Home prices stretched by 10%, bank report says

One of the country’s largest lenders, Toronto-Dominion Bank, believes home prices are susceptible to a pullback of as much as 10 per cent.

In a report published Monday, TD runs down a laundry list of metrics that experts use to get a sense of whether house prices have outpaced what the market can afford.

In the extreme, the bank said one metric known as the rent-to-income ratio shows housing prices being overvalued by as much as 60 per cent. But TD said that metric — used by some foreign observers as a telltale sign of a bubble — is “fundamentally flawed.”

Another metric comparing home prices to average incomes shows the market generally overpriced by 30 per cent, the bank said. But that measure too has its faults, namely that it doesn’t count investment income “which can be significant for many.”

TD does concede prices have gotten frothy, but its own estimate of how much is far, far tamer.

Viewing its “affordability” index, or what it costs the average household to service their home loan, the bank said prices sit more towards fair value.

Low rates equal ‘fair value’

With interest rates so low, most households aren’t dedicating too great of an amount of monthly income to service their mortgage costs. That’s kept affordability in check, the bank says, making the market “fairly valued.”

“The decline in interest rates over the last two decades has allowed the average household to comfortably carry a larger mortgage,” TD economist Diana Petramala said.

But the bank added: “In a more normal interest rate environment, affordability would be much worse than at present and point to 25 per cent overvaluation.”

TD said a “normalized” interest rate on a home loan is somewhere around seven per cent, compared to current average interest rates of around 4.3 per cent. Many hold mortgages below that level, as well.

READ MORE: Rising interest rates no cause for alarm, experts say

Thankfully, rates won’t be returning to 7 per cent anytime soon, it looks like. But they will grind slightly higher – by 0.25 of a percentage point this year and by more than half a percentage point in 2015, according to TD’s estimates.

In that scenario, home prices could be squeezed by up to 10 per cent, TD said, depending on how the economy performs and borrowers adjust to bigger interest payments.

More realistically, price growth will be flat this year and will fall nationally by two per cent in 2015.

That clashes with industry views that see prices continuing to climb.

The average price of a bungalow sits at $380,700, according to Royal LePage, and the real estate company said last month it expects that figure to rise 3.7 per cent through 2014.

But markets vary region to region, and price changes may fluctuate significantly depending on the city or area of the country you’re looking at, TD says.

Big city froth

“Some markets are more overvalued than others,” Petramala said. “For instance, Toronto, Montréal, Québec City and Vancouver look overvalued no matter which measure you choose, or interest rate you consider.

“These markets will likely feel the pinch from modestly higher interest rates over the next two years more so than others.”

An oversupply of condos in many of Canada’s biggest cities – led by Toronto – is also starting to tap the brakes on price growth, TD said, a process that will play out further in 2014.

“The number of new units scheduled to be completed in Toronto alone is three times its historical average,” the bank noted. In contrast, housing prices in Saskatchewan, Manitoba and Atlantic Canada all generally appear fairly valued.

READ MORE: Toronto condo construction towers over Big Apple’s

Most domestic housing watchers have spent the past year rebuffing the views held by a host of foreign observers that a bubble has formed in Canada, while assuring Canadians the market place is balanced.

In its latest outlook, TD maintains its view that it “only expects a gradual unwinding of excesses in the Canadian housing market” over the next few of years.

The bank added: “The first step to assessing the risk associated with Canadian home prices is to estimate how overvalued Canadian home prices actually are.

“It doesn’t tell us how the adjustment back to more sustainable levels will happen.”