Thursday, August 30, 2012

Price to Rent Ratios for Vancouver

I have been loath to publish price-rent ratios for Vancouver, even though I think it's one of the primary methods by which prices are set in the long run. I went over the issues with price-rent ratios here. For a backgrounder on why this is important, read Calculated Risk's posts (like this one) and refer to the Federal Reserve Bank of San Francisco's letter from 2004 on the subject.

When looking at an area like Vancouver with increasing density one must be careful using detached dwellings when formulating price-rent ratios as the earnings are forecast to increase greater than rental inflation into the future and would carry a higher price-rent ratio. The best gauge we have for a time-insensitive price-rent ratio is by using apartment rents and prices, that is, properties that have undergone most of their density increases.

Below is Greater Vancouver's apartment price-rent ratio, measured by using the MLS-HPI for apartments and the CMHC-surveyed one bedroom apartment rents, then normalizing them to a point in time.



As of December 2011 the price-rent ratio was 100% above the nadir in 2000 and 66% above the upper level of the price-rent band going back to at least 1991 (and likely longer).

As moderate stress test we can assume that the price-rent ratio will revert to at least within its historical band of 100-120 (on the graph above) in 5 years. For different rental inflation numbers the annual nominal price drops, from December 2011, required are:
  • -8.5% per annum (cumulative -35.8%) for rental growth of 1% per annum
  • -7.6% per annum (cumulative -32.6%) for rental growth of 2% per annum
  • -6.7% per annum (cumulative -29.2%) for rental growth of 3% per annum
For reversion to the middle of the 100-120 historical band:
  • -10.1% per annum (cumulative -41.2%) for rental growth of 1% per annum
  • -9.2% per annum (cumulative -38.2%) for rental growth of 2% per annum
  • -8.3% per annum (cumulative -35.1%) for rental growth of 3% per annum
For reversion to the bottom of the 100-120 band:
  • -11.8% per annum (cumulative -46.5%) for rental growth of 1% per annum
  • -10.9% per annum (cumulative -43.8%) for rental growth of 2% per annum
  • -10.0% per annum (cumulative -41.0%) for rental growth of 3% per annum
The US's experience found that most price drops occurred within several years followed by a more prolonged (and still ongoing) period of flat prices and at-inflation rental growth to fully revert price-rent ratios back to their norms.

If one believes the sanctity of price-rent ratios, those are a lot of scary negative numbers.

8 comments:

Shock Minus Control said...

Interesting work. The only problem I have with price-to-rent measures is that in every econometric study i've read, the error-correction to equilibrium using price-to-rent is exceedingly slow (and often, not statistically significant). I don't think it is enough to simply juxtapose price-to-rent with the US experience and conclude that Canada will share the same fate.

jesse said...

" don't think it is enough to simply juxtapose price-to-rent with the US experience and conclude that Canada will share the same fate"

This is true; I am not suggesting this, only that we have that one scenario we should consider as plausible. That is enough to run a stress test and I hope investors build this into their risk analysis which would include other scenarios as well.

Shock Minus Control said...

I think that is the best way to look at these valuation ratios - as measures of housing market vulnerability. Do you follow IMF economist Prakash Loungani's work on global home prices: http://www.prakashloungani.com/

Its interesting that UK price-to-rent ratios are still well above their long-term average even after a housing bust.

jesse said...

" interesting that UK price-to-rent ratios are still well above their long-term average even after a housing bust"

There isn't much evidence of a slowdown in London from what I've seen.

I do follow Loungani, some great analysis in his papers/writings that interested parties should read.

Shock Minus Control said...

"There isn't much evidence of a slowdown in London from what I've seen."

My mistake - they had the same whiplash of prices that we had in 2009.

Shock Minus Control said...

Have you looked at calculating a theoretical price-to-rent ratio (based on Poterba(1992))?

jesse said...

I'll have to look, but the problem with Vancouver is that there are density premiums built in to some properties that can lead to a higher price-rent. I'm attempting to look at it from a straight investment perspective ex density increases. I'll review your suggestion.

Easton Smith said...

Five years later what are your thoughts?