Canadian housing prices may have surged in Canada, but they haven’t reached bubble status just yet, say TD Bank economists in a new report. Vancouver and Victoria are the two cities that are showing some signs of a real estate bubble though.

TD introduced a new quarterly report today that monitors for a possible speculative housing bubble in local markets across Canada. It notes that several indicators are used to look for generally agreed upon characteristics of bubble behaviour, “whether the level of home prices are being bid up beyond what is consistent with underlying fundamentals and whether homebuyers are doing so with the expectations of future price increases.”

“It is important to note, however, that it is, by definition, impossible to identify a bubble before it bursts, since rational investors would refuse to hold any asset whose price was certain to fall,” TD says.

The report finds that Canadian home prices rose by more than 8% from a year ago in the second quarter, buoyed by a dip in mortgage rates that helped to improve affordability. “At first glance, the current pace of home price appreciation might sound excessive to some and might raise concerns about a growing speculative bubble akin to the late 1980’s experience or the ‘frothy’ condition south of the border. However, Canada’s recent price gains must be put into context,” it suggests.

First, it points out that the pace of today’s inflation-adjusted home price gains is much slower than the late 1980s. And, it says, the economic backdrop in which the current price gains are occurring are fundamentally more supportive to the housing market than they were in the late 1980s.

“Since the most basic definition of a housing bubble is that prices are being bid up beyond what their underlying fundamentals would justify, then most regional housing markets in Canada would not qualify for ‘bubble’ status either,” it argues. “While it is true that almost every region has seen some increase in their P/E ratios over the past few years, much of this can be justified on the grounds that historically low borrowing rates have helped to boost the equilibrium value of home ownership.”

Vancouver’s housing P/E ratio has risen much faster than any other major city in Canada over the past few years, TD says, and it finds evidence “that increased speculation by both investors and potential homebuyers in Vancouver has been a significant factor in driving up home prices in that city beyond underlying rents”. It calls the risks of a speculative bubble “elevated” in Vancouver’s housing market. And, it also sees increasing risk of a housing bubble in Victoria.

“It has become increasingly difficult to reconcile the outsized pace of home price growth in Vancouver and Victoria with underlying fundamentals in these regions. While this may not definitively prove the existence of a housing bubble in Vancouver and Victoria, our analysis does suggest that these two cities have the greatest risk in Canada of seeing a price correction at some point in the future,” it warns.

Elsewhere in the country, it finds fundamental justification for higher prices. TD says that housing markets in the Atlantic region, “remain effectively balanced with an increase in the inventory of existing home listings helping to stave off any excessive price pressure”. It says that price pressure is cooling in Montreal and Ottawa. Toronto’s current housing P/E ratio (at 13.3) is not that different from its 1995 value and it remains well below the 14.4 reading back in 1989 during the height of the last housing bubble, it notes.

Pricing pressure is intense in Winnipeg, it says, but it views this as a correction from past undervalued levels. “Indeed, Winnipeg’s housing P/E ratio only increased to 8.2 in the second quarter of 2005, and is still the lowest in the country,” it notes.

It adds that the threat of a burgeoning housing bubble remains low in Calgary given that underlying economic fundamentals remain strong; and Edmonton still remains the second most affordable large city to own a home in the country.