Is Big City Real Estate Overpriced?

The current issue of Maclean’s features a typically provocative cover on “Real Estate 2008.” The “Buy? Sell? Panic?” headline caught my attention because I am currently selling a place in Ottawa and moving to Toronto.

The story inside Maclean’s is far more soothing, suggesting that there is no risk of a real estate crash in major Canadian cities because: sub-prime mortgages are rare here, real estate is still much cheaper here than in other countries, and housing is still more affordable than during previous peaks.

The final point refers to the cost of servicing the mortgage on an average-priced home as a percentage of an average family’s income. In Toronto, the current figure of 27% is well short of the 40% reached in 1990. In Vancouver and Calgary, the current figures exceed the circa 1990 peak but remain below the circa 1980 peak. The implication is that, since housing is still relatively affordable, housing prices are unlikely to drop.

I do not find these comparisons particularly convincing. The short-lived 1980 and 1990 peaks in mortgage costs were driven as much by rising interest rates as by high real-estate prices. The current spike almost entirely reflects increasing real-estate prices.

The Maclean’s comparison is like arguing that, if cars cost twice what they used to but interest rates are half what they were historically, then the “automotive affordability index” has not changed. Certainly, low interest rates leave more room for increases in the price of big-ticket items that are often bought with borrowed money. However, this relationship does not mean that the prices of real estate or new cars should rise proportionally as much as interest rates fall.

Put another way, low interest rates and the advent of 40-year mortgages may give Canadians the means to keep bidding-up real estate prices for some time. However, they do not guarantee that Canadians will, in fact, choose to do so.

The comparison that I would like to see is between buying and renting. Imagine that a one-bedroom condo in downtown Toronto costs $300,000 and that condo fees, plus property taxes, plus utilities amount to $6,000 per year. Assuming that 6% is the mortgage interest rate and the opportunity cost of cash put in, owning the property would cost $24,000 per year.

By comparison, one could rent a one-bedroom apartment in downtown Toronto for about $12,000 per year. In this case, the financial argument for buying depends entirely on expectations that the property’s value will increase substantially after it is purchased.

Imagine that its value rises by 6% per year, exactly offsetting the interest payments and/or opportunity cost of funds. The benefit of ownership would then be the difference between rent and condo fees, plus taxes, plus utilities. This annual sum of $6,000 amounts to 2% of the principal value.

One would do just as well to rent an apartment, obtain $300,000 at an interest rate or opportunity cost of 6%, and invest it in the stock market for an 8% return. In this case, the financial argument for buying is based on the notion that real estate is safer than the stock market. However, this notion depends on the view that real estate is not currently overvalued.

Historically, I think that real estate has averaged less than 6% and stocks have averaged more than 8%, reflecting their greater riskiness. I am not advising anyone to go out and borrow hundreds of thousands of dollars to play the stock market. Indeed, few financial institutions would provide such a loan. My point is that similar caution would be warranted before taking out a mortgage of this magnitude.


  • Interesting, in fact i am signing of a 400,000 dollars mortgage next week for a townhouse i just got, i did the same calculations with 6% interest rate and utility fees, but my family needs a more spacious place than the rental appartment we are living in now, i think as royal lepage is predicting the value incease will be 3.3% for next year , but you have to consider, home prices are really lower than most countries , i am comparing prices to back home and toronto is really cheap and affordable to Tehran

  • Good point on interest rates and affordability, and rent v. own p/e ratios being a better measure of appropriate pricing.

    But even if you accept affordability as the measure, I’m always mystified that people take prices being somewhere between the last two points which were peaks followed by severe price declines as a reassuring fact.

    If you are interested in rent vs. own numbers this report from Scotiabank (issued over a year’s worth of price increases ago) has a pretty good comparison.

  • Nima,

    What kind of interest rate did you get for the mortgage that you are signing for?

  • I have read the abovementioned article and found it incredulous. For instance, the idea of comparing real estate prices in Canada lets say Toronto, to prices in a city such as London is like comparing a pound of apples to a pound of Caviar.

    1. Each GBP is worth two Canadian dollars
    2. London City is becoming, if not already, the finance hub of the world and had surpassed New York in terms of transactions
    3. London job market has an employment rate close to 98%
    4. The City-of-London’s has a culture of high bonuses, and it’s well established that most of those moneys end up in real estate. (it is called city bonuses)
    5. London is the main beneficiary of the Petro Dollar cycle shift away from New York. I am taking about Arab sovereign funds. More money than anyone can eat!
    6. London is a home for the Ultra rich from VIPs all over the world.
    7. Open city policy by the British Government
    8. This might be a hard one to believe but it’s true: less income tax, about 3% less if you make 75K GBP
    9. The Culture
    10. The view
    11. The people
    12. Notting Hill
    13. High Park
    14. Fish and chips
    15. Madonna lives there
    16. And no it does not rain all the time
    17. …….. etc.

    Now let us talk a bit about Toronto:
    Home for the Maple Leaf!
    You get the idea

    I guess what I am trying to say is that; London real estate market has a clear premium attached to it.

