On Wednesday, a report from Deutsche Bank, which claimed that Canadian homes are the most overvalued in the world, grabbed many headlines.
The bank’s economists found the nation’s price-to-rent ratio is 88 percent above its historical average, while the price-to-income ratio exceeds the historical norm by 32 percent. Combining these two metrics, Deutsche Bank concluded that Canadian homes are overvalued by an average of 60 percent, a figure that should strike fear into the heart of any homeowner.
But there’s reason to believe that this analysis is flawed. Business in Canada reached out to TD economist Diana Petramala, who keeps a close eye on the nation’s housing market, to get her take on Deutsche Bank’s findings.
She doesn’t like the price-to-rent ratio as a indicator of whether the housing market is overvalued, because rent controls limit the potential for increases. To this end, she cited the example of Ontario, which has mandated that rents cannot rise more than 2 percent per year for buildings occupied before 1991.
And Ms. Petramala believes that when you’re talking about the price-to-income ratio, it’s important to know what measure of income is being used. “Some measures suggest an overvaluation of 35 percent,” she writes, “But a more encompassing measure of income (including investment income and transfers from government) suggests the overvaluation is closer to just 8 percent.” In addition, the low interest rate environment has enabled households to carry larger mortgages relative to their incomes, which distorts the extent of the deviation from historical norms.
Here’s a shocker: by some measures, Canadian homes are actually undervalued, according to Ms. Petramala. When calculating affordability, which she finds to be a better measure of valuation, the interest rate being used is an essential input. While homes appear to be overvalued by 20 percent in a normal interest rate environment, we’re just not in Kansas anymore. “Using the 5-year posted interest rate – the rate banks advertise and actually income test at – then homes would be 10 percent overvalued,” she writes. But banks tend not to transact at that rate, and instead offer what she calls a “special rate” to borrowers that can be up to 1.5 percent below the posted rate. “Using this interest rate in the affordability calculation suggests homes can be up to 6 percent undervalued,” she concluded.
Putting all this together, TD believes that Canadian homes are only modestly overvalued, to the tune of about 7 percent.