The great Canadian housing myth!

It wasn’t that long ago that economists and observers put a brave face on the health of the Canadian housing market, arguing that tighter credit conditions, relatively moderate prices and a healthy economy would keep things humming, even as the U.S. market slid into oblivion.  

Now, there are cracks in this theory: The number of sales is declining even as the number of For Sale signs creeps higher. Are outright price declines next?

That would appear to be the case, judging from the observations put forth by David Wolf, economist at Merrill Lynch Canada – and if the housing market stalls, you can kiss goodbye any pickup in economic growth next year.

“After several years of great strength, the Canadian housing market has weakened materially through the first half of 2008,” he said in a note to clients. “It almost seems as though some time around the beginning of the year, maybe exhausted by the unending media coverage of the U.S. housing crisis, Canadian consumers en masse decided that the domestic market had gone too far.”

But there is more to this downtrend than a shift in consumer sentiment. Mr. Wolf noted that mortgage costs have risen 9 per cent, year-over-year, as of June – the steepest increase in 17 years. At the same time, authorities ended 40-year amortizations, putting the top end at 35 years, and raised minimum down payments to 5 per cent from zero.

Meanwhile, what looked like a reasonably priced market now seems pricey. The ratio of house prices to rents is now 25 per cent above the average. The ratio of house prices to incomes is also a troubling statistic: It is now about 4:1, meaning that the average house price is four-times the average household’s annual income. During the previous cyclical peak, in 1989, the ratio topped out at 3.2:1. Even more troubling, the U.S. market topped out at 3.9:1 in 2006, just before doom set in.

Merrill Lynch’s proprietary models suggested that Canada’s housing market was undervalued by 3.3 per cent in 2007. Scratch that: Thanks to new data, the market was actually overvalued by 7.4 per cent.

“Part of the upward revision is accounted for by the acceleration in house prices last fall beyond our assumptions, and part by the swell in mortgage rates upon the onset of the global credit crisis last summer,” Mr. Wolf said. He believes the housing market is currently 9.2 per cent overvalued.

Does this imply a nasty drop in the months ahead? His best guess is that house prices will flat-line nationally, which implies that some regions of the country will suffer. Regina and Saskatoon, in particular, appear to be 50 per cent overvalued (hint-hint); Vancouver and Victoria are 30 to 35 per cent overvalued.

“As the U.S. experience has shown, it can take several quarters for changes in housing wealth to show up in reduced spending growth,” Mr. Wolf said. “But the direction of the effect is clear. Strong house price appreciation in recent years has no doubt made Canadians feel wealthier and more willing to spend; that will likely be less true ahead.”