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Canada housing market overvalued by 10 per cent: TD

Brenda Bouw

Canada’s housing market has been scrutinized six ways from Sunday, but at least one economist claims to have the most sensible take on what’s happening in one of the country's most controversial sectors.

While there have been a wide range of forecasts, from fair value to a market that’s overheated by 60 per cent, TD Bank believes the market is overvalued by about 10 per cent. The call is based on housing affordability, which TD economist Diana Petramala says is the best measure to use.

What’s more, she says the low-interest rate environment is what’s keeping the market from heating up any further.

“The affordability index is highly sensitive to the level of interest rates,” says Petramala in a recent report.

“If we assume a more normal interest rate environment, the index points to a 25 per cent overvaluation. On the other extreme, using current interest rates points to a market that is fairly valued.”

She says current interest rates are unsustainable and expected to increase, which leads to the current call that "home prices are likely roughly 10 per cent overvalued."

The report also takes exception to two other measures used to gauge Canada’s housing market: the home price-to-rent ratio and the price-to-income ratio.

“Both these measures fail to take into account the drop in interest rates over the last two decades,” Petramala says. “What really matters is housing affordability.”

The home price-to-rent ratio suggests an overvaluation of 60 per cent, but she argues that is skewed by rent controls.

“It is difficult to know whether prices are too high, or if its rents that are too low,”

The price-to-income ratio shows the market is overvalued by 30 per cent, but she argues that depends on the definition of income, which often falls short. In fact, she argues if government transfers and investment income were included in the mix, the housing market would only be 8 per cent overvalued.

“In our view, the most superior measures generate an estimate of roughly 10 per cent, which place them in the lower end of the range,” the report states. “Our forecast is consistent with this imbalance unwinding gradually over the next few years through a combination of moderate income growth and a modest home price correction.”

TD is forecasting average house prices across Canada to stabilize this year and fall by about 2 per cent over the next couple of years, consistent with the “soft landing” calls from economists and the Bank of Canada.

Overbuilding and higher mortgage rates are expected to put pressure on housing sales in the coming years.

While 2013 started off slow, it turned out to be a surprising strong year for the Canadian housing market.

That performance defied doomsayers who have been calling Canada’s housing market is a bubble about to burst.

That includes Nouriel Roubini, aka “Dr. Doom,” who said recently that Canada is one of a handful of nations showing “signs of frothiness, if not outright bubbles.”

The Organisation for Economic Cooperation and Development (OECD) and the Economist magazine have also warned in recent months that Canada’s housing market it overheated.

The Economist said last summer that Canada’s housing market was the second most expensive among 19 countries surveyed when measured by price-to-rent, and among the top three when it comes to price-to-income. The OECD said house prices in Canada are overvalued by as much as 30 per cent, using similar price-to-income and price-to-rent data.

Deutsche Bank said the housing market was overvalued by about 60 per cent including both measures, according to a recent report in the Globe and Mail.