January 22, 2021 | 13:50
Unbreakable Canadian Housing?
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:
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.