A recent report from Capital Economics, which has received wide coverage in the media, predicts that Canadian real estate prices need to fall by 20-25%. This conclusion is based on the assumption that real estate prices tend to be determined by affordability as measured by the ratio of house prices to income. The chart below shows the trend in the house prices to income ratio over the past 25 years; the gap between the current ratio and the long term trend line is evident.
However, an analyis by Jason Mercer, the Toronto Real Estate Board’s Senior Manager of Market Analysis, indicates why this conclusion is flawed. The real issue is not the ratio of house prices to income but rather overall affordability, which is measured the proportion of household income that is used to pay for mortgage principal and interest, property taxes and utilities. The widely-accepted benchmark for affordability is a 32% share of income used for these items. As the chart below shows, the present level of affordability is still below this benchmark, though it is projected to move close to 32% over the next two years.
What this means is that the current real estate prices are justified by the present level of affordability, and that there is still room for prices to increase over the next couple of years, though likely at a slower pace than in recent years. Mr. Mercer has projected Toronto area prices over the next two years in the chart below – approximately 3% increase in both 2011 and 2012.