Canadian house prices are the most overvalued in the G7, another indicator shows
Real estate prices in Canada are the most overvalued in the G7, measured against rents. IMF data shows that Canada’s house price ratio in the second quarter of 2020 was the highest of any G7 country. The indicator is commonly used by analysts and economists to determine stretched valuations. House prices in the G7 have increased faster than rents on average. In Canada, however, they have increased almost twice as fast as the average in just a few years.
House price / rent ratio
The house price-to-rent ratio (PTR) is the ratio of the house price to the annualized rent. It is often used as a benchmark to determine whether it is cheaper to rent or own. More importantly, analysts often use it to determine if homes are overvalued for a market.
Rental costs are closely related to wages, with growth limited to what local incomes can support. You can’t easily charge an entire country 20% more rent if wages only go up 2-3%. However, house prices reflect the amount of credit the marginal buyer is able to consume. If house prices rise much more than rents, it is often because of easy credit conditions, not fundamentals.
The IMF uses an indexed approach to track change. They set 2015 as the base year with a value of 100. If the index increases, it means that house prices have increased faster than rents. If the gap between house prices and rents increases, the value of the index increases. If the gap between the two closes, the index value decreases.
It should be stressed again, the 2015 benchmark year is set at 100. It makes 2015 look like 2015 had the right price ratio, but doesn’t really mean that. The inefficiencies may have started long before this date and persist to this day. However, we are mainly going to talk about how much things have changed since that year.
Home prices in Canada have risen 28% faster than rents
The Canadian PTR is the highest of any G7 country, with prices rising much faster than rents. Canada comes in at 128.0 for its latest period, which is the second quarter of 2020. This means that the gap between house prices and rents has increased by 28% since 2015. It is also worth mentioning that the data relates to the second quarter of 2020. House prices have really taken off after this quarter, especially in smaller towns and villages. The disconnection is probably much greater at this point.
Price / rent ratio of G7 houses
The value of the index of house price / rent ratios, with 2015 set at the base year of 100. Source: IMF; Better accommodation.
Residential real estate in the United States is experiencing a similar trend, but not to the extent observed in Canada. Home prices in the United States had a PTR of 110.6 for the second quarter of 2020. Home prices grew 10% faster than rental prices. Home prices in Canada have accelerated faster than rents, at more than twice the pace in the United States. Canada is an outlier not only compared to the United States, but also compared to other G7 countries.
The Canadian gap between house prices and rents has grown fastest in the G7
The gap between Canadian home prices and rents is the fastest growing in the G7. Germany, the second highest PTR ratio in the G7, is 2.1 points lower than that of Canada. The average PTR ratio of the G7 is 13.9 points lower than that of Canada. The Canadian gap has widened twice as fast as the average for all G7 countries.
The house price ratio in Canada is the highest of any advanced economy in the G7. Since the latest data is for the second quarter of 2020, this ratio is also expected to have accelerated further by now. Much faster, since prices are skyrocketing, even in small towns.
Typically, a disconnect between house prices and rents is corrected. Any combination of lower house prices or higher rents would solve the problem. However, when the gap is this large, it is difficult for rental prices to close the gap by much. If it took a big leap in a reasonable amount of time, it would create inflationary pressures on wages. Accelerating wages to cope with rising living costs is the death sentence of an economy.
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