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Interest rates are climbing higher, but some economists argue that an adjustment to rates won’t make much of an impact in the housing market without dealing with Canada’s chronic supply issue.
In a new In Focus article with CIBC Capital Markets, Benjamin Tal, managing director and deputy chief economist, and Katherine Judge, director and senior economist, explained why higher rates will not necessarily cure the ailing housing market. Already, higher borrowing costs have caused a reaction in the marketplace, but this will not cure housing affordability challenges. Instead, a market slowdown may just ease symptoms or “worsen the supply-demand mismatch in the market.”
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“[Entering] a more relaxed housing environment should not ease the urgency in which the chronic lack of housing supply in the Canadian market is dealt with,” said the In Focus report. “After years of fighting supply issues using demand tools, governments at all levels finally recognize that over time, the housing affordability crisis will worsen without adequate supply policies.”
So what’s at the root of the supply issue? Tal and Judge pointed to inaccurate methodologies used to form housing policies and the industry’s lack of capacity to meet provincial and federal housing goals as part of the problem.
Comparing Canadian housing to other countries too simplistic
When it comes to judging how Canada’s housing market is doing, comparing its performance to other countries could be too simplistic of an approach.
To paint the picture of Canada’s housing supply challenges on an international scale, a comparison is usually made between the housing stock and the population using the Organisation for Economic Co-operation and Development’s (OECD) database. This method was used for the 2022 Federal budget by comparing Canada to fellow counties. However, this juxtaposition can be over simplified since it can be diluted by differences in household formation and demographics.
“Furthermore, taking housing stock as a share of the population doesn’t account for differences in demographics or cultural preferences that shape household sizes or formation rates,” said the CIBC economists. “Nor does it account for the different propensity to rent, as countries with higher shares of renters generally have more abundant housing supply.”
Even comparing the Canadian housing market to the United States can still be inaccurate. As Judge and Tal point out, both countries have similar housing stock by OECD standards, but this doesn’t explain why Canadian home prices have risen twice as quickly compared to the U.S. over the past 20 years.
“These shortcomings of international comparisons suggest that it’s more informative to look at Canada’s housing market in isolation to determine what’s behind the market’s imbalance,” said the report.
Undercounting of households leads to inadequate picture of demand
When it comes to gauging housing demand, Tal and Judge explained that household formation is the key variable to measure, but these numbers tend to be inaccurate.
Household formation data is gathered by the Canadian Mortgage and Housing Corporation (CMHC) by translating population growth into the number of households using the quality of households created from a given number of people. However, information is being lost in that translation, which is resulting in a “gross underestimate of the real number of households in Canada, and thus demand for housing.”
“And if demand is undercounted, then of course the supply released by municipalities to meet that demand will be inadequate,” explained the report.
For example, Statistics Canada’s Demographic Division counts all expired non-permanent resident visa holders as having left the country 30 days after their visas’ expiration. However, during the pandemic, non-permanent residents with expired visas were allowed to stay in the country through extensions, meaning those individuals are not included in any official statistics, but still need housing. In another case, Tal and Judge stated that CMHC calculations assume the same headship rate for new immigrants, non-permanent residents and long-term residents.
By Tal and Judge’s guess, current housing demand is undercounted by 500,000 households.
Industry faces limitations to meet promises for housing
By undercounting the demand for housing, the Canadian supply issue “is real and needs attention.” While there is no lack of ideas to create housing, not enough attention is being paid to the fact that the industry’s means to reach higher housing targets is limited, Tal and Judge explained.
One prong of the issue is the increase in the average time for construction completions.
“It takes twice as long to complete both low-rise and high-rise units today than it did two decades ago. And a lack of labour supply is a major cause of those delays,” said the report. “While large developers are usually able to secure their own labour pool, that’s not the case for mid-sized and small operators that account for 30 to 40 per cent of activity.”
Large-scale infrastructure projects have increased competition for labourers, a challenge that has been heightened thanks to shortages caused by COVID-19. Employment in the construction industry didn’t reach pre-pandemic levels until January 2022, much slower than residential investment, which recovered by Q3-2020. Meanwhile, few of the 400,000 new immigrants that arrived last year worked in construction.
Higher costs to build, supply chain disruptions and higher fuel prices have also contributed to construction costs during the pandemic. Since 2015, the cost of construction in Toronto has jumped 46 per cent while the price of a new condo unit has increased 42 per cent.
“That narrowing in profit margins is starting to impact supply by making developers think twice before committing to projects. Higher interest rates will add to development costs, while at the same time it will work to reduce demand,” said the economists.
“Without a dramatic reduction in the cost of construction, look for overall new supply to soften notably in the near future,” they added.