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How to tell we're in a housing bubble

Michael Wilson says standard investment analysis clearly shows we're in a housing bubble.

Vancouver's housing numbers describe a bubble real estate market
Vancouver's housing numbers describe a bubble real estate market.

Searching through the currently active listings in the Vancouver area today (as of this writing), I was able to find 11 homes on the market that are currently tenanted. Here is a list of those 11 properties, including the current asking prices, rents, taxes and condo fees (if any). I've also calculated the cap rates.

Vancouver Cap Rates

For comparison, I also looked through listings in the Seattle area and was able to find 11 homes there. Why Seattle? It's probably the most comparable city to Vancouver: both coastal, with similar populations, climates, culture, lifestyle, natural beauty and incomes.

Seattle Cap Rates

Cap Rates

Capitalization rate (or cap rate) is used to estimate an investor's potential return on his or her investment. The cap rate of a property is its net income divided by its value. For these examples, I've taken the annual rent and subtracted property taxes and condo fees to determine net income. I then divided this income by the current asking price.

In Vancouver, the average cap rate is a dismal 2.32 per cent, and not a single property generated returns higher than any of the 11 Seattle properties. Seattle cap rates averaged over two and a half times higher, at 6.11 per cent.

Considering you can buy a Real Estate Investment Trust ETF which currently yields 5 per cent, why would anyone settle for 2.32 per cent? At least in Seattle, you can be somewhat compensated for the extra hassle of being a landlord.

Price-to-rent ratios

When making a decision to buy or rent, a common metric investors consider is the price-to-rent ratio. To calculate the ratio, divide the price of the property by its annual rent. From an investment point of view, the lower the ratio the better. When the ratio gets too high, renting is usually a better option. Here are some commonly used price-to-rent guidelines from Trulia.

  • Price-to-rent ratio of 15 or less: Buying a home is a better deal than renting for a someone planning to live in a home for at least five years. However, if the plan is for less than five years, buying could be a better deal, if the index is 10 or less and depending on moving and closing costs.
  • Price-to-rent ratio of 15 to 20: Renting or buying a home could be a better deal, depending on the prospective buyer's personal situation.
  • Price-to-rent ratio of 20 or more: Renting is a better deal than buying a home, except for people planning to live in a home a very long time (15 years or more).

The average price-to-rent ratio in Seattle it is 14.5. According to Trulia's guidelines, buying is probably the better option for anyone planning to keep the home more than a few years.

However, in Vancouver the ratio is a staggering 36.9. Considering that Trulia recommends renting anytime the ratio is above 20, most rational investors wouldn't even consider buying here.

Sticker shock: Vancouver real estate bubble

Is Vancouver in a bubble?

When looking at these fundamental metrics, anyone buying a home in Vancouver today must be counting on continued, significant appreciation. But with valuations already at unreasonably high levels, why would anyone expect them to continue going up?

While there doesn't appear to be a standard, universally accepted definition of a bubble, here is a pretty good one from the Federal Reserve Bank of San Francisco.

Economists use the term “bubble” to describe an asset price that has risen above the level justified by economic fundamentals, as measured by the discounted stream of expected future cash flows that will accrue to the owner of the asset. The dramatic rise in U.S. stock prices during the late 1990s, followed similarly by U.S. house prices during the early 2000s, are episodes that have both been described as “bubbles.”

While the causes of the current situation are debatable, there is no doubt that prices in Vancouver are well "above the level justified by fundamentals"."

Using the definition above, the Vancouver real estate market is clearly in a bubble.

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