May 26, 2023 | 13:23
Catch-’23: Canada’s Affordability Conundrum
Catch-’23: Canada’s Affordability Conundrum
Catch-22: a dilemma or difficult circumstance from which there is no escape because of mutually conflicting or dependent conditions. Or a paradoxical situation from which an individual cannot escape because of contradictory rules or limitations.
Canada’s housing affordability problem is not easing, despite a significant correction in home prices across much of the country, and the problem is unlikely to go away under current settings. While most will argue for a supply-side fix, our longstanding view has been that it’s wishful thinking to believe that an industry, already running at full capacity, can simply double output in short order, flood the market with new units and bring prices and rents down. Bank of Canada policy has now appropriately taken froth out of the market, but robust immigration flows continue to fuel demand at a time when there is already peak domestic demographic pressure.
Conditions on the ground suggest that many markets have found a bottom after last year’s correction. Sales volumes turned up meaningfully through the spring and are now back into the range that prevailed before the pandemic boom. However, a lack of new listings is the bigger factor tightening the market (Chart 1). National new listings were running at the lowest non-pandemic level in almost 20 years, despite a population that is now larger by 25%, or by 8 million. Past real estate downturns that evolved from an asset price correction into something much worse have come at the hands of forced selling—think the U.S. during the GFC or Southern Ontario in the 1990s—but we’re not seeing that yet.
Among the factors holding back listings are potential sellers not wanting to let go in a down market; not having to let go because of a strong job market and built-up liquidity; less mobility if they’re locked into an attractive mortgage; and, a strong rental market for investors to lean on. At the same time, the structure of Canada’s mortgage market has blunted the impact of higher interest rates with many variable-rate holders seeing amortizations stretch out, rather than payments rise in real time. OSFI has also stress-tested most buyers such that even those that took out mortgages at the low for rates have proven an ability to pay in at least the 4.75%-to-5.25% range.
As prices level off, that leaves the national benchmark price correction at 16% peak-to-trough. That has simply scrubbed the extreme froth out of the market, but hasn’t gone far enough to actually make housing close to “affordable” again (Chart 2).
Affordability Still Strained
When mortgage rates jump from 1.5% to 5%, maintaining affordability would require a 25% cut in the price of the house, while holding income, down-payment size and amortization length constant. Chart 2 shows affordability over time, accounting for incomes, mortgage rates and house price changes, and the takeaway is that the pandemic-era deterioration has scarcely been touched. To do so would take another leg down in home prices, or a meaningful move down in mortgage rates, neither of which are on the radar for the rest of this year. Over the medium term, however, affordability can be restored by incomes growing in excess of home prices, and we suspect that eventual BoC easing will play a role. The affordability that we’re used to, however, is still a long way off.
Another affordability gauge is the path of inflation-adjusted home prices (Chart 3). Real home prices in Canada have historically grown about 3% per year dating back to the early 1980s. In the recent episode, even as inflation accelerated to multi-decade highs, real home prices surged by more than a third in the span of two years, opening the widest deviation from its long-run trend in at least 40 years. Fundamentally, housing is a good inflation hedge, so persistent pressure, along with rising building, labour and overall development costs are helping to put a floor under the resale market. But, from an affordability perspective, the price correction has only pulled inflation-adjusted home prices back down to baseline levels.
What about Those Supply Targets?
The knee-jerk response by seemingly one and all to Canada’s affordability constraints is “more supply”. There is no debate that increased supply needs to play an important part in improving affordability.
But there are at least three reasons why we simply cannot rely on supply alone to do the job. First, and most obviously, housing supply can only respond gradually, and is essentially fixed in the short run, whereas demand can change in a moment. Second, even over a more extended period of time, there are clearly limits to how quickly supply can respond, given Canada’s existing skilled trade workforce, availability of serviced land, and materials. Third, and perhaps more subtly, any success in improving affordability (i.e., lower prices) will sow the seeds for less building in the future.
