In economics, there are few things more controversial than the price of housing.

It inspires mass protests in well-off cities such as San Francisco. It is subject to regular calls for government intervention. It is also the trigger that provoked the Great Recession.

Advertisement for the sale of villa lots in Toronto, 1890 (via WikiMedia)

Yet regarding value, real estate still mystifies. No other item in your investment portfolio is as full of speculation, cultural zeitgeist, and outright sentimentalism as real estate. Much of this has to do with psychic value.

No matter the assessed value, a home is where you build memories, gain social prestige, and—knowingly or otherwise—attach a personal identity. But while real estate has psychic value, ultimately people purchase homes with dollars. When it comes to buying or selling a home, there is a hard way of gauging value.

Price-to-rent ratio: the most important metric

For the purposes of this article, several assumptions will be made. The first is that, as a prospective buyer or renter, you can afford your home. The second is that you’re willing to assess real estate value purely with dollars: this means temporarily disregarding important metrics such as transit times, amenities, and crime rate.

It is important to make these assumptions because one needs to ask, “All things being equal, what is the most important metric to assess real estate value?”

That metric is a property’s price-to-rent ratio. This ratio can be calculated by taking the total costs of ownership (TCO) of a home and dividing it by the potential yearly income created by rent. TCO includes several factors: mortgage principal, taxes, insurance, closing costs, etc. Hence:

Price-to-rent ratio = Average list price / (Average Rent * 12)

In general, there are 3 thresholds for price-to-rent ratio:

Price-to-rent ratio of 1-15 = much better to buy than rent Price-to-rent ratio of 16-20 = typically (but not always) better to rent than buy Price-to-ratio of 21 or more = much better to rent than buy

This metric is important because it can be assessed on both individual properties and as a general trend for a real estate area. It is therefore possible to find property that bucks the trend. But is it likely? No!

A Tale of Two Cities

I chose to examine Vancouver and Detroit because they are at two separate sides of the spectrum. Vancouver has the highest price-to-rent ratio in North America while Detroit has the lowest. This is in part due to broad national trends as illustrated in this graph:

Via The Atlantic

Internationally, Canada has amongst the highest price-to-rent ratios in the world. And while the U.S. does not have as low a price-to-rent ratio as Japan, its current trend indicates that its real estate is undervalued.

Vancouver is an extreme of an extreme. In contrast, while Detroit may have an extreme price-to-rent ratio for the US market, the US itself is not extreme within international markets.

Before I continue my examination, I must give full disclosure. I am a homeowner in the Vancouver market.

Vancouver: prestige at what cost?

Even amongst Canadian cities, Vancouver is different.

According to the IMF, here’s the price-to-rent ratio for three prominent Canadian cities:

Toronto: 35

Montreal: 35

Calgary: 32

In comparison, Vancouver price-to-rent ratio is an astounding 58! More astoundingly is Vancouver’s historic price-to-ratio trends compared to those three other cities.

What accounts for Vancouver’s extreme price-to-rent ratio?

Part of it has to do with being a prestige city much like New York, London, and Paris are. Lots of international capital flows into Vancouver’s real estate market—to the point where Hot Asian Money (HAM) has become a familiar trope amongst Vancouver residents.

(Realtors have actually milked the HAM mythos to drive up Vancouver housing prices—and were caught red-handed.)

Yet prestige cannot be the sole explanation. Even in suburbs that have no international appeal, the price-to-rent ratio is still higher than 30.

via the Vancouver Province

As seen in the above map, the far away suburb of Mission has a price-to-rent ratio of 40. From Mission, the commute time to Vancouver is more than 1 1/2 hours in ideal conditions (in rush hour, it’s greater). It has a very small city center compared with its population. Mission’s general “walkability” rating is low as well.

Understanding all factors, there is only one suitable explanation for why metropolitan Vancouver’s price-to-rent ratio is high: irrational exuberance.

Vancouver residents, accustomed to continuously high rising prices, simply cannot imagine a precipitous fall. Even worse, many potential purchasers are alarmed that they will get priced out. This in turn fuels rising speculation: “Better buy now before it’s too late!”

So far, speculation has acted as a self-fulfilling prophecy. Housing prices in Vancouver continue to go up because that’s the expectation. But as the OECD notes, Vancouver is due for a price correction. Whether this happens soon is debatable.

But as far as assessing hard value is concerned, Vancouver is certainly not the best real estate investment in North America.

Detroit: is there value after bankruptcy?

Real estate sentiment for Detroit is low. It’s easy to understand why.

American car manufacturers — all associated with Detroit — have veered towards death and required federal bailout money to survive. The Motor City continues to be inflicted with a high crime rate and low police response times. Worst of all, Detroit is the highest profile American city to declare bankruptcy.

Yet for all its warts, many people still want to live in Detroit.