Over the past two years, there has been substantial mainstream coverage, even internationally, regarding the possible development of a real estate bubble in at least some of Canada's largest real estate markets, particularly Toronto and Vancouver. In my opinion, the best way to determine whether or not a bubble is building is to examine the affordability of housing, that is, can an average family afford to buy an average house? Generally, a rule of thumb used by many economists is that an average house should cost no more than three times total family income. Beyond that, it becomes increasingly difficult for families, particularly purchasers of their first home, to service their monthly mortgage payments. This is particularly true today; the current ultra-low interest rate environment has meant that many purchasers could well be in over their heads when their mortgage payments rise as interest rates rise to historical norms.
To better help us understand affordability, I like to refer to the annual Demographia International Housing Affordability Survey. This study measures how affordable housing is in nine nations including Canada, the United States, the United Kingdom, Ireland, Australia, New Zealand, Japan, Singapore and Hong Kong. Affordability is measured using Demographia's median multiple which is defined as the median price of a home divided by the median household income in that market. Demographia then divides the median multiple into four categories as shown on this chart:
Historically, in Canada and the United States, median house prices have generally been between 2 and 3 times the median household income, a situation that suggests that a housing market is in a state of equilibrium. Such is no longer the case as you will soon see.
Let's look at a summary of housing affordability rankings for all nine countries in the study:
Canada's median market has a multiple of 3.9 compared to 3.4 for the United States, 4.9 for the United Kingdom and 5.5 for both Australia and New Zealand. This puts it just above the nine nation median of 3.7, telling us that Canada's real estate is considered relatively unaffordable compared to its peers. Lack of affordability is increasing; in Demographia's 2006 data, the median multiple was only 3.2, making Canada the most affordable of the six nation sample in that year's study. Of the 35 Canadian markets, only 7 or 20 percent of the total are considered affordable with a median multiple of 3.0 or less. Of the 28 markets that are considered unaffordable, five or 14 percent of the total are considered severely unaffordable, 6 or 17 percent are considered seriously unaffordable and 17 or 49 percent are considered moderately unaffordable.
Here is a chart showing the ten most affordable real estate markets in Canada:
Notice that in seven of the markets, affordability has declined slightly on a year-over-year basis. It is also interesting to see that median housing prices have shown substantial increases in four of the ten markets with annual median price increases ranging from 6.3 to 10.2 percent, far outstripping inflation.
Here is a chart showing the ten least affordable real estate markets in Canada:
As usual, Vancouver is a standout when it comes to lack of affordability, a situation that worsened over the year. In fact, of the 360 markets in the Demographia study, Vancouver has the second-least affordable real estate after Hong Kong. Half of the markets with data for both years show a rise in the median multiple (a decline in affordability from 2012 to 2013). Of the ten least affordable markets, four are located in British Columbia and four in Ontario with Alberta and Quebec each having one. Median house prices dropped in both Montreal and Kelowna with drops of 8.1 percent and 5.6 percent respectively. On the other side of the coin, year-over-year prices rose substantially in Oshawa (12.9 percent), Victoria (10.2 percent), Calgary (9.5 percent) and Vancouver (7.9 percent), again, well above the rate of inflation.
Let's look at a graph showing what has happened to housing affordability in Vancouver:
From 2012 to 2013, Vancouver's median multiple rose from 9.5 to 10.3, its second highest level after 2011 when the multiple hit 10.6. As you can see on the graph, the multiple has risen sharply from its level of 5.3 in 2004. This basically means that housing in Vancouver is now half as affordable as it was in 2004.
Here's a graph showing what has has happened to housing affordability in Canada's largest urban area, Toronto:
While Toronto has not seen its affordability decline by as much as Vancouver, it has gone from a level that was considered moderately unaffordable in 2004 to a level that is now severely unaffordable. Like Vancouver, real estate in Toronto is becoming increasingly unaffordable by an average family unless they don't mind the risk of mortgaging oneself to the hilt.
Just in case you wondered what a housing market correction could do to the median multiple, here's a graph that shows the drop in the median multiple for Los Angeles, formerly one of the United States most unaffordable real estate markets:
You can almost feel the pain of watching the value of your home reduced by hundreds of thousands of dollars, swallowing up all of your equity and more.
The deterioration of housing affordability in Canada's two largest markets and in British Columbia in particular should be of great concern to individuals, federal, provincial and local governments and to the newly minted Governor of the Bank of Canada. It is becoming increasingly difficult for young families to afford to enter Canada's overpriced housing market and those that do manage to save the minimum downpayment, could quickly find themselves underwater with even a small percentage decline in the price of homes.