Bubble Contagion? Bank of Canada Finds Suburban Real Estate Prices Outgrew The City
Canadian real estate prices have made absurd gains over the past year, especially in big city suburbs. A new study from the Bank of Canada (BoC) looked at this phenomenon, observing the gap between city centers and the suburbs has been quickly narrowing over the past two years. The central bank ponders if this has been a permanent shift, but this is likely a frequently observed phenomenon called “bubble contagion.” It happens in literally every real estate bubble, with bubble buyers exhibiting similar exuberant behavior at the peak of every real estate cycle.
Canadian Real Estate Prices Have Been Growing Faster In Distant Suburbs
Typically real estate commands a premium for being located next to amenities. Consequently, real estate in city centers tends to command a substantial premium over suburban home prices. This is known as the bid-rent theory.
The bid-rent theory is based on the premise that land users will compete for proximity to use amenities. The greater the potential use, the higher the premium more central land carries. The BoC found the city-center premium was substantial before the pandemic, but narrowed as public health measures and low rates stuck.
Looking at the 15 largest census metropolitan areas (CMAs) clearly presents this trend. Within 5 kilometers of downtown, prices climbed 19.4% higher from 2019 to 2021.
The further out, the higher the growth — peaking at 46% growth over the same period, between 70 and 75kms from the city center. If faster growth persists in far away regions, it can begin to erode at the discount for living far away from a city’s resources. This lowers the attractiveness of satellite cities, potentially killing their growth pre-maturely.
The Discount For Living Further From A City’s Business District Is Shrinking Quickly
The narrowing gap between buying a home in the city and a distant suburb is nothing short of remarkable. The chart below shows the estimated discount of living further from the city center over time. In 2016, living 80kms from the city center provided around a 36% discount from the City’s business district.
Gradually this discount narrowed right into 2021. By 2019, suburban prices the same distance were only 29% lower than the city center. By 2021, it narrowed further to just 11% lower. Not exactly much of a discount for living 80kms from the center of the city, is it?
It’s important to note this trend was occurring before the pandemic. Rates had been absurdly low before 2020, with valuations already beginning to look frothy in Canada’s big cities. However, had the pre-2020 trend persisted the BOC estimates the discount would have only narrowed to 23% below city center prices. Not exactly great, but the current gap is less than half the size.
It’s Called Bubble Contagion, and It Happens Every Real Estate Bubble
The BoC researchers looked at survey data and concluded this trend was driven by a change of behavior during the pandemic. The end of the study ponders if this shift is permanent, and the consequences of what that means. There’s just one problem with that narrative — this wasn’t unique to the 2020s. Literally every real estate bubble sees this occur, and it’s called bubble contagion.
We talked about suburban home prices and bubble contagion last year, including the point regarding bid-rent theory. Taiwan-based academic researchers found that as bubbles get too large, demand (both real and speculative) is pushed further from the city center, out to the suburbs. Bubbles push prices so high, buyers think it’s their last chance to buy real estate anywhere near their city. This forces them to bid up whatever they can afford, disregarding premiums typically paid for amenities. The only perceived risk is not owning a home.
Yes, the pandemic did help to accelerate this trend — but that always happens. “… abnormal demand shock qualifies as a bubble,” reads the bubble contagion study.
This is likely due to the circumstances that create excessively low capital outruns productive income growth. As we show in the following video diving through newspaper archives, a justification for why people are leaving the city center is always seen.
It doesn’t matter if people all of a sudden really, really want to buy a home because of low rates. An increase in price that’s abrupt and not ground in a change in local market fundamentals isn’t a rational price movement.
The researchers found that typically as bubble contagion disburses higher prices, the narrowing gap isn’t always warranted. Suburban prices that narrow from the city typically represent larger bubbles, making them prone to larger home price corrections. Essentially the speculative prices these homes trade at go through price discovery, finding out what the discount should be with normalized credit conditions.
Was this time different? It’s always the same trajectory, but justified with different reasons.