Are we in a housing bubble?
By Peter Diekmeyer • Bankrate.com

In recent weeks, good news about the Canadian economy keeps on coming. Job creation, inflation and interest rates are all at historically attractive levels, and the country seems to be slowly crawling out of recession.

Canada's housing sector has also done well. Housing starts were up again in November. Existing home sales also shot up spectacularly. But the real eye-opener for housing sector stakeholders was the $337,231 average price of existing homes sold during November, which, according to the Canadian Real Estate Association, or CREA, rose a breathtaking 19 per cent compared to the same period last year.

If you are a Canadian homeowner, it's almost as if the financial crisis, which experts say was the worst since the Great Depression, never occurred. True, within the last two years, house prices did fall by 13 per cent, but then they quickly bounced back up by 21 per cent to above pre-recession levels.

The dramatic rise in house prices has caused numerous policymakers ranging from Bank of Canada governor Mark Carney to Finance Minister Jim Flaherty to speculate about whether recent rises have been overdone. In short: Are we in a housing bubble?

Why a bubble would matter
Whether Canada's housing sector is getting overvalued is more than an academic question. In recent weeks, Flaherty has noted on several occasions that he is watching residential real estate prices closely. If he detects what he calls "irrational" price levels, the finance minister has said that he would consider introducing measures to cool things off. These include toughening rules on the size of down payments that homebuyers need to come up with. Flaherty has also suggested that he may force banks to shorten mortgage lengths, which are currently capped at 35 years.

By two measures at least, Canada's housing market does show characteristics of moving out of line with its long-term historical valuations. For example, during the past nine years, house price increases have averaged around eight per cent. That's far above the rate of inflation, which has hovered between two per cent and three per cent annually during much of that time.

Secondly, the average price of existing homes sold here in Canada ($337,231) seems way out of line with the US$171,900 average price of homes that changed hands south of the border during November.

That said, Canada has several things going for it that would justify somewhat higher local real estate prices. Unemployment here is lower than it is south of the border, and Canada's banks, which are in far better shape than their U.S. counterparts, continue to lend money at a reasonable pace. As a result, Canadians have been spared much of the frenzied foreclosure activity that continues to push U.S. house prices down. Furthermore, Canadian families save more of their income than U.S. families (5.5 per cent compared to 4.5 per cent) and carry less debt. That means they have more room to weather shocks such as a job loss, mortgage rate increase or a future drop in real estate valuations.

Bubble-like characteristics
One big problem with determining whether Canada's housing market is entering in bubble territory lies in finding a consensus regarding just what the word is supposed to mean. One noted economics glossary doesn't even provide a definition. Wikipedia, a pretty good barometer of current thinking, defines an economic bubble as "trade in high volumes at prices that are considerably at variance with intrinsic values." Nowhere in the definition does it state how wide that variance must be.

For example, when historians talk about bubbles, they often refer to the stock market crash of 1929 and the Internet stock implosion earlier this decade, both of which sent prices down by more than 75 per cent and were thus presumably massively overvalued before the plunges. Real estate prices in many regions of the United States, which have fallen by more than 30 per cent, also demonstrated many bubble-like elements.

However, Canada right now shows few signs of any such discrepancies. For example, Benjamin Tal, an economist at CIBC World Markets, figures that the current average price of a home is roughly seven per cent over what would be consistent with current housing market fundamentals such as interest rates, income growth, rents and demographics.

True, overpaying by seven per cent for a home does work out to a lot of extra cash. But home purchases are capital transactions; you don't make them every week. If you plan to own your home for 10 years, a slight overvaluation is unlikely to be a deal-breaker. That is, unless you are prepared to sit around in your apartment for much of that time, hoping that prices might come back down again.

Peter Diekmeyer is Bankrate.ca's economics columnist.