The line goes up — Canadian real estate edition
How we ended up with one of the most expensive housing markets, and where to next
It is said that Canadian real estate prices have always gone up. Of course those who bought their house in 2017 felt differently for a couple of years. And looking back further in the past, there were some downs between the ups. The main reason for the preconception of always rising prices can be found by going back to 2008. During the US subprime mortgage crisis, housing prices in the states have halved. But it hasn’t made a dent in the Canadian market. We’ve only seen a 10% correction, and the market recovered in a year. Meanwhile it took a decade for US prices to return to early 2008 levels.
A similar unbroken, and exponential growth trajectory can only be seen in Australia and New Zealand. After this glorious march continuing during the pandemic, and only ending in 2022, the 20% drop in the average real estate prices came as a shock to many. Especially to those who took out the largest variable rate mortgage they could get, to win a bidding war.
This sudden and huge drop was quite predictable. Especially if we look into the mechanisms behind house prices, that investors have ignored during these years, and what will put an end to this improbable growth.
Besides the price index, an often quoted chart is the ratio of median income to median house prices. It’s trivial: if people earn more, they can spend more on housing. But adjusted for household income, real estate prices are still going up!
While I couldn’t find historical data before 1980, anecdotally this number has also been steadily increasing, with a sharp drop in 2022. And closely follows the price chart. The reason for this: incomes haven’t risen nearly enough to bring the ratio down.
Affordability
While everyone is talking about housing affordability, the housing affordability chart rarely comes up. Partly because it’s really sad. And partly because it hasn’t been as sensational as the previous two line-goes-up charts. Until 2023…
Affordability metrics show how much of the household income has to go towards housing expenses to buy a house. The formula calculating housing costs uses the mortgage rate, excluding renters from the affordability index.
In the formula, r is the mortgage rate, U is the cost of utilities, N is the mortgage term in months — this complex part of the formula is used to determine the monthly payment, using the compound interest model.
This in turn has to be divided by the average after-tax household income to get the affordability ratio. Two things to note that will be important: first, the mortgage rate is the rate available to new buyers, and second that it uses the average household income.
This chart is very different from the housing price chart, or the house price to income chart. First, let’s see why housing affordability has barely changed while house prices rose, and wages were left behind.
Interest rates
Those who had “interest rate” can pat themselves on the back. The answer to the discrepancies between the three charts shown is interest rate. The keen eyed probably noticed that r is the only parameter appearing twice in the formula. It does a lot of heavy lifting when calculating affordability.
Human memory is a funny thing. I often hear people of all venues and ages complain about high interest rates. Mortgage rates have risen sharply. Variable rates have risen from 0.99% pandemic lows to 6.5% nowadays. People are urging the Bank of Canada to this nonsense and give them the normal rates back.
Looking at the historical chart, 6.5% — not that bad.
Mortgage rates have been dropping since the 80’s. And that drop compensated for the rise in house prices. I would argue that it was the main contributor to rising house prices. North Americans have the proud tradition of spending other people’s money. Mortgages are essential to real estate purchases. People look at the sticker price, but only to compare it to their pre-approved mortgage amount. What counts at the end is the monthly payment. And with mortgage rates coming down, the same monthly payment qualified people for bigger houses. A drop from 5% to 1% is a 54% increase in purchasing power. The person who could afford a $500k home in 2019 could afford a $770k home in 2021, without any change in their income. No wonder that the price of set house also went up, by about 54%.
Of course there’s also the matter of downpayment. As mortgage rates dropped and house prices rose, people started complaining about not being able to afford the downpayment. Which is fair, not many have $200k in their pocket for the $1M average home in Toronto. First, the required down payments went from 20% to 5%. That brought the $1M home closer to many. Then, for those who couldn’t come up with the $50k, two shortcuts were introduced. The shared equity program allowed for people to co-own a house with the government. Instead of offering a personal loan to cover the downpayment, the government decided to put down the 5–10% itself, in exchange for a matching stake in the property. A bold step towards communism: state owned housing. The other incentive was to allow people to use their RRSP — a retirement saving where people contribute from their pre-tax income — as downpayment for up to $35k per person, or $70k per couple. These removed the last obstacle from the path of rising home prices. Thank you Trudeau!
Conclusion
While interest rates have risen, that didn’t give too much leeway to housing prices. We won’t be seeing 0% policy rates unless there’s another financial crisis on the horizon. In fact, I think the current 5% target is a healthy rate, and won’t drop more than 1–1.5% before stabilizing. Short of handing out money, or subsidizing mortgages, the government has exhausted all tools at their disposal to raise housing prices. I make the bold statement that housing prices have plateaued, and for the foreseeable future, will only increase to match the growth in wages.
Looking at the affordability chart, two things are surprising. First, the affordability of housing (the index being around 30%) for the past three decades. Those living through those years usually felt that their housing situation is just getting worse. Second, the sharp rise in the index in 2023, to 60%, meaning that people have to spend twice on housing than what would be healthy. Not considering other factors, it should have resulted in a deep crash of the market. In the next article, I’ll explore these discrepancies: why and how all these metrics are detached from the average Canadians’ reality.
If you haven’t seen it, I invite you to go and watch the video about crypto currencies that inspired the title.
