Overvalued housing prices and how to read them: Don Pittis

I was reading about baseball cards over the Christmas holidays and it made me think of Canadian houses.

From the Bank of Canada's warningto last week's devastating analysis from Germany's Deutsche Bank that claimed a 63 per centovervaluation, it seems we are being told once again that we think our houses are worth a lot more than they really are.

As we wait for the latest figures from the Canadian Real Estate Association (CREA) this week, homeowners and prospective buyers will be looking for concrete signals about what to believe.

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The article I readabout collectible cards ostensibly had nothing whatever to do with houses. It was light and charming, an autobiographical feature in the Economist's Christmas double issue, about how a childhood craze for collectible cards had turned into a serious financial speculation.

Baseball cards that had sold in thethousands began trading at absurd prices. Canadian hockey star Wayne Gretzky bought one card for nearly half a million dollars.

House of cards

It is easy to say in retrospect that the results were predictable. But it was the following line in the story that made me sit up and think of Canadian houses.

"The potency of a bubble is its plausibility,to laypeople and experts alike, right up until the moment the game is over," the Economist writer said in an elegant turn of phrase.

Of course, houses are not baseball cards. As I have said in the past, the great thing about houses is no matter how much you paid for it and how much you owe, so long as you can afford to keep up the payments, a house hasinnate value as aplace to live. It retains a house-worth of value.

The house market should be boring.Economist David Madani

But the great thing in reading about baseball cards rather than houses is that you can examine the structures and systems of a bubble without the crushing feeling that your most valuable single asset is at stake.

Reading thatfeature made me wonder ifthere was a set of signals we could watch, whether in the markets for housing or baseball cards,that would tell us ifwe were in bubble territory.

Growing supply

One feature of the card market was the sudden appearance of an oversupply asprices rose. High prices began to drawbaseball cards out of people`s basements and attics, and one indicator we couldwatch for in this week`s CREA numbers (or future ones) is an increasing supply of houses on the market.

So far, supply has been gobbled up byirrepressible demand. But if prospective buyers begin to believe prices could fall, they may become reluctant to pay what sellers expect.

"Perhaps most important, speculative fervour thrives on expectations of rapidly rising prices rising rapidly enough that buyers find it rational to make bets they could not normally afford," said the author of the articleon the card market.

Mint condition

When it comes to houses, the same thing applies. It is certainly something I have heard among young friends in Toronto. If you are confident the house market will continue to ride an updraft, what does it matter if you overspend?

That may be what's happening in Vancouver, where by some calculations, property prices are 10 times incomes.

"That's just so overvalued historically speaking," says David Madani from the Toronto office of Capital Economics, who has repeatedly warned that prices will have to fall.

"A normal ratio is around three, three and a half," says Madani, "When you get up to five you know housing is starting tolook pricey. When you get to seven it's very expensive."

Looking pricey

Toronto prices, says Madani, are running around the seven-times income level. Calgary, despite the falling price of oil, has been running much closer to the normal ratio, partly because of higher income levels. Smaller communitieslike Thunder Bay are well within the affordable range.

Another indicator of whether house prices are overvalued might be the average shelter-cost-to-income ratio (ASTIR), which compares the carrying costs of a house including taxes, heat, etc., to gross income. Traditionally, that ratio for a new home buyer should be about 30 per cent.There are increasing signs Canadian homeowner costs have crossed that threshold.

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If U.S. bond rates rise slightly, say by one or two per cent over the next few years, forcing Canadian five-year mortgages up by a similar amount, it would be easy to calculate whether the house you are considering will cross over the ASTIRthreshold.

Other indicators to watch are whether people are building homes too fast or creating an inventory glut. Some say this has already happened in the Toronto condo market.

Most important, just as with the market for pictures of baseball players on cardboard, we should be wary when people get over-excited aboutthe housing market as a thrilling investment money-maker.

"The house market should be boring,"says David Madani.