Wednesday, 24 September 2008

Strange Results in UBC Study that Says Canadian Real Estate Over-Priced

Last week I dumped on CBC for misrepresenting the study by UBC prof Tsur Somerville and student Kitson Swan titled Are Canadian Markets Over-Priced?.

Today I look at the same study from a different tack - its contents. It pains me to criticise my MBA alma mater but the conclusions - that houses in certain cities are over-priced by as much as 25%! - don't look right and they don't seem justified.

The first strange result in the study is that the cities with the cheapest houses are said to be the most over-priced. Look at the table below using numbers copied from the report.

Apart from the suspicious pattern, the conclusions about individual cities like Ottawa seem positively crazy. Slicing $80,000 (25% of $320,000) or so from the price of a house in Ottawa would make it equivalent in real value (i.e. after removing inflation) to the price in 1984 per this chart taken from the UBC Centre for Urban Economics and Real Estate website.

As they say, thanks for nothing.

The paper states it is "treating housing simply as a financial asset". What investor would be willing to take on something with zero return over 24 years? Were Montreal houses also to lose 25%, the amount they are said to be over-priced, they would be back to 1975 values in real terms (again, see the UBC website for the chart)!

In other words, I doubt whether houses can be valued purely as an investment. The type of house examined in the study is the traditional suburban family home - single family detached houses. My guess is that such houses have their rent determined by the main rental market and that rent has little effect on the value/price of the house. Probably, the owners are making sure that rental covers their cash costs on an after-tax basis and are only thinking of the appreciation in the house price or capital gain as a bonus or source of extra profit.

The study authors themselves acknowledge possibilities other than a price rise or decline to balance their equation:
  • "If we underestimate the rate of expected house price appreciation, we will predict an equilibrium house price that is too low, below the actual figure, potentially suggesting a market is over priced that is really not." (p.3) A case in point is Ottawa, which comes out by their estimation with an expected rate of capital appreciation of only 2.7% (that's why I highlighted it in red in the previous table), much less than any other city and only half that of Toronto and Vancouver. Maybe their estimate of future Ottawa price appreciation is way too low? Add 2% to Ottawa's expected growth rate, which would make it comparable to all the other cities and presto, Ottawa is not over-priced at all.
  • "Changes in the economy and in interest rates will yield different results." (p.3) If interest rates fall, the proper house price goes up according to the study's formula. A Bank of Canada policy decision to lower rates could thus instantaneously solve the problem of over-priced houses by the author's measure - no need for prices to actually fall.
  • "The assumption about rents presumes that this is the correct expected flow of revenue from the unit." (p.3) If rents rise, then the problem of over-priced houses disappears.
That's not to say there are no over-priced markets in Canada where prices might stagnate or fall slowly or suddenly. But if there are any such cities amongst the ones examined in the study, I'd bet more on the highest-priced ones like Vancouver, Toronto and Calgary than lowly Ottawa, Montreal, Winnipeg or Halifax.

If the authors really wanted to come to a definite conclusion as they did, rather than a much less certain "might be over-priced by one measure whose assumptions are debatable" which is what I think is all they can claim, then they should have carried out the other tests they mention on page 1: "historic rates of price growth, comparing price growth with income and population growth, or measuring price to income ratios." If these other tests all came to the same conclusion I would have much more faith in the study's bold assertions.

Those who think that their house is a wonderful sure-fire investment are well advised to take note of the series of charts in the study's appendix showing the evolution of historical prices. Every major Canadian city in the study has had a lengthy period in the 1980s and 90s when real prices fell significantly and stayed low. Pity the person in Regina who bought a house in 1982 and had to wait till 2008 - 26 years - before they got their money back after inflation, let alone made a return.


Neil said...
This comment has been removed by the author.
Neil said...

There's elements of your analysis that I agree with - that high priced markets like Vancouver and Calgary are probably the real risks - and elements I don't.

In particular, I disagree with your comment about "what investor would purchase an investment with 0 real return."

In a perfect world, houses would be an inflation hedge that pays a dividend (in the form of rent either saved for single-home owners, or collected in the case of landlords). So even if houses stayed at the same real value, it seems to me that it would still be a decent investment.

Having a return above inflation on houses causes the distinctive problem that each successive generation must take on more debt, or else experience a declining quality of life, which seems unsustainable in the long term.

CanadianInvestor said...

Neil, the reasons I would as an investor expect a real return above zero are: compensation for the risk that house prices can go down and may stay down for many years and cashing in is not as easy or quick as selling a stock for example; capital could be invested in something that does earn a real return like stocks or bonds.

Rising real personal income from generation to generation can avoid housing becoming too expensive. Housing can thus keep a constant manageable ratio of expenses (say 30%) to a person's income.

Wikinvest Wire

Economic Calendar

 Powered by Forex Pros - The Forex Trading Portal.