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Why gravity-defying home prices refuse to heed the market

What's up with Canadian housing prices? Perhaps the better way to phrase that is, Why are Canadian housing prices up? On Tuesday, economists were trying to make sense of the fact that sales of existing homes fell sharply, by 17.4 per cent in December from a year earlier, while home prices actually rose by 1.6 per cent, according to data from the Canadian Real Estate Association.

It's an unprecedented standoff between buyers and sellers. Finance Minister Jim Flaherty is happy about the cooling of the housing market, but what about sellers? Are they being self-delusional, ignoring an inevitable drop in prices, or are they being savvy by holding their ground during a temporary reset of market dynamics?

Let's consider the arguments.

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Martin Barnes, chief economist with BCA Research, says there's a stickiness in prices, and "psychology is at work here." The idea is that despite a drop in demand, sellers are reluctant to accept that prices are actually falling. But inevitably, he warns, "the laws of supply and demand will work. There can be a lag between volume and price – people will hold off for a while and hope prices come back again – but it's unlikely." Home prices rise and fall in broad cycles, and "eventually people will accept these lower prices … and prices will fall."

In the opposite corner is Craig Alexander, chief economist with Toronto-Dominion Bank. He doesn't see the recent collapse in demand as the start of a down cycle, but the natural result of the government's tightening of mortgage lending rules last July. Research from TD Economics shows that after mortgage policy adjustments, housing demand changes accordingly over the next two to three quarters – until the market eventually adjusts to the new realities.

Think about it: A sudden change in policy will force people currently in the housing market to readjust expectations, leading to big shifts such as December's drop in sales. Subsequent entrants to the housing market will merely operate in accordance with the by now entrenched rules and proceed accordingly. Mr. Alexander expects stabilizing sales and flat prices going forward, with a robust market returning as soon as the spring.

There's good reason to favour the more optimistic view: Interest rates remain near historic lows, providing a strong incentive for people to buy real estate. Meanwhile, housing prices are now growing at a slower pace than personal incomes, putting the housing market more in balance. Furthermore, "there isn't a catalyst for a deeper correction," such as a recession, Mr. Alexander says. That means fewer motivated sellers, with the rest confident they can wait out a period of soft demand to get their price.

The wild card, of course, remains the direction of interest rates. There's little doubt what will happen once rates rise: Sellers will try to get relatively high prices while they can, prices will fall, and sellers, sensing their moment, will pounce. But that's still in the offing.

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