If it makes you feel better to say Canada’s housing market is a bubble, go ahead and say it. Everyone else has.
Ten years ago, The Economist magazine concluded Canadian real estate was grossly overvalued. Nine years ago, Merrill Lynch declared Canadian housing was afflicted by “overvaluation, speculation and oversupply.”
Seven years ago, the Organization for Economic Co-operation and Development and the International Monetary Fund began sounding sirens about the dysfunctional state of Canadian housing. And a year ago, the Canada Mortgage and Housing Corp. warned home prices could fall 18 per cent as a result of the COVID-19 pandemic.
What did this multiyear outburst of public shaming accomplish? Absolutely nothing. Canadian home prices marched relentlessly higher. The latest surge – a 10.8-per-cent jump over the past year to March, according to the Teranet House Price Index – extends a long saga of persistent gains in the face of unrelenting skepticism. Another popular benchmark, the average selling price on the Canadian Real Estate Association’s MLS system, shot up by 31.6 per cent in March compared with the same month in 2020.
So maybe, just maybe, we should be cautious about throwing around that bubble label. Have Canadian real estate prices surged upward at an unsustainable pace in recent months? Absolutely. Are lofty prices leaving the economy vulnerable to future threats, such as unexpected interest rate increases and other possible shocks? For sure. But is Canada’s housing market an epic bubble on the verge of popping? Not so fast.
Economists usually define a market bubble as a sudden rise in price based on obviously implausible or contradictory beliefs. A bubble, in other words, is doomed to collapse under the weight of its own irrationality.
By that standard, Canada’s real estate market looks less bubble-like than exuberant. Beneath the frenetic behaviour of the past few months is a market that is reacting predictably to unusual stimulus.
The recent gains in home prices, at least until January, were largely a mechanical response to falling interest rates and tight supply, says Stephen Brown, senior Canada economist at Capital Economics, an international consulting firm. He points out that five-year fixed mortgage rates fell by half between February, 2019, and February, 2021. For buyers who exceed government down payment requirements, the decline in borrowing rates boosted the price they could afford by 22 per cent.
Since January, prices have become more detached from fundamentals, Mr. Brown says. But he notes that demand remains robust and mortgage underwriting standards for new home buyers are still high. Whenever mortgage rates do start to rise, he would not be surprised to see prices in some of today’s hottest markets fall by 10 per cent or so. However, he regards a full-scale crash as unlikely.
“The message from the Bank of Canada has been that rates are going to be lower for longer,” he says. “In that environment, housing should continue to do fairly well.”
At least in some areas, strong fundamentals in recent years have laid the foundation for optimism. Consider the red-hot southern Ontario market. From 2015 to the start of the pandemic in early 2020, home prices in Toronto soared more than 50 per cent, according to Teranet. A broad swath of the province – from London to Kitchener to Niagara – enjoyed similar gains.
Mike Moffatt, an assistant professor at the Ivey Business School in London, Ont., says the biggest single factor behind the rapid gains over those five years was an unexpected jump in Ontario’s population that created a persistent mismatch between supply and demand. During that period, the province added nearly a million people, many of them foreign students and temporary foreign workers. The increase was out of all proportion to the 600,000 or so newcomers in the previous five years. It exceeded even the most optimistic official forecasts. Policy makers were caught by surprise and failed to ensure the province’s supply of housing was in line with the influx of people.
“It was completely unanticipated,” Prof. Moffatt says. “Projections had called for growth of maybe 700,000 people during that period. But for a whole variety of reasons – higher immigration targets, perhaps an anti-Trump effect making Canada look more attractive, the oil price crash in Alberta – Ontario’s population grew faster than anyone expected.”
The population surge pushed young couples out of Toronto in search of affordable housing. It transformed sleepy southwestern Ontario towns such as Tillsonburg, Ont., into unlikely hot spots for real estate speculators. Now a somewhat similar story is unfolding, but this time on a national level. Cities and towns that once regarded real estate fever as a Toronto and Vancouver affliction are coming face to face with their own outbreaks. It’s a buying surge that is sweeping through communities from Halifax (where, according to Teranet, home prices have shot up 22.5 per cent over the past year) to Abbotsford-Mission, B.C. (up 16 per cent).
