Canada’s real estate bubble is popping, and another indicator is flashing a warning. Residential investment as a share of GDP fell again in Q3 2022, after peaking a year before. Such a large drop in housing investment has only ever preceded the popping of a real estate bubble. Central bank research also indicates real home prices are likely to fall until 2025, lining up nicely with prominent forecasts.
Residential Investment Is Great Until It Swallows Your Economy
Residential investment is the contribution to GDP made by housing investment. It includes new housing construction and major renovations, as well as some services. It’s the most direct contribution to GDP, but far from the whole impact. Related industries like finance and construction are strongly influenced by housing too.
Residential investment growth is great, until it consumes your economy. A rising share of GDP means it’s outpacing general economic output. That’s a sign of a real estate bubble, since excess growth is sunk into a non-productive asset. Non-productive means it doesn’t provide more goods or services, regardless of cost. It could cost a nickel or $1 million, but it does the same thing for output.
The US Housing Bubble in 2006 is the best known example of housing consuming GDP. Residential investment peaked at 6.7% of GDP in 2006—nearly 1 in 15 GDP dollars. It fell sharply after the correction kicked off, falling to nearly 2% by 2010. An economy is more dependent on real estate as this surges, increasing the risk of shock. Countries don’t want a significant share of their economy to be just warehousing people.
Sharp Drops In Residential Investment Precede Sharp Corrections In Home Prices
The BIS, a central bank for central banks, produced a working paper confirming this. They found residential investment surged relative to GDP before spikes in home prices. A decline in the share is typical of real home price growth decelerating. On average, they found a recession occurs 2 years after investment contracts. Home prices also fell for an average of 4 years, according to an analysis of dozens of recessions.
What about cuts to interest rates? Rate cuts during steady investment periods have historically sent home prices surging higher. That’s due to the impact of pulled forward demand, but the impact is different post-bubble. The BIS found rising interest rates are associated with lower residential investment. However, the opposite wasn’t statistically significant.
Why it fails to stimulate home price growth was outside of scope for the research. They speculate reluctant sellers avoiding price drops to a sufficient level prevents the cycle from completing. If prices fell sufficiently, a faster growth cycle would then follow once again.
That said, on to Canada’s latest data.
Canada’s Economy Was More Dependent On Housing Than The US In 2006
Canada’s residential investment is falling almost as fast as it increased. It represents 6.7% of GDP in Q3 2022, down 0.4 points from the previous quarter, and 0.9 points lower than last year. It remains at a level that was thought to be unusually high for the US, but it’s coming down sharply.
Canadian Real Estate Might Not Bottom Until 2025
It’s not just interest rates either. The share of residential investment peaked at 8.7% in Q1 2022, and fell 1.1 points in the year leading up to rate hikes. Annual real home price growth peaked one quarter after, according to US Fed research. A ballpark estimate using average timelines in the research would see a recession next quarter, and real home prices fall until 2025. The former is easier to see than the latter.
Canadian Residential Investment Vs Real Home Price
Canadian residential investment as a share of GDP compared to the annual percent change in real home prices.
*correction period is peak to trough for real home prices following a real estate bubble.
Source: Statistics Canada; US Federal Reserve; Better Dwelling.
Canada’s Real Estate Bubble Typically Pops With A Drop This Big
How does this hold up historically? Canada had two major real estate bubbles with sharp corrections—one in the early ’80s and early ’90s. The early ’80s bubble saw residential investment peak in Q2 ’81, and home prices a quarter after. The correction lasted peak to trough for nearly 4 years, close to the average.
The ’90s real estate bubble saw residential investment peak in Q4 1989. Real home prices followed two quarters later, before a correction in ’96. Nearly 7 years of sliding prices until the market returned to growth.
No two corrections are the same and the timelines are based on averages. In the ’80s, the correction was slightly under the average and the ’90s was much longer. However, an average length correction is what prominent forecasters are calling.
Global macro forecasting firm Oxford Economics sees home prices bottoming in mid-2024. RBC’s model shows the deepest correction in history, with prices bottoming in 2025. They used different models but came to similar conclusions on timeline. But maybe that random real estate agent that said rates can’t rise is right and home prices will rise this year.