A recent UBC report that found real estate in many Canadian cities to be overvalued got much play in the media. It found that home prices are over-priced by as much as 25% in some cities. The surprising part is the cities mentioned wouldn’t be the first ones that come to mind as overvalued: Montreal, Ottawa, Regina, Winnipeg and Halifax. Calgary and Vancouver were found to have “balanced” conditions with predicted price declines ranging from 7% to 11%, Edmonton undervalued by 8% and Toronto priced just right.

If you dig deeper, you’ll find that the report is riddled with questionable assumptions. The study arrives at its findings by comparing difference between the cost of ownership (calculated by adding the mortgage rate, taxes, insurance and maintenance) and the rental yield of a home with the expected rate of appreciation. If the cost differential equals the expected price appreciation, home prices are said to be in equilibrium; if it’s less, homes are undervalued, overvalued otherwise.

The problem isn’t with the methodology (in fact, we’ve used the same method in many earlier discussions on housing) though there is a lot to quibble about in the data. For instance, does a 7.37% mortgage rate sound reasonable when a discount of almost 2% off the posted rate can easily be obtained? The key question is the expected rate of home price appreciation and the authors recognize the challenge:

The greatest challenge in measuring the cost of capital is determining the expected price appreciation. All other variables in the equality are directly measurable, even if they are measured with some error, but individuals’ subjective expectations are not. The “correct” rate cannot be solved for from the relationship without assuming that prices and rents are already in equilibrium because the owner cost of capital relationship is an equality. There is always some expectation of future house price growth that will ensure that the relationship between rents, prices, and the cost of capital holds. In this study we assume that the best predictor going forward of expected long run equilibrium house price appreciation is the historic rate.

The authors then assume that future returns will be the same as “the average of trough-to-trough and peak-to-peak rates of appreciation of past cycles”. In addition, conclusions are drawn about certain markets (Halifax and Ottawa) using data that spans just 17 years. As Canadian Financial DIY pointed out, these assumptions are, at best, tenuous and hardly justify the bold assertions made in the report.

Merrill Lynch joined the negative parade recently warning that Canada faces a “meltdown” but their report is not available online (Update: Thanks to Retire @ 31 for the link to the report). Scotia Bank economists, on the other hand, think that a “modest erosion of house prices” is more likely.