Rather than population pressures, the recent mania reflects financial and psychological factors. Ultralow interest rates are key. So is the growing pool of cash that is building up in family savings accounts as opportunities for spending dwindle in a locked-down economy. Added to that is the plausible theory that more and more people will be working remotely and so will require more living space. Finally – and perhaps most important of all – there is the you-only-live-once attitude that seems to feed on itself when too many bored consumers are cooped up at home for too long.
“What we’ve experienced since March, 2020, is due to a combination of ridiculously low interest rates and white-collar professionals with too much money in their pockets buying up everything from Bitcoin and GameStop stock to vintage hockey cards and real estate,” Prof. Moffatt says.
Will real estate go into reverse when the economy eventually reopens and animal spirits subside to more normal levels? No one would be surprised if prices wavered.
However, one good reason to bet against any housing collapse is the attitude of key decision makers. Political leaders and central bankers have been cheering on the recent gains. It seems unlikely the powers-that-be would deliberately inflate home prices only to stand back and watch them topple.
This is true not just in Canada but in advanced economies around the world. From Australia to Britain, governments and central banks are attempting to stimulate their plague-stricken economies by doing everything they can to encourage home buying. Rather than taking away the punch bowl just as the party gets going, decision makers in many countries have been spiking the policy brew with as much happy juice as possible. Thanks to low interest rates and other stimulus measures, home prices are soaring at double-digit paces in the U.S., New Zealand and Australia.
In Canada, Tiff Macklem got the good times rolling last year when he declared “we are being unusually clear that interest rates are going to be unusually low for a long time.” The Bank of Canada governor adjusted his rhetoric slightly in late April when he opened the door to an interest rate hike as soon as the second half of 2022. However, he has done nothing to dispel the core message that low rates are going to be with us for a long, long time.
Adam Vaughan, the federal Liberals’ Parliamentary Secretary for Housing, also delivered an upbeat message recently when he assured television viewers that Ottawa is not going to do anything that would endanger recent gains in home prices. Even a 10-per-cent decline would be unfair, he asserted.
“When you hear the Bank of Canada promising rates will stay low for a very long time and politicians like Adam Vaughan promising to do everything possible to prevent a price decline, you can see why some people decide it really doesn’t matter what they pay for a home because it will just keep going up,” says John Pasalis, an economics researcher and president of Realosophy Realty, a Toronto real estate broker.
This don’t-worry-be-happy attitude concerns Mr. Pasalis. He attributes much of the galloping gains in Toronto and Vancouver home prices over the past several years to persistent underbuilding combined with strong inflows of well-heeled, highly skilled immigrants. But he argues the past few months have seen the market lurch into a new and disturbing phase, in which desperate buyers are paying far more than asking prices.
“It’s not all irrational what is happening,” he says. “But the irrational component, what makes it a bubble … is that these crazy outliers are becoming the norm. Everyone is feeling they need to spend $30,000, $40,000 or $50,000 more than what comparable homes sold for three or four weeks ago just to get into the market.”
Mr. Pasalis, like many other observers, urges policy makers to push through measures to cool the buying fever. The problem is how to do so without crashing the market – something that would be disastrous at a time when the economy is still grappling with the effects of the pandemic.
So long as the economy remains fragile, policy makers and central bankers seem more likely to feed the real estate exuberance than restrain it. That was demonstrated in the recent federal budget, in which the Liberal government responded to the housing frenzy by introducing a new measure to tax non-resident buyers with vacant homes in Canada. Few people expect this cautious initiative to do much of anything to cool the market.
More optimistically, new supply may help to restore some sanity. Housing starts surged 21.6 per cent in March to a record annualized pace of 335,000 units. If that trend continues, home buyers may begin to have more choice and the current buying fever could gradually abate. But that will not happen overnight.
In a perfect world, home prices would slowly slide back to more comfortable levels as supply rises. More realistically, some bumps are likely.
