), while Vancouver was designated as “low risk,” despite the highest house prices in the entire country.

fitch-ratingsThe question isn’t, whether Canada’s real estate market is overvalued. Their seems to be quite a bit of consensus on this claim. The question we should be asking is by how much? There is some disagreement when it comes to this figure, with the CMHC underestimating it drastically, based on what others have predicted. Variations in this metric can be explained by differences in the measuring process and formulas applied.  As Tamsin McMahon of The Globe and Mail explains, the Bank of Canada has stated that housing prices are overvalued by 20%, as of the third quarter of 2014. Canada’s central bank uses a model that compares the level of house prices to the level of per-capita after-tax income and 10-year government-bond rates, which it uses as an approximation of mortgage rates. Both house prices and incomes are adjusted for inflation. While the popular private credit rating firm, Fitch Ratings, stated that the housing market is overvalued by 24% (as of the second quarter of 2014). Fitch’s model is concerned with “sustainable house prices” – prices based on factors that have consistently driven the demand for new housing historically, factoring in population growth and new-home construction.

David Kaufman of The Financial Post makes the argument that a housing correction would be good for the real estate market, with homeowners in Vancouver and Toronto, in particular, seeing massive gains on the equity value in their houses, having taken advantage of low interest rates, high loan-to-value mortgages and long amortization periods. Kaufman’s argument is interesting, in that, he claims only one of the three main groups of homebuyers — first-timers, young homeowners with growing families, and older homeowners thinking about downsizing — would suffer from a decline in home prices, while the other two groups would benefit. The big winners appear to be first-time homebuyers, with many more being able to enter the market and potentially buy a home, should prices be slashed significantly. The big losers will end up being the “empty nesters looking to downsize,” who will see the value of their home plummet.