Canadian real estate is receiving a big warning sign from an indicator that was an alarm for the US in 2006. The house price-to-rent ratio shows Canadian real estate is overvalued. When contrasted to the US is when you really get a feel for how much Canada went all-in on real estate. It makes 2006 America look like a sleepy backwater market of value investors.
House Price-To-Rent Ratio
The house price-to-rent ratio is an indicator used to gauge overvaluation. It compares the cost of a home to the cost of renting a similar place. Since rent is a fundamental indicator tied close to income growth, it tends to be mostly stable over time. That is, it reflects a change in earnings or productivity. As opposed to home prices, which mostly reflect access to credit.
When home prices grow faster than rents, it means valuations are becoming stretched. Persistent growth means prices are becoming overvalued. US economists feel this was one of the most obvious signs of the housing bubble in 2006, in hindsight.
When the ratio falls, it means home prices are becoming more fairly valued. If it persistently falls, it can mean home prices are becoming undervalued. In a healthy market, the price-to-rent ratio would move relatively horizontal.
Today we’ll be looking at the indexed values, which help to allow multi-country comparison. When looking at the indexed value, you’re looking for the change over time, instead of the actual number. What you don’t want to see is persistent and high growth. That would mean the market is becoming overvalued.
Canadian Home Prices Grew 107% Faster Than Rent Since 2005
Canadian home prices have grown much faster than rental prices, indicating significant overvaluation. The index increased 7.7% in Q4 2020, compared to the same quarter a year before. This means home prices accelerated 7.7% faster than rents over the same period. It’s also 36.0% higher than it was in 2015 as well. This is a significant detachment from fundamentals, and a steep premium to own vs rent.
Canadian House Price-To-Rent RatioThe indexed quarterly value of Canada’s house price-to-rent ratio from Q1 1970 to Q4 2020. Source: OECD; Better Dwelling.
Although this is a long-term trend for Canadians. The index has increased 107% since 2005. On a much longer scale, the index has increased 574% since 1970. Home prices have been rising at a breakneck speed for almost 50 years. Looking at the chart though, you can see it really starts breaking away in the early 2000s. The index almost triples over just the most recent 20 years.
When looked at by itself without context, these kinds of numbers may seem normal. What’s it supposed to look like? Let’s check out how Canada’s closest neighbor looks. After all, they have extensive experience with overvaluation.
US Home Prices Grew 1% Slower Than Rent Since 2005
The US has also had a big year for home prices growing faster than rents. It actually saw larger growth than Canada. The index increased 8.1% in Q4 2020 when compared to the same quarter a year before. It is also 26% higher than it was in 2015, so it’s had some decent growth over that period. The growth over the past 5 years is still only three-quarters of that seen in Canada. Even more interesting is how this looks over a much longer term.
US House Price-To-Rent RatioThe indexed quarterly value of the US house price-to-rent ratio from Q1 1970 to Q4 2020. Source: OECD; Better Dwelling.
The long-term trend looks totally different from Canada over the past few decades. The index is actually down 1.5% from 2005. To rent is a little more expensive than to buy, compared to just before the Great Recession. On a much longer basis, the index is only up 26% from 1970. Once again, home prices have accelerated in growth more than rents, but not nearly as much as in Canada. The trend is almost horizontal.
The overvaluation of Canadian real estate based on rent is much higher than US real estate. Over the past year appears to be a bit of an exception. The American price-to-rent ratio grew a point faster than Canada’s ratio. That seems to be one of the few times it has happened in the past few decades.
In general, Canadian home prices grew faster than rents. From 2005, Candian home prices grew 105.7 points faster than the US. Since 1970, it’s about 21 times faster. This is one of those things that’s easier to understand as a chart.
Canadian and U.S. House Price-To-Rent RatioThe indexed quarterly value of Canadian and US house price-to-rent ratio from Q1 1970 to Q4 2020. Source: OECD; Better Dwelling.
The Canadian line looks like persistent growth, all the way through. This indicates home prices have grown much faster than rental prices. It’s not until Canada enters the early 2000s, when it really starts to take off though.
There is a brief moment around 2008, where it pauses, before going for a second run higher. Home prices are now far in excess of what rental prices can support. In hot markets, private landlords subsidize rent. That’s because home prices are growing so fast, who cares what the rent collected is? You more than likely plan on kicking the tenant out in a few months, and collecting your capital anyway.
The US price-to-rent ratio is more cyclical in contrast, with spikes during bubbles. It also tends to form a trough during recessions, allowing for value balancing. Home price overvaluation can be seen, just not to the same extent as Canada.
The price-to-rent ratio is another fundamental indicator showing questionable valuations. Like disposable income, this highlights fundamentals lag the US on a long-term basis. Despite the US being notoriously expensive, it’s actually much more affordable than Canada. Even so, you would be hard-pressed to find a Canadian that thinks home prices can fall anytime in the near future.
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