House Prices Soar, but is it Sustainable?

While a long road to recovery remains for the Canadian economy, one sector experienced an unexpectedly good year. In August, Canada’s housing market saw national sales increase by 33.5% year-over-year. The upsurge follows months of record low interest rates, pent-up demand, and liquidity relief from the Federal government and Bank of Canada (BoC). While this is a win for many new homebuyers, it may not be for those who are concerned that these measures are artificially propping up the housing market and increasing its exposure to economic shocks. To avoid a potential crisis, the focus must shift to stimulating housing supply instead of consumer demand and consequently household debt.

The pandemic has caused nearly one in five Canadians between the ages of 18 to 34 to accelerate their plans to purchase a home or investment property, according to a recent Scotiabank survey. The increased demand can largely be attributed to Canada’s all time low mortgage rates, with most major banks offering five-year fixed mortgage rates well below 2%. The BoC’s effort to maintain credit availability during the pandemic is partly responsible for such low rates. The central bank’s overnight rate currently remains at the effective lower bound of 0.25% after the BoC slashed it by 50 basis points on three separate occasions in March. Additionally, at the start of the pandemic, the BoC also established the Canada Mortgage Bond Purchase Program (CMBP). This allowed the central bank to purchase up to C$500 million dollars of Canada Mortgage Bonds per week. As a result of these measures, the uninsured five-year fixed mortgage rate has fallen 100 basis points from 2.84% to 1.84% since the beginning of 2020.

In conjunction with low interest rates, pandemic-induced supply constraints generated pent-up demand in the housing market. Lockdown restrictions limited new sale listings in the spring, and homeowners who likely would have defaulted without the pandemic were given the opportunity to defer payments up to six months and avoid foreclosure. Canada’s six major banks approved deferrals on payments for over C$180 billion residential mortgages and real estate-secured loans during the pandemic. This amounts to more than 14% of residential mortgages held on the balance sheets of chartered banks in March. The lack of supply has caused housing prices to soar. According to Canadian real estate company Royal LePage, 97% of regions across the country saw housing prices increase in the past three months – and they believe prices will continue to rise. The company predicts that by the end of the year the median home price in Canada will reach C$693,000, a 7% increase from last December.

While many Canadians are rushing to take advantage of market conditions, there is growing concern that transitory demand-side stimulation is not sustainable. Such measures may cause investment in housing to act more like a liability than an asset, as they may result in price correction or a loss in household net worth. CEO of the Canada Mortgage and Housing Corporation (CMHC), Evan Siddall, spoke in May about limiting CMHC’s underwriting practices to limit excessive borrowing in light of the rising debt levels. He believes that as mortgage deferral periods and household income support programs that helped Canadians make mortgage payments come to an end, Canadian housing prices could still fall by 10%, exposing more households to the risk of default. Recent estimates suggest that 10% to 20% of mortgages under deferral are at a high risk of defaulting. While this estimate demonstrates the more immediate threats that the pandemic imposes on the housing market, it does not encompass the full uncertainty developed by artificially generated demand. CMHC predicted in May that nearly 70% of deferred loans have loan to value-ratios of over 90%. The policies allowing these high leveraged ratios increase the volatility in the equity of the home, exposing these homeowners to greater risk. For instance, if housing prices fall just 5%, at least half of the equity in these homes will be lost.

While lenient rates and borrowing policies have made homes affordable for many Canadians, they have also contributed to Canada’s growing mortgage debt. Growing at nearly twice the rate of GDP, Canadian mortgage debt was equivalent to 84% of GDP in Q2 2020, up from 69% the previous year. The recent increase is explosive considering that the figure was 59% just a decade ago. While a high mortgage debt-to-GDP ratio indicates that growth has been highly debt dependent, it also reveals the market’s increasing vulnerability to shocks. The UBS Global Real Estate Bubble index deemed Toronto as the only city in North America to present a bubble risk. Out of 25 cities, Toronto ranks third place, and Vancouver is also listed as over-valued.

In order to manage mortgage debt, policies aimed at making housing affordable need to stimulate housing supply, not demand. A study by the Fraser Institute found that from 2002 to 2014, the Vancouver and Toronto areas generated approximately 61,000 new jobs per year and experienced a yearly average of 57,000 housing starts. Despite the number of new jobs per year increasing to 120,000 between 2015-2019, the number of yearly housing starts remained relatively the same, suggesting that the two regions face a lag in housing supply. Red tape and construction costs remain as some of the largest barriers to housing supply. In Vancouver, development approval timelines can take as much as two years and costs of construction have increased by almost 50% in the last five years. If housing is to remain a worthy investment for home buyers, Canada must address its supply shortage.

While home buyers are enjoying their low rates while they still can, a correction may be hitting the market soon. The BoC recently ended the CMBP on October 26th, bringing an end to its C$9.32 billion purchases of Canadian Mortgage Bonds. As mortgage payment deferral periods begin to end and household income support programs begin to dry up, many Canadians may feel the unfortunate consequences of over-stimulated housing demand. If a housing bubble does pop, demand will be forcefully reigned in, sending a shock not just through the Coronavirus-battered economy, but also through the nest eggs of all Canadians.