Moreover, note that the marked deterioration of affordability in the past few years has come at a time when new homebuilding has surged. For example, housing starts in 2021 and 2022 were the strongest on record for a two-year period, averaging 267,000 units, or 40% above the 50-year average pace (Chart 4). True, a much greater share of this new building is aimed at condo construction than in the past, with single-family homes accounting for less than 30% of starts in 2021/22 versus a long-run average of just above 50%. This is significant because condo towers take longer to build, and tend to house fewer people per unit. But even completions were at 40-year highs in the past two years, and dwellings under construction are running at a record 1.5 years’ of supply (at 378,000 units). The point is that supply has indeed responded in recent years, and yet the affordability needle has barely moved.
There are some who look at starts relative to population levels, and suggest that they are inadequate. But a more appropriate metric is the growth in the adult population (which is a flow, as are starts). Based on that comparison, the level of new building in the past decade is far from unusually low—on the contrary—at least up until the most recent sprint in population (Chart 5).
Investors Playing a Role
Clearly, there are more fundamental factors at play driving demand and weakening affordability. The investor class is increasingly dominating the Canadian housing market. A recent StatCan study of five provinces (including Ontario and B.C.) finds that over 25% of dwellings are owned by investors as of 2020. If anything, that share likely rose further during the pandemic. While it’s no shock that a high proportion of condos are investor-owned, much more eye-opening is the fact that almost 15% of detached homes are now investor-owned, or more than one in seven. Some analysts assert that investor demand helps create supply, so is thus not a big factor in the affordability issue. That may be the case in some new condo developments, but is clearly a spurious line of reasoning on existing houses, where investor buying is compounding a tough affordability situation.
Population Flows: A Demand Juggernaut
Beyond that, Canada’s strong population growth is no doubt a steady source of support for home price appreciation. Over the short term, the housing market can be swayed by cyclical factors such as interest rates, unemployment and income growth. But over the longer term, demographic trends have the biggest weight on home prices. Evidence from 18 large advanced economies since the start of the century shows that real home prices are closely correlated with population growth over time (Chart 6). For example, New Zealand, Australia, and Canada have seen both the fastest growing populations (aside from Ireland) over that period, and the fastest rise in real home prices, while Japan and Italy have been at the other end of the spectrum on both counts.
Regression analysis suggests that every 1% rise in population will be associated over time with real home price growth of just over 3% per year. In recent years, Canada’s population has been growing at an average annual pace of 1.5% per year (and a whopping 2.7% in 2022 alone), which is consistent over time with 5% annual home price gains on top of inflation. In any given year that relationship will likely be overridden by short-term factors such as rates or job growth, but it tends to remain strong over time and across economies. Some national housing markets stray from the trend line due to timing factors—the sample period includes a housing boom/bust in Ireland, Spain, and the U.S., and they are all below the line, while Canada, New Zealand and Sweden are all a bit above the line, perhaps partly reflecting the low level of prices in those countries at the start of the sample period.
But regardless of the starting point, there isn’t much debate that Canada’s home price inflation has been much stronger than in most other major economies over a long period of time (Chart 7). The divergence with the U.S. market over the past 15 years is quite stark and cannot be explained away by the small differences in interest rate policies or economic growth.
How Much Is Too Much?
Canada’s 2.7% population growth in 2022 was the strongest since at least the 1970s, with more than 1 million people added to the country (Chart 8). This comes at a time when domestic demand for housing is just about peaking, with the crest of the Millennial cohort around 32 years old, or right in their household formation and family building years. So, with the construction industry already building at full speed to satisfy domestic demand, we clearly don’t have the infrastructure or ability to meet the additional demand created by historic immigration levels. That is reflected in a worsened affordability problem. It’s notable that breaking down the population surge of the past year shows that the gain was almost entirely (2.6 ppts) driven by international immigration and, of that, more than half was driven by a massive 600k inflow of nonpermanent residents (i.e., students and temporary foreign workers). The result is not only still-high resale prices, but surging rents across many markets, including smaller cities with universities.
Canada’s affordability crisis may be an unintended consequence of record international inflows layering on top of peak domestic demographic demand, both of which are combining to pressure a construction industry already near full capacity. The catch is that driving down prices will incent less supply; and at the same time, heightened immigration flows designed to ease labour supply pressure immediately add to the housing demand they are trying to meet. The infrastructure in place and the industry’s ability to build clearly can’t support unchecked levels of demand, so the affordability conundrum continues...