|Real estate: more of a burb than a bubble|
April 18, 2012 Will Van’t Veld Troy Media
EDMONTON, AB – Bubbles tend to be defined as situations in which an asset’s price has been bid up well beyond what current, or even future, fundamentals would dictate – which tend to centre on interest rates, the labour market and demographics.
It might, therefore, seem relatively straightforward to identify and deflate bubbles before they occur, but the reality of the situation is far different.
Betting against sentiment
Bubbles are most often associated with real-estate and there’s a very good reason for this. One reason is that most organized markets are dominated by professionals, many of whom will bet against the prevailing sentiment if they believe things are getting ‘frothy’.
This is almost impossible with real-estate, where most people are buying homes for shelter and what investor activity does take place tends to fuel the bubble.
None of this is to say bubbles don’t occur in other markets (think of the dot.com bubble of the late 90s); it’s just that real-estate tends to be far more prone to having unrealistic expectations drive buying decisions. Eventually those expectations come to pass, revealing whether they were rational or irrational, but it’s pretty difficult to determine beforehand.
One way to illustrate how hard it is to determine if a bubble is forming is to look at a common metric used to evaluate the frothiness of the housing market, the price-to-rent ratio. Renting might not be a perfect substitute for owning, but it does give an indication of what people are paying strictly for shelter.
Let’s assume that an individual owns outright a standard condo in Toronto worth $340,000. Let’s also assume that the individual could otherwise get a 4 per cent rate of return on the funds; pays condo fees at 1.25 per cent of the value of the property; and the property tax bill is equivalent to 1 per cent of property value. Under these assumptions, the monthly cost to the owner of having all their money tied up in the condo is about $1,770/month (we’re assuming the individual owns the condo outright).
With the average rent being about $1,100/month, our price-to-rent ratio is about 1.6. The individual is essentially paying $8,000/year extra to live in their own condo which might be worth it, given higher quality, location and other benefits. That said, if we incorporate even a modest appreciation in real-estate values the equation tilts dramatically in favour of owning. If the value of the condo appreciates by just 2 per cent, then the cost to our hypothetical owner drops to $1,275/month and our ratio drops to 1.09.
As housing prices tend to move higher, it’s not hard to see why the math normally tends to favour owning over renting. Also, since most people purchase property with the help of a mortgage, the benefits of owning in a rising market become even more explicit. Suffice it to say that our ratio dips to well below parity for someone who is leveraged up to 20-to-1, which is the limit in Canada, even with today’s already high values.
It’s clearly not hard to see how a case can be made to illustrate that the Toronto condo market isn’t completely out of whack, so long as the expectation is that interest rates remain low, the economy improves and prices rise at least modestly.
What fuels the bubble debate is whether the above-mentioned assumptions are rational, especially with respect to further price appreciation given the recent surge.
What would trigger a correction?
Aside from a the onset of a second recession unrelated to housing occurring, the trigger for a worst-case scenario to unfold would likely be either higher interest rates without a strengthening in the labour market; or international investors, who’ve piled money into Canadian real-estate, suddenly changing course.
While it’s likely that interest rates will move higher before the labour market tightens significantly, rates won’t likely spike dramatically higher. With respect to foreign investors, we just don’t really have a lot of experience with how they influence the market and it will likely be an important area of research going forward.
All told, the possibility that there is a bubble in some real-estate markets isn’t negligible, but it’s not a given either. One thing is clear, however: high leverage ratios certainly lowers the margin of error for policy makers.
Will Van’t Veld is an economist with ATB Financial.
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