Client Outlook - Special Series, 3 of 3

At Leith Wheeler, we are value investors that are keenly concerned about the valuation of assets. But as stock and bond investors why would we bother looking at the real estate market? In short, because it is an important factor in the economy and can have a large, indirect impact on other asset prices.

To conduct our analysis on the Canadian real estate market, we looked at 40 years of housing fundamentals in 21 OECD countries to see how house prices interacted with inflation, household incomes and rents. Over the sample period 1970-2012, prices went up most of the time. However, we concluded that in the long run, prices go up primarily because incomes and rents go up, mostly due to inflation.

When we used a combination of price-to-rent and price-to-income ratios to analyze the Canadian real estate market, our straightforward conclusion was that Canadian housing needs to unwind about 30% from the current valuation ratios. That’s not the same thing as prices crashing by 30%! Importantly, if rents and incomes continue to go up, prices may not need to drop that much. In fact, annual growth in income and rents of 3% would deflate half of the valuation bubble over seven years. It is also conceivable that we don’t revert all the way back down. A modest price decline coupled with gains in rents and incomes, called a soft landing, is exactly what the central bank and federal government is aiming for. However, watch out for weaker inflation or income gains, particularly as the economy adjusts to slower housing activity, as they represent the primary threats to a soft landing.

In conclusion, a housing bubble is hard to define, but we see it in Canada right now. However this doesn’t have to mean financial disaster is around the corner. In fact, our research indicates that housing is almost always either inflating or deflating and while it is a very important factor for the economy, as most Canadian homeowners know, moderate price changes are not the end of the world.