    Further, the article has ignored the international money supply, which is currently adversely affecting the real estate market in Canada and elsewhere. This is due to the diminishing investors’ appetite worldwide for real estate backed assets. In fact, they will not touch them with a 10-inch pole.

    I am no expert, but Canadian lenders (banks) cannot keep on originating real estate mortgage loans and stack them on their Balance Sheets indefinitely, they have to securitize them and sell them off their Balance Sheets to investors to make room for new loans. This is how banks maintain compliance with Basel-II’s Capital Adequacy requirements. Eventually, this will lead to reduction in money supply available to real estate lending and put a downward pressure on homes prices.

    The main points I am attempting to make here is the above Apples with Caviar comparison and market structure relevance to home prices. Notwithstanding Toronto-market’ structure is differently than that of the United States, and factors such as sub-prime lending practices, tax treatment of interest, growth rate and immigration are all solid, let us not ignore the money supply to which any real estate owes its boom to.

  • I’ve started a blog about Calgary real estate valuations. The price to rent ratio is almost double traditional valuations (and less than safe investments like bonds and GIC’s). I hope to be doing more regular posts regarding the subject:

    Calgary Real Estate Market Blog

  • I would like to commend Saad for this slightly opinion based, but accurate view.

    “Comment from Saad
    Time: January 5, 2008, 1:41 pm

    I have read the abovementioned article and found it incredulous. For instance, the idea of comparing real estate prices in Canada lets say Toronto, to prices in a city such as London is like comparing a pound of apples to a pound of Caviar.”

    Property valuation in Calgary is in dangerous territory. The rent to own cost ratio is more like 1:3. The only reason prices have not already plummeted (by plummet I mean a %30+ decline) is because of the solid and difficult to sell nature of real estate. The market is sitting right on the middle of the teeter totter right now. On one side of the teeter we have income trust taxation, political instability (royalty review), a massive slow down in conventional oil and gas exploration, and a reduction of what all albertans are strangely addicted to OVERTIME PAY. On the other side of the teeter we have nothing more than human emotions, desperation, unwillingness to admit fault in an awful decision to purchase and over valued highly taxed chunk of dirt and lumber that is rapidly suffering from a global and local liquidity crisis. What I am saying may seem outlandish to some who “desperately” believe they made a good decision buying a soulless large scale developer house with a 45-60 min commute to work for $500 000-$1 000 000.

    On to the second part of this tangent. Ask yourself: What is my annual income? Is this income sustainable? Are my affordability calculations based on overtime pay? Are there any other investments in canada that have a annual tax on them based on the value? If you answered anywhere below $150 000/yearly for income or your income is that high but dependant on overtime you shouldn’t be considering purchasing a $400 000 home (aka crappy house with nieghbours 4 feet away in calgary). How is your health? Are going to be able to work stupid amounts of overtime for ever? Is your rate of pay increasing fast enough that you won’t need to wsork overtime soon? Are you planning on having kids and losing some income from your partner not earning a full income? Wow.

    Think before you buy. Or just stop buying and force the prices back into a reasonable range so we can all live happily with some spare cash at the end of the month to take the family skiing or something.

  • Interesting artical in the economist:

    BRITAIN: Britain’s economy
    The bust begins
    Housing-market woes spread to Britain
    Apr 8th 2008

    The qustion is, are we their yet?

  • Rising inventories in Calgary.
    Merrill Lynch releasing report that Saskatoon housing is 50% overpriced.
    We are headed there very soon.

  • And we now have reports that even the Vancouver market has apparently peaked, with a small 2% decline in prices in the last month, and a much lower volume of completed sales.

    In a stable, long-run equilibrium real estate market an investor owned property that is for rent must make a net return equal to interest rate on secure liquid assets like bonds, plus an additional premium for the risk of the rental property being damaged, plus other costs such as taxes, condo fees if applicable, and an allowance for maintenance. IOWs, there needs to be a rate of return that supports the price level of that property.

    In Vancouver, at least, that hasn’t been the case for decades. Prices are far above what can be supported by rents as the income on the asset. Investors are all counting on capital gains in the price of that asset, otherwise, it makes no sense for them to hold it. As long as prices are rising, everthing’s fine. But the moment they stop rising, the rational for holding these properties disappears.

  • I like Rod’s post: investors stop buying when prices appear to decline, hoping they will fall further; and owners start to sell to realize gains, driving prices further down.
    Th five percent appreciation per annum of property takes place over a long period, and it does not account for the costs of holding property, but these are offset by the tax benefits offered on operating costs.
    Hold rental property, and you can depreciate an appreciating asset.
    In developing a strategy for affordable housing, it seems to me the co-op model is best, and this is one policy area where it appears tax expenditures might create appropriate incentives for this type of owner-owned property to displace the speculative housing market developed by city hall in Vancouver.
    I would be interested to hear more from co-op housing people on what is needed to make this the default option for most Canadians.

  • Where do these facts come from? I do not know ANYONE paying as little as 27 – 40% of their income on housing. Its way above that.
    ALso you cannot rent a decent one bedroom for $1000 a month in Toronto. A craphole yes but not a condo that sells for $300k.
    I also like how media keeps saying we have no sub prime …. 40 year mortgages – people that is sub prime by another name.

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