Focus

January 22, 2021 | 13:50

Unbreakable Canadian Housing?

Economist

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Michael Gregory , CFA

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Art Woo

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Carl Campus

Economist
Economics

Carl Campus joined BMO Economics in 2007 as a Research and Technical Assistant; he was later promoted to his cur... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Michael Gregory , CFA

Deputy Chief Economist, Head of U.S. Economics and Managing Director
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Art Woo

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Carl Campus

Economist
Economics

Carl Campus joined BMO Economics in 2007 as a Research and Technical Assistant; he was later promoted to his cur... (Read more)

Feature

Unbreakable Canadian Housing?

The past year has displayed in glorious detail just how hard it is to keep the Canadian housing market down—even a global pandemic couldn’t knock it off its perch. While much of the rest of the economy struggled with the deepest downturn of the post-war era, Canadian home sales and prices hit record highs, while starts churned out shockingly solid gains. Suffice it to say that this was diametrically opposed to what the conventional wisdom expected for the housing market during the depths of the spring lockdown, including an official call for a double-digit price decline. Instead, residential investment—which includes new building, renovation activity, and sales costs—was a rare source of growth. And it looks set to remain robust in 2021.

As a result of the resilient sales and construction activity, as well as record prices, housing’s share of Canadian nominal GDP rocketed above 9% by the third quarter of last year. To say “that’s an all-time high” would be an understatement, as Chart 1 reveals. It’s far above the long-run norm of a bit less than 6%, and it’s more than double the current U.S. ratio of 4.3% (finally almost back to its long-run norm). Historically, housing takes up a bigger share of Canada’s GDP compared with the U.S., but the spread has gapped up from an average of less than 1 percentage point in the 50 years to 2010 to today’s extreme of almost 5 ppts. Yes, some of the spike in the ratio reflects a weak denominator, but that’s also the case for the U.S. reading. And recall that the U.S. has experienced a relatively quick rebound in housing in the past year as well, and yet we are left with this massive divergence.

While a big part of the extreme share of spending on housing is due to relatively strong building activity (starts and renos), raging home prices play an equally big role. The real residential construction-to-GDP ratio is at a 30-year high of 7.8%, but actually not far from the average of the 1970s and 1980s (7.6%). So, the true extremes are on prices. Many have pointed to supply issues as the main cause of lofty home prices, including zoning constraints or building costs. These forces would largely affect non-residential construction as well, and, as Chart 2 shows, those prices rose mostly in-line with housing prices up until around 2015. But then we began to see some real separation, with home prices rising much more rapidly in the past five years, pointing to a fundamental change on the demand side.

Another way to look at just how extreme Canadian home prices have become is to compare them with the U.S. Such comparisons are always fraught with serious challenges given differences in incomes, mortgage markets, interest rates, urban/rural splits, housing stocks, and a variable exchange rate, but we will make the comparison nonetheless. Using a purchasing power exchange rate (a very stable measure which takes income differences into account and is currently about 0.83), we convert average U.S. existing home prices into Canadian dollar terms. As of December, the seasonally adjusted average Canadian home price was $617,000. In contrast, the U.S. mean home price was just over US$350,000, or roughly C$420,000 (adjusted at PPP), a gap of about 46% (Chart 3). Even if we instead use today’s market exchange rate, the average U.S. price is about C$445,000, still leaving Canada’s average home prices a whopping 40% above U.S. levels.

What are the factors behind that 40%-to-50% gap in average home prices? That seemingly simple question is a source of great debate; and, for starters, note that Canadian relative prices really only began to pull away just over a decade ago. We can look at it from both the demand and supply side. On the former, some of the biggest potential, oft-cited, drivers are:

Demographics: In particular, stronger population growth in recent years (Chart 4).
Lower interest rates: Canadian mortgage borrowing is clustered in the 5-year space or under, versus the U.S. preponderance of 30-year mortgages, which tend to carry higher rates. (However, this factor is largely countered by typically longer U.S. amortization; 30 years versus 25 years in Canada for the most part.)

Urban population: By some measures, the rate of urbanization is similar between the U.S. and Canada at just over 80%. However, a higher share of Canada’s population is in the largest—and generally more expensive—cities. For example, a third of all homes sold last year in Canada were in the three biggest cities; and, these are precisely the three cities where prices look stretched relative to incomes.
Home ownership rates: Following the 2007-11 U.S. housing bust, home ownership rates plunged well below Canada's levels but have begun reversing notably in recent years. The 2016 Census pegs Canada at 68.7%, while much more updated U.S. figures have risen to 68.4%.
Tax treatment: Lack of capital gains taxes on the principal residence in Canada no doubt plays a role in juicing investment in real estate, and can contribute to relatively high home prices. U.S. gains exemptions are limited to $250,000 ($500,000 for joint filers), and can only be claimed every two years. However, this factor is at the very least countered by partial mortgage deductibility for U.S. filers.

Sorting through that list, the only truly compelling factor is Canada’s relatively robust population growth, driven primarily by net immigration. (That growth happens to have nearly stalled out in 2020, but will almost certainly rebound in coming years; but, so too will U.S. inflows with the new Administration looking to reset immigration policies.) As mentioned, many also point to supply constraints and costs as a relative driver. While a factor, we view it as secondary to the demand side forces. Even with any supply issues, Canadian new home building has been persistently above the U.S. pace on per capita terms for years, due to robust population growth (Chart 5).

More generally, a much more fundamental answer may simply be that on balance Canadians have made a collective choice to allocate more resources to (and thus “consume” more) housing than other countries. And that’s not necessarily a bad thing, just a consumption choice. It’s debatable that the heavy investment in housing relative to other areas is a misalignment of resources—as some have suggested—if that truly represents the preference of Canadians. After all, housing is in fact an investment that can provide an ongoing benefit. While some dismiss it as “consumption”, who is to judge if this type of consumption is better or worse than other forms of spending?

Having said that, there is a price for that relatively heavy investment in housing consumption, and it’s a famous four-letter word: debt. Canada's household debt/income ratio forged above the U.S. about a decade ago and never looked back (Chart 6). True, it took a step down last year, due to the spike in household incomes (on government support) and as debt growth temporarily cooled. But, in the past 12 months, mortgage debt growth has perked back up (+7.5% y/y, the fastest in more than nine years). And while overall household debt has been restrained by a slide in consumer credit, that is likely to reverse when the economy reopens and spending on services (presumably) resumes. Meantime, incomes will inevitably take a small step back when some of the exceptional government support programs begin to wind down. The point is that the respite for household debt ratios is expected to prove temporary, and the focus will revert to this underlying issue when the pandemic eventually fades as economic concern #1.