Canada’s real estate market now stands at the intersection of two ugly possibilities. In one scenario, home prices plunge. In another, they continue edging higher. Either outcome carries unsettling consequences.
The most dramatic danger is the first scenario: a market crash. Over the past 30 years, countries such as the United States, Japan, Spain and Ireland have suffered through home price collapses. In each case, a devastating recession and a multiyear slump quickly followed. The obvious lesson for Canadian policy makers? Don’t let this happen here.
But supporting further real estate gains results in pain of its own. Take the effect on productivity, for instance. Today’s lofty home prices discourage people from moving to the most expensive locales – cities such as Toronto and Vancouver.
These superstar metropolises are centres of economic activity. They are also stunningly productive. Yet rather than welcoming new residents and new housing, they zealously protect the character of many existing residential neighbourhoods through zoning restrictions and other initiatives that prevent new construction from rising to meet potential demand. As a result, only a limited number of workers get to participate in those highly productive local economies.
The overall drag from such policies is just beginning to be recognized. In a renowned 2019 paper called Housing Constraints and Spatial Misallocation, Chang-Tai Hsieh of the University of Chicago and Enrico Moretti of the University of California, Berkeley, estimated that exclusionary zoning shrunk the pace of growth in the United States by about 36 per cent from 1964 to 2009. Simply increasing housing supply in hot spots such as New York, San Francisco and Silicon Valley would have boosted average annual earnings for the entire country in 2009 by US$3,685 a person, they calculated.
The effect of residential restrictions in Canada may be just as significant. At the very least, high home prices are breeding social stress as young Canadians shell out increasingly obscene sums to old Canadians for the privilege of owning a house.
Two decades ago, the all-in cost of owning a single-family detached home ate up 40 per cent of an average household’s income, according to Royal Bank of Canada calculations. By October, 2020, buying the same home required an excruciating 55 per cent of income.
The vast sums flowing into housing increase financial fragility because families who struggle to keep up with home payments are not well positioned to withstand any economic shocks that may occur.
“It’s not good for the country,” says Anthony Scilipoti, president of Veritas Investment Research, an equity analysis firm in Toronto that closely follows the housing market. He worries Canada’s economy has come to depend too much on the unpredictable residential sector, leaving it vulnerable to any weakness in that area.
Residential investment has swelled to make up more than 9 per cent of economic output, the highest level on record, he notes. Meanwhile, home prices are rising far faster than fundamental factors, such as incomes or rents. The result is that young Canadians who lever themselves into home ownership now have far less to spend on other things, from buying new cars to saving for retirement to starting a family.
Yet despite the social and financial strains, Mr. Scilipoti doesn’t see an imminent end to Canada’s housing addiction.
By Veritas’s reckoning, Canadian households accumulated more than $148-billion in savings since the final quarter of 2019, or about $9,400 per household, largely because of lower consumption during the pandemic. A good part of those savings have flowed into real estate and there is no obvious reason why the money gusher should suddenly stop.
“The problem is that all the usual fundamental ratios – home prices-to-rent, home prices-to-income, and so on – just show the market is stretched,” Mr. Scilipoti says. “For a correction to occur, you need a catalyst.”
What could that catalyst be? The most obvious threat, says Mr. Brown of Capital Economics, would be a sudden rise in interest rates. “At their current levels, home prices are vulnerable to any unexpected hikes,” he says. He, too, worries about the risks that are building up.
But the Bank of Canada knows better than anyone how sensitive home prices are to interest rates, he says. He expects the central bank to proceed cautiously in tightening policy.
Others argue the housing market’s first big test will come when the economy begins to reopen. What happens next for home prices will hinge on several factors, including interest rates, how quickly immigration bounces back and how rapidly the economy recovers from the pandemic lockdowns.
The problem, Prof. Moffatt notes, is that big recent gains mean even double-digit home price correction would simply reverse the advance of the past few months, punishing recent buyers but not making homes that much more affordable.
“I’m not predicting a crash, but I could see a scenario where we get the worst of both worlds,” Prof. Moffatt says. “You can imagine a fall in prices that would be enormous by historical standards and reverse much of the gains of recent months, but that would still leave home prices really high.”
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