Over the past few weeks, older homeowners have been pointing me to Canada’s Affordability Index. The index, created and maintained by the Bank of Canada (BoC) shows a big drop in Q3 2020. Further, it also spurred a few emails saying affordability was worse in the ’80s, Millennials are just complaining. Well, the issue is the BoC’s Affordability Index isn’t very accurate during certain periods. Let’s unpack the current reading, and why input bias creates an index that means nothing during recessions and over time.
The Affordability Index measures the share of disposable income spent on housing costs. Disposable income is the money left over after mandatory taxes and transfers. Housing costs are the mortgage payment, and utility fees. If the index goes up, things are getting less affordable. If the index goes down, things are getting more affordable. That’s the theory, at least.
Canadian Real Estate Is The Most Affordable In Years?
The Affordability Index had a small quarterly increase, but is still much lower than it used to be. The index shows households require 31.5% of their disposable income for housing in Q3 2021. This is up a full point from the previous quarter, but both readings are the lowest since 2015. Homes are the most affordable they’ve been in half a decade, apparently.
Canadian Housing Affordability Index
The BoC’s housing Affordabitity Index, which is the estimated percent of disposable income needed to service a mortgage.Source: Bank of Canada, Better Dwelling.
But Prices Are Rising, So What’s Driving The Trend?
There’s a few reasons driving the index lower, and the most obvious are mortgages, incomes, and home prices. Mortgage rates dropped very quickly, lowering monthly payments, when financing the same amount. Another point is the index assumes a 95% loan-to-value (LTV), which is not possible in some regions. Toronto and Vancouver’s benchmark condo, the cheapest segment, wouldn’t qualify at 95% LTV. Homes over a million dollars also require a minimum downpayment of 20% at most lenders as well. Both of these mortgage issues would lead many to experience reality different from the index.
The index also uses average household income, which is problematic for a few reasons. The methodology states the total of household disposable income is taken, and divided by the number of households in Canada. There’s no adjustments for high or low income households. The lack of adjustments for high and low income households pops up in a few ways. Low income households see much slower growth than high income households, but get averaged up.
Disposable Income Boost Temporary, Due To Pandemic
The big issue driving the affordability index lower recently, is government transfers. Disposable income soared in Q2 and Q3 2020, due to transfers amounting to double the wages lost. This was due to various reasons, including part-time employees collecting more in transfers than their wage. As many economists have pointed out, this was a temporary rise, which will correct at the end of the pandemic. Once that’s fixed, disposable income should revert closer to pre-pandemic levels. With that decline will come a higher Affordability Index read, even if prices were flat.
The last one is how home prices are used, which can have a big impact over time, making historic comparisons useless. The index uses the average resale price, not the benchmark price. There’s no adjustment for location, size, quality, or basically anything. It’s just a primitive addition of the total dollar value of all sales, divided by the number of homes sold. This misses issues like the apartment stock grew 5 points faster than single-family homes from 1990 to 2017. Saying affordability improved by using more small shelters, is like saying food affordability can be improved by eating less. It makes long-term historic comparisons of affordability using the index not exactly helpful.
Is the index totally useless? Not exactly. During a normal period in history, it can be useful for short-term analysis. Quarter to quarter, or even year to year, most indicators aren’t very volatile. In an environment where disposable income is boosted by emergency government transfers, not so much. Ditto for long-term historic comparisons, that peak at 60% of income as an all-time high, when in reality data shows it was closer to 16% of income during that period.
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