September 22, 2023 | 13:15
Pie in the Sky on Housing Supply
Pie in the Sky on Housing Supply
To clear the air at the outset, we are not supply denialists. Given Canada’s robust population growth, rapidly rising rents and lofty home prices, there is no debate that the nation requires a strong and steady supply of new homebuilding. The record 1.2 million increase in the population over the past year simply reinforces that stark reality. However, where we fundamentally diverge from the conventional wisdom is on two points: 1) ramped-up supply alone is not going to “solve” Canada’s affordability issues, and 2) raging demand, including investment demand, has been every bit of a driver of the lack of affordability as a perceived supply shortfall. Accordingly, the current all-consuming focus on dramatically boosting supply may be misplaced and is frankly unrealistic.
The Canadian Mortgage and Housing Corporation (CMHC) recently updated its estimates of how much additional supply is ‘needed’ to bring home prices back down to early 2000s affordability levels. Its latest estimate is an additional 3.5 million units by 2030 on top of the normal flow of new supply, or roughly 500,000 extra units per year. Again, that’s above and beyond the recent pace of housing starts of roughly 250,000 annually—so they are essentially saying it will take a tripling of the pace of homebuilding to make housing affordable. To put it in perspective, the all-time record annual high for Canadian housing starts is 273,000 way back in 1976, and they nearly got back to that level in 2021 (Chart 1). In other words, the bar is not going to be approached, let alone cleared.
These targets look especially challenging when set against an industry already operating at full capacity. There are currently almost 400,000 housing units under construction in Canada, the highest level on record in raw terms, and even surpassing the 1970s building boom in per-capita terms (Chart 2). Interestingly, a substantial portion of the recent run-up has been in the purpose-built rental space, even before recent policy proposals such as the HST removal. Indeed, this level of building activity has opened up significant labour shortages in the industry, with almost 90,000 job vacancies at one point last year. While fading recently, the job vacancy rate still sits at 5%, or almost 2 ppts higher than pre-pandemic levels. Demographics are also playing a challenging role, with many skilled trades pushing into retirement years, leaving the pipeline of workers difficult to fill.
Meantime, the surge in financing costs has made new project development a challenge. While rental rates are rising quickly, current cap rates don’t ‘pencil’ well after 475 bps of tightening by the Bank of Canada. And, investors have backed away from the market for the same reason (and the fact that prices are no longer on a one-way trip higher). The implication is that builders are finding it more difficult to pre-sell new developments, which is usually a hurdle to receive financing and break ground on construction. Suffice it to say that these tougher conditions are not going to just go away overnight.
Moreover, let’s dig into CMHC’s basic assumptions. We believe it is not appropriate to arbitrarily pick 2003 as the benchmark for affordability. It just so happens that Canada’s housing market was unusually affordable (at least relative to history) in the early 2000s, and may thus be an unrealistic benchmark (Chart 3). That period followed a decade-long bear market in housing, particularly in Ontario, where nominal home prices took more than a decade to recover declines. The 1990s recession saw double-digit unemployment in the province, a large overhang of housing inventories, and many industry participants go out of business. In other words, not conditions we’d want to recreate. Meantime, population growth trends were starkly different leading into the early-2000s, with growth in the 25-40 age cohort (indicative of incremental housing demand) in outright decline for 13 years through 2006 (coincidentally 2003 was the absolute low). The demographic forces couldn’t be further from those conditions today, with Millennial demand peaking and supplemented by robust international immigration flows.
Finally, the early-2000s predate transformative housing policy changes such as the Ontario Places to Grow Act, which took shape after 2006. Such policy pushed intensification and effectively began to crowd out single-detached housing. That has created a scarcity factor for family homes (think suburban GTA) that couldn’t look more different than the early-2000s when that supply was ample. These factors all suggest that 2003 ‘affordability’ took place in a world we can’t, or wouldn’t want to, totally recreate.
If we instead look at average housing affordability levels in the 1995-to-2020 period, the homebuilding task becomes much more manageable and within the realm of reality. And the BoC’s affordability measure just happened to clock in at 32% on average over that long time period; that’s typically viewed as a roughly appropriate percentage of disposable income that should be directed to housing costs. And, in fact, housing was not far from these norms as recently as 2019, and really only became unhinged during the pandemic buying frenzy. That frenzy was particularly stoked by not only record-low borrowing costs, which have since been more than reversed, but also by a wide variety of additional factors that created a wave of demand. And we believe that it was this sudden shift in demand that has been the leading cause of the affordability strain—supply didn’t suddenly shift; it never does.
One underlying demand force that we are dealing with, and which partly explains the seeming relentless strength in investment demand, is the tremendous rise in household wealth in the past 30 years (Chart 4). Whenever the quarterly balance sheet figures are released, the focus inevitably lands on household debt totals—for the record, debt dipped to 180% of disposable income in Q2, down modestly from record highs in earlier quarters. But assets have been chugging sharply higher at the same time, with much less drama. After subtracting out debt, and even with last year’s widespread market downdraft, the net asset position of households has risen to a massive 1000% of income (doubling from 30 years ago). Looked at another way, household assets are more than six times the size of debt. And while real estate appreciation has accounted for a good portion of the enormous rise in household assets, financial assets have also risen rapidly and account for a bit more than half of the total. This run-up provides households with plentiful financial firepower, and at least some of this deep well is finding its way into real estate investments, whether on an individual basis, in partnerships, or through institutional channels.
Bottom Line: It’s good to have lofty aspirations for homebuilding given the tightness in Canada’s housing market and rapid-fire population growth. But we can’t be led down a blind alley of wildly unrealistic targets; then, expect a major push to build will alone solve affordability strains. If demand is allowed to continue to run amok, then even torrid supply will simply be quickly swallowed whole.