One sta­tis­tic can tell you a lot about where a city mar­ket is headed

By Scott McGillivray – Globe and Mail

“Afford­abil­ity” is one of those famil­iar buzz­words in the world of real estate. But the afford­abil­ity index is a fan­tas­tic metric.

The afford­abil­ity index is the home pur­chase price divided by the gross house­hold income. The result is the one num­ber that gives us a look into the real estate health of a house­hold and even an entire city. I have used this tool for years to iden­tify great com­mu­ni­ties to invest in.

On a city level, a low index indi­cates that jobs are pay­ing very well in com­par­i­son to the price of hous­ing. There’s poten­tial for increased value, since res­i­dents have the dis­pos­able income to invest in their home and com­mu­nity. Peo­ple mov­ing into the neigh­bour­hood have high incomes and are able to spend more on a home, dri­ving home prices up. I often see home val­ues increase faster than the national aver­age in cities with a low index.

On the other hand, a high index tells me that peo­ple are overex­tended. Hous­ing costs account for a per­cent­age of their income which is much too high. House­holds find it dif­fi­cult to save and invest in their homes. Main­te­nance becomes neglected as there is no money to pay for it. We may see homes, and even entire neigh­bour­hoods, begin to appear run­down. High index cities can be held afloat by low inter­est rates in the short term, but home val­ues tend to be cor­rected down eventually.

What makes the afford­abil­ity index such a great indi­ca­tor is that it accounts for local income. Home prices then become rel­a­tive to income lev­els, cre­at­ing an “apples to apples” comparison.

So what is an accept­able afford­abil­ity index level? Every­one has their rules; these are mine:

* I never buy an invest­ment prop­erty in an area where the index is above the provin­cial or national average.

* I wouldn’t advise any­one to buy their home with an index above 4. This means that if you are look­ing at a $400,000 home, your gross house­hold income should be at least $100,000.

The afford­abil­ity index has proven to be a good indi­ca­tor of a pos­si­ble “bub­ble.” Using the U.S. exam­ple, it appears that a real estate bub­ble begins to grow around an afford­abil­ity index of 6. As the afford­abil­ity index increases, so do the chances of the bub­ble burst­ing. Of course, there are many other fac­tors unique to each city, but the index pro­vides mar­ket watch­ers with an early warn­ing system.

It is clear that some Cana­dian cities are now in such a bub­ble, as afford­abil­ity has rock­eted way out of con­trol: In Van­cou­ver, the index is at 9.46; in Burn­aby, B.C., 7.6. Toronto logs in at 4.93. The national aver­age is about 5.35.

Com­ment: So Toronto is below the national aver­age when it comes to afford­abil­ity? So there to all those who pooh-pooh our real estate market!

I wanted to inves­ti­gate whether Cana­di­ans overex­tended them­selves. I cal­cu­lated the aver­age afford­abil­ity across five cities; a city is con­sid­ered “afford­able” if the afford­abil­ity index is under my accept­able cut­off of 4.

I also pro­filed two homes from each of these cities to com­pare what we are buy­ing to what we can actu­ally afford.

We seem to be hold­ing things together – for now. While our national aver­age is approach­ing bub­ble ter­ri­tory, we seem to have learned from the sad exam­ple of the United States.

A few mar­kets are due for a cor­rec­tion soon, some experts say as much as 20% or more in mar­kets like Toronto and Van­cou­ver. These and the other inflated cities are only sus­tain­able in the short term, because inter­est rates are so low. As inter­est rates rise over the next 24 months, we’re in for some major changes.

Com­ment: Def­i­nitely in Van­cou­ver, but Toronto is safe. There will sim­ply not be a 20% price drop here, I will bet my career on it!

Toronto

Aver­age house­hold income: $89,519
Aver­age home price: $441,607
Afford­abil­ity index: 4.93

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