The Canadian housing market is HOT, regardless of the ongoing pandemic. So hot that it was recently ranked as the third biggest housing bubble in the world. House prices have risen by over 22% in the last year. This is despite national unemployment rates still hovering over 8%, which is the highest that it reached during the Great Recession.
If you thought there was a lot of hype around GameStop and cryptocurrencies, you haven’t seen anything yet. There are countless stories about houses receiving dozens of offers and selling for hundreds of thousands over the asking price. This, however, is not a new trend. In 2016 someone I know moved to Toronto and bought a small condo for a modest $300k. Three and a half years later he sold it for over $500k, $200k of profit for doing absolutely nothing! Houses in Toronto are expected to reach $1 million for the first time later this year. Just 10 years ago you could expect to pay closer to $400,000 for a house, million-dollar homes were unheard of. Why have things changed so drastically over the last decade?
Interest rates impact the type of house you can afford
The purchase of a home is almost always financed through a mortgage. The fact that loans are so prevalent in real estate purchases means that interest rates play a big role in determining the dynamics of the market. The cost of the home that you can purchase isn’t limited by how much money you have, but by how much money the bank will allow you to borrow. Getting a mortgage can be a painful process, but behind the scenes, banks will base their decision on whether or not to give you a mortgage on a simple formula. If the monthly cost of the mortgage is below some predefined percentage of your earnings, they will give you the loan. This means that your ability to get a mortgage is a function of your income, the cost of the house, and interest rates.
When interest rates are lowered, the monthly cost of a mortgage falls, so the bank will allow you to take out a bigger mortgage for a more expensive house This is because the cost of this mortgage is now an acceptable percentage of your income at the new, lower interest rates. Not only can you afford a more expensive home, but everyone else can too, without any increase in income. Sounds like magic doesn’t it? Unfortunately, things don’t work so simply in the real world. The increased buying power bestowed upon consumers through lower interest rates means that each home can now be afforded by more potential buyers. According to the laws of supply and demand, this should push house prices higher, and this is exactly what has happened in the Canadian housing market.
Here we see the 5-year (variable) mortgage rate in Canada since the Great Recession. It has been at historically low levels for over a decade. Prior to 2009, it had never been under 4% for an extended period of time.
So, the mortgage you qualify for determines which house you can purchase. Qualifying for a mortgage depends on your income, the price of the house, and interest rates. But, the price of the house is also influenced by interest rates. Hopefully, this makes clear how dependent the housing market is on interest rates. Of course, many other factors affect house prices, including government regulation, supply, the attractiveness of other investment options. However, the ceiling on house prices is only as high as what people can afford, which as we’ve seen is limited by how large of a mortgage they can get, which in turn is a function of interest rates.
The table above shows us a price index for homes in Toronto. Price growth became much more aggressive starting in 2010 when lower interest rates allowed people to qualify for ever-larger mortgages. Now that we understand how interest rates influence housing prices, let’s see why they have been so low for so long.
Controlling inflation by managing interest rates
The Bank of Canada aims to keep inflation low, stable, and predictable, in order to ensure stability and confidence in the economy. Inflation is a decline in purchasing power over time. It can be measured by tracking the changes in the price of a fixed basket of goods. This price is referred to as the Consumer Price Index or CPI. The basket of goods is supposed to represent the things and services purchased by a typical citizen. If the CPI increases by 2% in a given year, then a typical citizen will spend 2% more to make their usual purchases. This is the same as saying that their purchasing power declined by 2%, or inflation was 2%.
The main tool that the Bank of Canada uses to influence inflation is adjusting interest rates. At a high level, the theory is that when interest rates increase money becomes harder to borrow, which makes less money available, causing price growth to slow.
Canadian inflation mostly unaffected by recent housing market activity
There is a specific slice within the basket of goods that is meant to measure the change in housing costs. This is the “shelter component of CPI”, which makes up about 27% of the basket of goods. Given the steep rise in house prices that Canadians have seen recently, we would expect the shelter portion of CPI to have skyrocketed. When I pulled up the data I was surprised to see that this was not the case. Below we see the Canada (blue) and Toronto (red) housing price indices, along with the overall CPI (green) and Shelter Component of CPI (yellow).
The growth in the shelter component of CPI has barely outpaced that of overall CPI and has trailed the increase in the actual price of houses dramatically. According to this chart, house prices increased from an index value of 100 in 2005, to 250 in 2021, for an average growth rate of over 6% a year. Over the same period, the shelter component of CPI has gone from 100 to 136, reflecting an average increase in shelter cost of about 2% a year. Clearly, the shelter component of CPI is not reflecting the higher housing costs we are seeing in the market.
These weightings are completely out of sync with reality. Here is a great visualization that shows us that in many of the most populated regions in the country people are putting more than half of their income towards housing and utilities (utility expenses are typically quite small compared to rent). Similarly, with the price tag of an average home now closing in on a million dollars, new home buyers are typically spending much more than 3% of their income on mortgage interest. A mortgage of a modest $500,000 will cost you about $11,000 of interest in the first year, at current interest rate levels.
This failure of CPI to accurately capture current housing costs is caused by the method used to track prices within the basket of goods. The rent price used in the index is not an average of recently signed rental agreements. Instead, it includes leases that may have been signed many years ago, when rent prices were only a fraction of what they are today. Similarly, mortgage interest includes both new home buyers, and the nearly retired who are only paying a few dollars in interest each month. In this way, the shelter component of CPI acts as a slow-moving average of the cost of housing, over many decades. This is not necessarily an incorrect approach, in fact, it may actually accurately reflect the average cost of housing. However, it heavily benefits those who already own a home (and even more so those who own multiple homes), at the expense of those who don’t.
If the shelter component of CPI truly reflected current housing costs inflation would be much higher
This would force interest rates higher, which would probably end up reducing housing prices. Unfortunately for young people, CPI includes the housing costs of older generations who bought mansions for less than what a small bachelor apartment now costs. Ironically, those older generations have gained massive amounts of wealth through the housing price boom caused by the inclusion of their cheap accommodations in CPI. Many of them have extracted this wealth from their primary residence in order to purchase more homes, driving the cost of housing up further. There are at least a million people in Canada who own multiple homes, making it even harder for many younger or less fortunate people to buy their first one. This has left us in a situation where it will take multiple decades for a typical wage earner to save up a down payment for a house in one of Canada’s main economic centers.
Imagine there was a way to pre-purchase a lifetime’s worth of food from your favorite grocery store at a reasonable price. 20 years later, for whatever reason, the price of food has skyrocketed. Wages have barely risen, but a loaf of bread now costs $10 rather than $2, cucumbers are $5 rather than $1. Would we leave things as they are, because on average people still have an affordable cost per meal, or try and do something about it to help those who weren’t able to lock in their prices earlier? I hope that we wouldn’t let people go hungry or struggle to pay for food, hoping that the “free market” would sort things out. Sadly, this is pretty much what many advanced economies have decided to do with regards to housing, all in the name of “economic growth”. In reality, this is not true growth, instead, many economies are becoming more and more dependent on increasing debt levels fueling higher asset prices. Only time will tell how things will play out.