Millions of Americans have been devastated by the bursting of the US housing bubble. Most of them are people who bought close to the peak of the market then lost their down payments and more when prices collapsed. Home values in the US are back to 2002 levels and people who bought near the top have lost over 30%.
The moral of the story is clear – when housing is significantly overvalued it’s better to rent than to buy.
But what about people who did the prudent thing and rented during the bubble? Did they also pay a price? And what about Canadians renting today waiting for the Canadian housing bubble to burst?
To answer that question, let’s look at an example of someone living in today’s bubbliest North American market – Vancouver. According to the latest Rental Market Report from CMHC, the average rent for a Vancouver condominium is $1,474. The average price of a Vancouver condo is $445,458.
Traditionally, real estate values are proportional to rents. The rule of thumb is that homes should cost about 15 times their annual rent. For example, a condo that rents for $1,000 per month ($12,000 per year) should sell for about $180,000. For the average condo in Vancouver, the current ratio of price to annual rent is 25.2 – implying (as did my earlier post) that Vancouver is due for a 40-50% correction.
So let’s compare two scenarios: renting during a bubble versus buying in a normal market.
Scenario 1 – Renting in today’s Vancouver condo market.
At today’s average monthly rent ($1,474), the annual cost of renting would be $17,688.
Scenario 2 – Buying that same condo if there were no bubble.
In a normal market, the average condo would be selling for 15 times annual rent – $265,320. Assuming condo fees of $3,000/year and property taxes of $1,750, the total annual cost of owning would be about $4,750/year (for the purposes of this discussion, let’s ignore mortgage costs). Additionally, an owner could expect that condo to appreciate. The long-term average inflation rate in Canada is 3.26%. Being conservative and using the average inflation rate, this condo could be expected to appreciate $8,650 during the first year.
The total benefit of buying over renting would be annual savings plus appreciation. In this case that number would be $17,688 – $4,750 + $8,650 = $21,588. For someone able to purchase that condo for $265,320 without a mortgage, this benefit would come out to 8.14%. That’s how housing bubbles hurt people who do the prudent thing and rent during a bubble. It deprives them of a tax free return of over 8%.
And in the event readers are wondering if a price to rent ratio of 15 is realistic, 98 out of 100 US housing markets now have a price to rent ratio less than 15!
So says Bill McBride, author of Calculated Risk. In my opinion, his blog is the single best source for information on the US housing market. I’ve followed his blog for years, and can’t think of a single time he’s been wrong.
First there are two bottoms for housing. The first is for new home sales, housing starts and residential investment. The second bottom is for prices. Sometimes these bottoms can happen years apart.
For the economy and jobs, the bottom for housing starts and new home sales is more important than the bottom for prices. However individual homeowners and potential home buyers are naturally more interested in prices. So when we discuss a “bottom” for housing, we need to be clear on what we mean.
For new home sales and housing starts, it appears the bottom is in, and I expect an increase in both starts and sales in 2012.
And it now appears we can look for the bottom in prices. My guess is that nominal house prices, using the national repeat sales indexes and not seasonally adjusted, will bottom in March 2012.
There are several reasons I think that house prices are close to a bottom. First prices are close to normal looking at the price-to-rent ratio and real prices. Second the large decline in listed inventory means less downward pressure on house prices, and third, I think that several policy initiatives will lessen the pressure from distressed sales (the probable mortgage settlement, the HARP refinance program, and more).
Of course these are national price indexes and there will be significant variability across the country. Areas with a large backlog of distressed properties – especially some states with a judicial foreclosure process – will probably see further price declines.
And this doesn’t mean prices will increase significantly any time soon. Usually towards the end of a housing bust, nominal prices mostly move sideways for a few years, and real prices (adjusted for inflation) could even decline for another 2 or 3 years.
But most homeowners and home buyers focus on nominal prices and there is reasonable chance that the bottom is here.
With all the information Canadians have heard about the US housing bubble and the incredible economic damage it’s bursting has caused, it’s hard to believe they would follow the same path – and yet they have. The average price of a Canadian home currently stands at $362,899 – about 70% more than in the US.
(Note: Canadian realtors typically report average prices while American realtors report median prices. Average home prices in the US are about 20-25% higher than median prices. The current median US price is $169,500 making the average US home approximately $210,000.)
According to a recent article in The Economist, Canadian house prices are 29% overvalued relative to household incomes and a staggering 71% overvalued relative to rents.
Things are even worse in Vancouver, where the latest Demographia Housing Affordability Survey ranks Vancouver the 2nd least affordable city in the English speaking world. According to the survey, the median price of a home in Seattle was $321,500 while in Vancouver it was $602,000. In the year since that survey was published, Vancouver prices have gone up another 7.8% while Seattle has gone down 7.1% – making a home in Vancouver more than twice as expensive as a comparable home in Seattle. This is in light of the fact the two cities are similar in almost every way – including incomes.
How did things get so out of whack? Same way as they did in the US – with a debt fueled housing bubble. Lesson not learned.
How will the situation resolve itself? In all likelihood the correction will also follow the path of the US – a multi-year housing crash which ruins the lives of countless Canadians and takes down much of the economy with it.