A shortage of homes isn’t the main reason house prices keep rising

George Fallis is a professor emeritus of economics and urban studies at York University.

Ontario faces a crisis in home ownership affordability. At the end of 2021, the average price for a home in Ontario was $923,000. Ten years ago, the average price was $329,000. Average house prices have climbed 180 per cent while average incomes have only risen 38 per cent.

In response, the Ontario Housing Affordability Task Force recently released its report with a bold recommendation: Ontario should set a target to build 1.5 million homes over the next decade, more than twice the number built over the previous decade.

The task force had a very short timeline and could not do any original analysis. It accepted the dominant narrative that these huge price increases were because Ontario has not built enough houses to accommodate its growing population. Lack of supply is the cause, and the solution is to build more houses. This analysis is consistent with our economic intuition: Demand is growing and prices are rising, so the explanation must be that supply is not keeping up.

Unfortunately, the data do not support this narrative. The 2021 Census reported that from 2011 to 2021, Ontario’s population grew by 10.7 per cent and the number of occupied dwellings grew by 12.5 per cent. The same has been true for the past 30 years. From the late 1960s to the early 1980s, dwellings grew much faster than population, but the fact remains that new construction is still outpacing population growth. Many of the new units are high-rise condos, whereas many buyers want ground-oriented units. The problem is not so much the number of units being built as the type of unit.

Because the excess of new building over population growth has declined, it is true that an increase in supply would moderate the price increases. But lack of supply is not the sole explanation of price increases. As cities grow, as in Ontario, the price of housing rises – even with no constraints on supply. This is because dwelling units nearer the centre become relatively more attractive as the city spreads out. This is why housing is more expensive in larger cities.

We must also look at the demand side, though the report offers no analysis of demand. Demand for home-buying increases if mortgage interest rates fall. This past decade, interest rates began at historical lows, drifted downward slightly until 2017, rose slightly until 2020 and then dropped sharply. They have never been so low. House price increases are part of the worldwide problem of asset price inflation caused by ultralow interest rates.

However, the data on population growth, income growth and falling interest rates cannot explain why demand has remained so strong in the face of such high prices. This is because demand is also influenced by expectations about future prices – if you expect prices to keep increasing, you are willing to pay more today. Suppose you bought an $800,000 house with an $80,000 down payment. If prices went up 10 per cent in the next year, your home equity would have doubled. When demand is driven by expectations of future price increases, and the increases cannot be explained by market fundamentals, there is said to be irrational exuberance or a bubble.

This has been a concern of the Bank of Canada for several years and governors Tiff Macklem and Stephen Poloz have often raised it as a risk to the national economy. In response, the bank will be gradually raising interest rates, hoping to deflate the bubble, not burst it.

Further, COVID-19 also plays a role in Ontario’s rising house prices. More than half of the absolute increase in house prices occurred during the two years of the pandemic. Measures to slow the spread of COVID-19 included working from home and greatly reduced interest rates. Despite the recession, the demand for housing surged, pushing prices up by 54 per cent over two years. Because of the need to work from home, households wanted more space. It is important to note that most of the increase in demand was for larger dwelling units, not for an increased number of dwelling units.

The task force’s report has many well-justified criticisms of delays in building approvals and of NIMBYISM, and highlights the need for modest multi-unit buildings in neighbourhoods zoned for single-family dwellings. Reform of local land use control is needed but not the wholesale deregulation recommended by the report. But the real challenge is to reduce the well-entrenched expectations of continuing price increases that are driving demand.

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