Home prices overvalued by 20%, says Fitch

Canadian home prices remain overvalued, says Fitch Ratings.

Despite government efforts to moderate growth, the agency adds, home prices rose 7.1% in May (on a year-over-year basis) according to the Canadian Real Estate Association.

In addition, both property sales and building permits for residential construction have picked up in recent months, says Fitch, which points out home prices continue to be supported by historically low interest rates and a lack of supply in the major metropolitan areas.

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According to Fitch’s sustainable home price model (which measures home prices relative to long-term fundamentals), Canadian home prices remain approximately 20% overvalued in real terms.

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The agency notes high household debt relative to disposable income has made the market more susceptible to market stresses such as unemployment or interest rate increases—the country’s debt-to-income ratio reached a high of 164.1% in Q3 2013 before declining slightly in the following two quarters.

Also, Fitch projects unemployment in Canada will likely remain in its current 7% range.

However, low interest rates are unlikely to fall further. And that’s a good thing since rising interest rates could pressure the market more than others given high borrower leverage and the short-term structure of Canadian mortgages.

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Fitch finds the Canadian government has taken several proactive steps in recent years to mitigate some of the risks to the housing market. For example, it’s tightened underwriting guidelines for loans insured by the Canadian Mortgage and Housing Corporation.

CMHC has also pulled back on the amount of low-ratio portfolio insurance offered to lenders, and has introduced limited securitization of insured mortgages to CMHC-administered programs.

Further, the Office of the Superintendent of Financial Institutions has issued a guideline for prudent bank underwriting that must be adhered to for bank originations, as well as those purchased from nonbank lenders.

Still, Fitch says the long-term impact of overvalued housing markets remains unclear, which means policy makers may be required to take extra steps over the short term to engineer a soft housing landing.

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