A tale of two housing markets

The U.S. is rolling over, but Canada is not.

The U.S. housing market finally seems to have heard the pundits. Through February, sales of new and existing homes had fallen 21% and 5%, respectively, from their peaks last summer. Inventories of unsold homes have shot up to decade highs. This combination of waning supply and rising demand has, not surprisingly, started to take its toll on prices. The median resale price of a house in the United States is down 5% from its August high — the largest six-month drop since the second half of 1990.

Higher interest rates and tightened lending standards have clearly helped bring the U.S. housing market to heel. But, in our view, the greatest drag is coming from valuations. Average prices in many cities, such as Los Angeles and Miami, have more than doubled from four years ago. By our proprietary valuation approach, which factors in household incomes, mortgage rates and local supply conditions (essentially, a normalized affordability approach), prices across much of the U.S. have reached levels well beyond those supported by fundamentals. Further declines are a clear risk.

What, then, for Canada, where prices and bubble murmurs have also ramped up in recent years? Certainly, there are grounds for concern in certain cities and segments of the market. But, on the whole, we believe talk of a real estate bubble in Canada is misplaced. Here's why.

First, the market itself is not sending the same bearish signals as in the States. Both prices and sales in Canada have accelerated on net in recent months; new listings have barely kept pace. Markets in Ontario and Quebec do seem to have downshifted a bit, but this has been more than made up for nationally by exceptional strength out west. Notwithstanding the inevitable pockets of weakness, the Canadian housing market is not demonstrating the behaviour we would associate with looming bust.

Nor have the increases in Canadian house prices to date delivered the frothy valuations currently challenging the U.S. market. The consistent valuation approach, which found many U.S. markets to be significantly overvalued, found housing in Canadian cities to be, by and large, moderately undervalued. Toronto looks to have one of the “cheaper” housing markets nationally, which may come as a surprise to some. But consider that average prices have risen only 32% from their 1990 peak, not even keeping up with inflation. Over that period, average household incomes have grown roughly by half and mortgage rates have fallen roughly by half. We calculate that carrying the average house now takes 22% of the average household's gross income, down from 38% in 1990. Largely as a result, we estimate that Toronto housing has gone from 54% overvalued at the peak of the boom 15 years ago to 17% undervalued today.

The only Canadian city we currently estimate to be overvalued is Victoria — by 5%. The most overvalued U.S. city in our research was San Diego — by 50%.

So is it “different this time” in Canada? We don't think so. As ever, the housing market is responding to supply and demand, to fundamentals of affordability and valuation. Those fundamentals warned of bust 15 years ago; they remain, on balance, supportive of boom at this point.

There are risks, to be sure. We expect interest rates to rise only gradually ahead, with the strong Canadian dollar still doing much of the Bank of Canada's work in limiting inflation; a return to the double-digit interest rates of years past, while unlikely, would of course pose a far greater threat. We are also seeing a ramp-up in construction, with housing starts in the first quarter reaching an 18-year high. While added supply may relieve the pressure in some markets, long lead times mean that the eventual delivery of that supply may not find the expected level of demand. Finally, though we have found most Canadian cities' housing markets to be undervalued, many won't stay that way long if recent rates of price appreciation keep up. Calgary is a prime example, where the 30% year-on-year increase in average resale prices through March has essentially eliminated what looked to be a decent-sized valuation gap last year. Albertans should yet keep in mind the (paraphrased) advice of that bumper sticker of lore: “Please bring us another oil boom — we promise not to blow it all again.”