Housing affordability getting worse even though prices are falling.

Conventional wisdom states that falling prices should improve housing affordability.

Though the logic is appealing, Canadian housing markets paint quite a different picture, with housing affordability worsening even though average housing prices have fallen.

Unlike many other assets classes, housing markets are complex and heterogeneous, with no two homes (or buyers) being identical. As a result, the housing market does not necessarily follow the typical wisdom of markets.

Recent housing market data and research reveal that affordability eroded in Canada even as prices have tumbled.

The reason for this anomaly is that housing affordability only partially depends on prices. Regulatory changes also play a large role in determining housing affordability.

A report by RBC Economic Research reviewed housing affordability in the third quarter of 2018 and concluded that it was “getting less affordable to own a home in Canada.”

The report tracks the income required to cover the cost of owning an average home with a 25 per cent down payment. When compared with the third quarter of 2015, the qualifying income had increased significantly by the third quarter of 2018.

In Vancouver, for instance, the income required to cover ownership of an average home was $211,000 in 2018, up from $127,000 three years ago. The qualifying income in Toronto was $187,000 in 2018 compared to $103,000 in 2015. In fact, the qualifying income had increased in all large and small housing markets across Canada.

One big reason for the higher qualifying income required in 2018 was the increase in housing prices since 2015, a rise that was most pronounced in Greater Vancouver and Toronto.

Qualifying incomes, therefore, increased by $34,000 in Vancouver and $27,000 in Toronto since 2015 as a result of higher prices, the RBC report estimated.

But rising prices were not the only factor. Even without their impact, the qualifying income would have climbed considerably because of the stress test that required the borrowers to qualify at a higher interest rate than the contracted rate as of January 2018.

The RBC report estimated that the increase in qualifying income due to the stress test was almost the same as the one resulting from the increase in housing prices.

The stress test raised the qualifying income threshold by $36,000 in Vancouver and $27,000 in Toronto.

It also didn’t help that mortgage rates also increased over the same period further raising the bar to qualify for home ownership.

The RBC Economics Report illustrates the peculiarities of housing markets where price alone does not determine the affordability of an asset. Certainly, the increase in housing prices eroded affordability. However, equally instrumental were the regulatory changes (stress test and mortgage rates) that also erected huge affordability barriers.

The impact of the stress test is further illustrated with data from Toronto where housing prices rose sharply from 2015 to the first quarter of 2017. Tor o n t o’s housing market experienced two regulatory shocks. The first shock came in April 2017 when the Ontario government imposed new taxes on foreign homebuyers. The immediate impact was a decline in sales and prices. The second

TORONTO MARKET

30% 24% 18% 12% 6% 0% 2015

THE REPORT TRACKS THE INCOME REQUIRED TO COVER THE COST OF OWNING AN AVERAGE HOME WITH A 25 PER CENT DOWN PAYMENT.

shock came in January 2018 when the stress test was imposed.

Toronto’s sales data reveals that the share of the market taken up by the least expensive homes (those sold for less than $400,000) declined as housing prices increased.

For instance, 30 per cent of the homes sold in 2015 transacted for less than $400,000. By the first quarter of 2017, when housing prices peaked, the share of low-priced homes accounted for a mere 12 per cent of the transactions.

As the housing prices slid in Toronto as of May 2017, the share of homes that transacted for less than $400,000 increased slightly and represented 13 per cent of the total transactions for the rest of 2017.

However, the share of low-priced homes in 2018 declined from 13 to 9 per cent (a 31 per cent drop), which took place even when the nominal average

home price in Toronto declined from $822,681 in 2017 to $787,300 in 2018, and $766,197 in February 2019.

Again, the conventional wisdom would have dictated an increase rather than a decline in the share of low-priced homes that attract low- to moderate-income households. But that didn’t happen.

The stress test and the increase in mortgage rates increasingly affected the affordability of low-income households and priced them out of the market even when house prices were declining.

Housing affordability will improve with a decline in home ownership costs, which will require regulatory changes in the short run and greater housing supply in the long run.