House-price boom poses dangers beyond affordability

Analysis of the Canadian housing market tends to focus on affordability. This is indeed a problem, especially in Toronto and Vancouver, where house prices have grown much faster than incomes. However, as the recent trouble at Home Capital Group Inc. has demonstrated, the house-price boom in these regions poses dangers beyond affordability, according to academics Kevin Bryan, Joshua Gottlieb, and Joseph Steinberg.

“Since 2010, nominal house prices have nearly doubled in both the Toronto and Vancouver metro areas, two regions that account for nearly half of Canada’s residential housing value. In contrast, rent growth has been restrained, with nominal two-bedroom rents up less than 15 per cent in both regions since 2010,” they said in an article that recently appeared in The Globe and Mail.

These regions aren’t exactly experiencing a population boom, as both cities have grown only slightly faster than Canada as a whole since 2011. Both cities are also growing much more slowly than they did during the 1990s and 2000s.

House prices and rents normally increase simultaneously when demand rises faster than supply, the academics said. In cities such as San Francisco, a booming economy combined with restrictive construction laws has led to significant increases in both rents and prices. In contrast, prices in Canada have skyrocketed, but rents have not.

“This can happen when interest rates fall, housing subsidies increase or expected capital gains are high. Although mortgage rates have declined in recent years, academic research suggests that they have not declined enough to explain the dramatic price growth we have seen. With housing subsidies relatively constant, this points to expected price growth as the key factor,” the academics said.

When buyers expect house values to skyrocket dramatically, they prefer buying at high prices to renting at relatively low rates, investing their savings elsewhere. The academics question the rationale behind this strategy. “An elevated ratio of house prices to rents historically predicts falling rather than increasing prices. These declines can be large even in globally attractive cities,” they said.

Changes in expectations are notoriously difficult to predict; hence, predicting the timing of rapid house-price increases or decreases in Canada is nearly impossible. Moreover, artificially high current prices and potential future declines pose serious problems for the nation’s economy.

“Falling home prices would … affect more than just homeowners. Declining construction and real estate activity directly affects the economy since, for example, more than 30 per cent of British Columbia’s GDP is in those sectors. Indirectly, when house prices decline, homeowners stop borrowing against their [houses] and start saving elsewhere, lowering total consumption,” the academics said.

Canadian housing finance has numerous weaknesses: the lack of long-term fixed-rate mortgages, precarious alternative lenders, a heavy reliance on foreign investment, and taxpayers’ extensive backstopping of mortgages via Canada Mortgage and Housing Corp.

“In the short run, there is no magic bullet to stabilize housing markets without substantial risk to highly indebted households and exposed industries. That said, public access to real estate data, clear public statements about housing market risks, such as Bank of Canada Governor Stephen Poloz’s recent speech, and Australia-style collection of data on foreign housing investments can help manage buyer and investor expectations about the returns to ownership,” the academics said.

The government should also avoid poorly considered policies that prolong price booms and increase price volatility. Bryan, Gottlieb, and Steinberg recommend removing existing distortions such as favourable treatment of capital gains on real estate, provincial ownership subsidies, and restrictive zoning, among others.

“These policies encourage businesses and individuals to focus on real estate instead of other economic activity, exacerbate price volatility and fail to improve affordability. What better time to cut back these subsidies than when the market is soaring of its own accord and does not need artificial support?” they said.  

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