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Demand on the part of investors for low-cost rental properties has helpedshrink the size of the average condo unit.Brian B. Bettencourt/The Globe and Mail

One fifth of Toronto-area homeowners could be struggling to afford their mortgage payments if interest rates rise just two percentage points, a new report from Toronto-Dominion Bank warns.

The rally in home prices in the Greater Toronto Area has been among the strongest in the world. Average prices have doubled since 2002. Middle-class homeowners have watched as their modest bungalows turned into highly coveted, million-dollar properties. Nearly a quarter of new jobs in Toronto created over the past decade have been tied, directly and indirectly, to the housing boom.

Yet the housing rally has also come at a steep cost, with rising home prices masking serious and growing economic problems in the region, including a sharp drop in affordability and a lack of new investment in other types of housing beyond high-rise condos stuffed with tiny one-bedroom units, the bank's economists warn.

Nearly one quarter of GTA residents spend roughly one third of their income on shelter costs. Many of those are low-income renters, however about 16 per cent of homeowners are spending 30 per cent or more of their incomes just servicing their mortgages, a figure that could rise to 20 per cent if the Bank of Canada hikes its overnight lending rate by two percentage points. The average Toronto-area household carries $409,000 in mortgage and consumer debt, among the highest in Canada, TD Economics says. At the same time, first-time buyers are increasingly struggling to get a foothold in the market. The average age of a first-time homebuyer in the region hit a new high of 37 last year.

While some of the trends toward skyrocketing land values and rising household debt can be chalked up to Toronto's evolution into a world-class city that has attracted an influx of new residents and driven up land prices, many of the problems come down to government policy, the bank says.

Densification policies that have encouraged developers to build along existing transit corridors have pushed up land prices in those neighbourhoods. Other policies, such as development charges that rise steeply on two-and three-bedroom units and city requirements that buildings have a set amount of parking – even in neighbourhoods where residents prefer to walk and take transit rather than drive – have driven up costs, encouraging developers to build larger projects filled with small, one-bedroom apartments. Investors' appetites for low-cost rental properties have helped to shrink the size of the average condo unit, which has dropped from more than 900 square feet a decade ago to 800 square feet today, even as the average cost has nearly doubled from $300 a square foot to $600.

"Some of the policies have been contributing to rising land costs and that does suggest that [government policy] is driving up prices even beyond what would be reflected by rapid growth in the economy," said the report's co-author, TD deputy chief economist Derek Burleton, in an interview. "Our concerns relating to some of these issues aren't going to be resolved by just a moderate cool down in the homeownership market."

In particular, the trend of developers flocking to downtown Toronto to build massive high-rise condominiums stuffed with tiny one-bedroom units could cause problems as the housing market cools. With nearly a fifth of renters saying their homes are too small for their needs, double the national average, and half of households planning to move within five years to find larger, more family-friendly housing, Mr. Burleton questions whether the trend toward small one-bedroom units will be a sustainable one.

"To the extent that we don't have the type of housing stock that meets the needs of residents in the future that's going to not only negatively impact on the economic performance of the region, but the broader quality of life," he said.

The glut of small one-bedroom units has also helped widen the gulf between condos and other types of housing, such as townhouses and detached homes. As the housing market cools, it will disproportionately affect such units, making it even harder for young buyers to afford to trade their one-bedroom condos for a larger home when they start having families.

The slowdown in the housing market may come with some hidden benefits, however, if governments choose to use them. New tax credits could help encourage developers to offload a glut of unsold one-bedroom condos to housing non-profits, helping to open up a supply of affordable housing in the city core. Governments could also use tax incentives to encourage non-profits to create social housing real estate investment trusts, the bank said.