Rational Advisor

I found this a very interesting read. It was from this weekends Sept 08 Financial Post, and written by Dr Livio De Matteo, Professor of Economics at Lakehead University - a very smart guy!

Here it is

The recent global stock-market drops, combined with the news that median housing prices in the United States have declined for the first time in decades, have created grave concern. Nevertheless, these events are not that unexpected. After a decade of low interest rates, it is no surprise that investors poured their money into real estate and the stock market. Given the global economic boom and the threat of inflation, it was only a matter of time before credit began to tighten and prick the growing bubbles in real estate and stocks. In the case of the United States, the proliferation of low quality debt via the sub-prime mortgage market aggravated the prospect of rising rates. Not raising interest rates in the foreseeable future may stave off pain for a little while longer, but the end of cheap credit is near.

While the tumble in global stock markets affects Canadian investors too, to date our housing market has continued to exhibit strength. However, Canadian housing prices over the last decade have risen to the extent that we may also need to be concerned, given interest rate trends. In Canada, the average MLS residential price rose from $150,720 in 1995 to reach $249,311 in 2005 — a 65% increase. In many cities, the price increases are so steep that homeowners are experiencing massive wealth effects as their homes appreciate, while first-time buyers are increasingly unable to afford a home. In Toronto, the average MLS residential price rose from $195,311 in 1995 and reached $336,176 in 2005. In Calgary, the average MLS residential price rose from $132,114 in 1995 to reach $222,860 in 2004 and $250,832 in 2005. In 2006, it has been estimated that average prices shot up a further 37%. Winnipeg had an average house price of $82,994 in 1995 and by 2005 had an average of $137,263 — a percentage increase that matched the Canadian average.

The lowest interest rates in 40 years fuelled this boom, and as prices and mortgage sizes have risen, financial institutions have “helpfully” come up with new affordability strategies, such as putting only 5% or even a zero down payment and extending amortization periods beyond 25 years. Despite the advertising enticements that maintain we are richer than we think, the fact remains that the road to debt, like the road to hell, is paved with good intentions. In the United States, the housing boom has peaked and prices have begun to come down, not only in local markets but nationally, which, combined with the huge mortgage levels, bodes ill for the average American homeowner. In markets like Toronto, the cost of household debt servicing– that is, the share

of gross pay accounted for by mortgage payments, property taxes and heating costs — is in the 40% range, which limits discretionary spending.

Another interesting measure to examine the sustainability of the housing boom is to borrow the concept of the price-earning ratio from stock markets. A price-earnings ratio is the ratio of the price of an asset to its earnings flow. The lower the price-earnings ratio, the less you are paying for an asset relative to what you can earn from it. In the case of housing, a crude P/E ratio can be constructed by taking the average MLS residential price and dividing it by the average annual rent for a two-bedroom apartment. Rent is a measure of the potential cash flow from the housing asset. What the P/E ratio does is relate the market valuation of the worth of the housing asset to the actual income or return that the asset can generate. If market valuations of housing prices are related to the income flow, then the ratio should stay constant, but if prices become disconnected from income, then the ratio should change fairly dramatically. Declining P/E ratios can represent undervaluation, while rising P/E ratios can represent overvaluation.

For example, in Toronto, the residential housing P/E ratio remained at about 20 from 1995 to 2001 and then jumped to 27 by 2005. Calgary’s P/E ratio was about 19 from 1995 to 2000 and then jumped to 26 by 2005, suggesting the Calgary market may also be over-heated. These markets both pale in comparison to Vancouver, which already had P/E ratio of 31 in 1995. This actually declined to a range of 26 to 28, but then soared after 2003 and reached 35 by 2005. On the other hand, in 1995, the residential real estate P/E ratio for Winnipeg was 12 and remained thereabouts until 2003, when it rose to 14 and by 2005,Winnipeg’s P/E ratio reached 17. Even in Saskatoon, the P/E ratio had risen to 21 by 2005.

Does this mean anything? Maybe no. After all, this is only a crude estimate of a residential P/E ratio and many factors affect prices and rents in the housing sector. However, in stock markets, whenever the P/E ratio for the market has risen substantially above 25 there has often been a correction, meaning a sharp drop in the prices of shares. The P/E ratio for Canada as a whole is about 28, suggesting that the real estate market may be overvalued. Overvaluation is less of an issue in markets like Saskatoon and Winnipeg. In light of the turmoil in the U.S. economy and the tightening of credit markets, which foretell a rise in interest rates, the question is not if but when the housing boom here will end.

Okay, now you have been warned - But, many of you will ignore this and carry on as if you are smarter than this dude!

Rational

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