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BMO Report: House Prices Need to Moderate to Avoid Bubble

Housing-Bubble Although BMO analysts aren’t predicting a “significant” housing correction this year, they say the risks of one would increase if prices continue to outpace income growth.

In a report released last week, BMO Capital Market’s senior economist Sal Guatieri said the housing market should cool this year as interest rates creep back up.

“The risk of a correction would increase…if prices rose alongside rates and incomes,” says Guatieri. In that case “the affordability measure would reach 43% (affordability = mortgage payments / household disposable income) and approach the threshold of prior corrections…Of course, if prices outpace incomes, a correction could be inevitable.”

Other highlights from the report:

  • Mortgage payments for the typical new homebuyer consume 35% of estimated household disposable income (HDI), which is just above the 23-year mean of 34%.
  • Based on Guatieri’s forecast of a two percentage points increase in interest rates in 18 months, and assuming incomes rise 8% and prices stabilize, “affordability would deteriorate to 40% of HDI for first-time buyers.”  (Roughly 2-3% of Canadians are first-time buyers in any given year.)
  • Guatieri says that deterioration of HDI should restrain demand, along with prices, but should not trigger a significant correction similar to the one in 1989 and 2008 when the HDI measure exceeded 45%.
  • “Demand will be restrained by a reduction in the maximum amortization period on insured mortgages from 35 to 30 years that takes effect March 18, which will raise the effective mortgage rate for the typical homebuyer by one-half percentage point and thus reduce affordability about 7%.”
  • He said price-to-income ratios (as often quoted in the mainstream media) provide only a crude estimate of valuations and that structural factors—such as land-use restrictions, an influx of foreign wealth, rising resource prices, and strong population growth—can also justify a long-run increase in house prices in some regions.

Steve Huebl, CMT