It’s a housing bubble in Toronto, not a supply squeeze

Last month, the average house price in Toronto was up 16.7 per cent vs. March 2020. This was an acceleration of a trend in which Toronto house prices have risen 10 per cent a year over the last five years. A house that cost $521,300 in 2014, now sells for $1,007,600. Over these six years, median household incomes rose at only four per cent per year. Is there a bubble in the Toronto ownership housing market? Or is it a supply problem?

Former Fed chairman Alan Greenspan said you can only identify a bubble after it bursts so maybe we won’t know for sure until that happens — if it ever does. But let’s try.

Many economists argue that a bubble exists when price increases cannot be explained by market fundamentals. A market-fundamentals analysis would examine how important influences on housing demand and supply have changed and then calculates what that implied for house prices.

Consider demand first. From 2014 to 2019 the population of the Toronto “census metropolitan area” grew by 7.7 per cent, which certainly increased demand. At the same time, median household income rose 20 per cent, boosting it further. On the other hand, mortgage interest rates, after a slight fall in 2015, moved up steadily up over the period, as did property taxes and insurance and heating costs. As a rough estimate, the carrying cost per dollar of house price rose about two per cent per year. Combining all these influences suggests demand was probably higher by about 18 per cent.

Then COVID-19 hit. A severe lockdown was imposed. During the second quarter of last year, Ontario’s GDP fell 12.2 per cent, while unemployment soared to 13.5 per cent. Yet the demand for home ownership kept growing. Toronto’s population growth did slow but the Bank of Canada dropped interest rates to all-time lows and mortgage interest rates followed suit. Both because GDP bounced back strongly after lockdowns were eased and because governments provided massive financial support to individuals and businesses, household disposable income actually rose in 2020, contrary to most people’s expectation.

The increase in demand goes beyond these influences, however. Households appear to believe work-from-home will continue after the pandemic, for a day or two a week but maybe even more. Households who think they will be spending more time in and around home want space for a home office and other amenities.

If on balance we assume demand has risen by about a quarter since 2014, what would a market fundamentals analysis say should have happened to price? In the very short run, the supply of housing is quite unresponsive to demand. Over the long haul, it can be very responsive. For the six years we’re considering, it’s probably something in between. The costs of labour, building materials and land do rise as supply increases but they don’t rise infinitely. Using estimates of their responsiveness from the economics literature, the market fundamentals analysis predicts house prices should probably have risen about 12 per cent in Toronto since 2014. In fact, they rose 93 per cent. The 81 per cent that market fundamentals can’t explain is likely bubble.

This analysis simply assumed a supply response. But what actually happened on the supply side in the Toronto housing market? A total of 230,210 “dwelling units” were completed over the six years. Population had increased by 556,470; assuming household size remained at 2.8 persons, the population increase required 198,740 new units. The supply of new units was more than enough to accommodate the growing population. Moreover, the housing stock was further augmented by renovation and by tearing down old houses to be replaced by larger new houses, both of which have been booming in Toronto. Residential real estate investment, which includes both new construction and renovation, has been a rising share of GDP. There is thus no problem on the supply side of the Toronto market. Of course, more supply will reduce prices slightly, but the Toronto price escalation is not caused by supply problems.

Demand is growing steadily, supply is responding, but prices are soaring. What can explain that? If households are bidding more for houses because they believe prices will continue to go up in the future, that’s convincing evidence of a bubble. When prices go up next year, the very high carrying costs of this year will be more than offset by capital gains. Result? You will have enjoyed an increase in wealth. Suppose you had bought the average Toronto house in 2014 with 10 per cent down; by March 2021, your equity would have risen to $538,000, a tenfold increase. People are willing to keep paying higher prices because they believe prices will keep rising.

The delicate task for government is to dampen these expectations by tightening mortgage lending rules — and deflate the bubble without bursting it.

HOUSEHOLDS APPEAR TO BELIEVE WORK-FROM-HOME WILL CONTINUE.