The call is coming from inside the House. Canadian real estate is significantly overvalued, according to the government’s own research. A new report from the non-partisan Parliamentary Budget Officer (PBO) dropped this week. It looks at housing affordability, and is meant to give policymakers a primer on the issue. The report concludes real estate prices grew far more than income and credit. By their calculations, some markets are now over 50% overvalued with many more just under that. The agency warns this will make households vulnerable to economic shock.
Canadian Real Estate Markets Are Up To 50% Overvalued
The PBO’s report on housing affordability shows home prices are significantly overvalued. They found Toronto, Hamilton, Halifax, and Ottawa were over 50% overvalued in December. Home prices have advanced tens of thousands of dollars since then as well
Canadian Real Estate Overvaluation
The estimated overvaluation of a composite benchmark home based on the attainable price credit should allow. Positive numbers indicate an overvaluation, while negative numbers show under undervalued markets.
Source: PBO; IMF; Better Dwelling.
Even more Canadian cities were significantly overvalued, just not as much as Toronto. Prices in Vancouver, Montreal, and Victoria were between 30% and 45% overvalued as well. These are massive overvaluation numbers that only look small compared to Canada’s world-class bubbles.
Canadian Home Prices Rise Above Credit After 2015
Canadian residential real estate prices began to outgrow credit over six years ago. The PBO calculations show credit and income no longer explain prices after 2015. “In early 2015, house prices in most CMAs were below, or close to, affordable levels based on normal utilization of its borrowing capacity,” writes the PBO.
After 2015, Canadian real estate prices began to really take off. It consistently outpaces credit growth, and then accelerated when the pandemic hit. Low rates are often the fuse that kicks off a buyer exuberance spree. Other factors also contribute to this kind of behavior, such as seeing large profits.
The Bank of Canada (BoC) recently called out the market’s exuberance. They said buyers are now paying higher prices, because they expect them to always grow. It’s a classic hallmark of a real estate bubble to explain growth based solely on expectation.
Speaking of real estate bubbles, PBO findings are consistent with the Federal Reserve. The US central bank’s Exuberance Index also shows Canada’s real estate bubble began in 2015. There’s been a brief break in the trend, but it shows fairly persistent froth.
Canadian Home Buyers Are Vulnerable To Shock
High home prices are pushing Canadians to the limit. The PBO stresses household budgets are approaching their maximum at the national level. “House prices that exceed affordable levels imply that a household is stretching its finances and borrowing capacity, increasing its vulnerability to adverse economic shocks,” said the PBO.
The PBO used mortgage debt servicing capacity to determine most of the country is at its upper limit. Pricey cities like Toronto and Vancouver are way above their upper service capacity. The stress test increases durability against shock. However, the larger the regular payment the more difficult it is to absorb the cost. “While approximate in nature, our results suggest that household financial vulnerability is elevated in several CMAs for households that have recently purchased homes,” they add.
Higher interest rates are a concern for the PBO, in particular for new buyers. They warn reduced credit capacity will impact affordability even further. It’s a traditional conclusion, but at odds with recent research. BoC staff research shows home prices respond to credit capacity. The central bank concludes they moved the wrong way for housing affordability for the past 30 years. Whoops!
The PBO Uses An Odd Timeline To Agree With The Government’s Existing Affordability Solution
The PBO suggests more supply is the solution to higher home prices, but in an odd way. To determine this, they compare the number of houses and people, as though one person equals one home. They also curiously used 2021 data for prices, but only 2019 data for new home completions. It feels like an oddly intentional conclusion to reinforce the one they started with.
If the PBO used 2021 data, they would have seen what banks like BMO have been saying. A near-record amount of completions and slow population growth didn’t slow prices. The opposite happened, with prices rising even faster and growing like never before.
Further, there are so many homes under construction in Canada it’s become inflationary. Material shortages, despite record production, are experiencing a squeeze. Ditto for labor, which has seen costs rise 20% over the past two years. This is resulting in more expensive homes due to rising construction pressures.
Big Six banks are increasingly saying, breaking speculative psychology is the only solution. Once the BoC raises interest rates, they also expect more inventory to hit the market. That isn’t to say building should slow, but the impact demand has on price can’t be properly assessed without efficient market credit.
About Today’s Data
There are a few noteworthy points about the PBO report that need a bit of an explanation. The first is, they say “average price,” but they actually used the CREA composite benchmark price. A composite benchmark is a weighted average adjusted for type, size, and quality. It seems this was just a terminology error on their part, but the mistake actually created a higher quality analysis.
The size of the down payment assumed is also astronomical. They use a household average of 67% loan-to-value (LTV) at originations in their math. That implies people put 33% down, which is very ambitious for new buyers. The LTV average across the spectrum is boosted by people who can leverage an existing home.
Without the frothy valuations transferred over to the down payment, it’s a lot harder to do. Bluntly put, housing might actually be much less affordable than stated. Probably not what you think of when they do an affordability analysis.
Language is also worth diving into a little further. The PBO uses the term “above affordable levels” instead of “overvalued.” It’s an IMF model, and the IMF used the term “overvalued” when discussing it with us when it was first created. The term overvalued is an objective and non-political term, so that’s what we use.
The PBO is non-partisan but still plays politics like other government agencies. Canada measures the same data points as other countries, but often softens the language. This results in Canada having unique and industry-friendly lingo that’s inconsistent with more direct international terms.
For example, Canada doesn’t have “vacant” homes but homes “not occupied by a usual resident.” Foreign buyers are a myth, but non-resident purchasers of housing exist. Money launderers are probably now referred to as global liability reduction money managers. We stick to the international and objective terms used by the agency. Sorry, eh.