Pathways to Affordability for Canada’s Housing Market
You would need to go back to the era of double-digit mortgage rates in the early 1990s to see the last time buying a home in Canada was as expensive as it is today. The workout last time involved a major price correction followed by a long period of stagnation. Is there a less painful route back to affordability this time, and, if so, how long will it take?
Underlying demographic, interest rate and income fundamentals have dictated housing valuations, or ‘affordability’, over time. Chart 1 shows that the current state of affordability in Canada has deteriorated sharply from what were reasonable pre-pandemic levels and is now stretched to the worst limits in over three decades. With the construction industry effectively operating at capacity, the deterioration reflects a multi-pronged demand crunch due to:
The peak of the millennial cohort is in their mid-30s, and there are 8.7 million people in the 25-to-39 age bracket. These are prime household formation years that drive demand, particularly for single-detached homes. Policy, however, has pushed intensification and (ever-smaller) multi-unit properties for over a decade.
International immigration has risen from about 450,000 per year before the pandemic to almost 1.2 million people in the past year. This is a historic demand shock that presents a challenge to infrastructure, including housing. We maintain that the long-run benefits of a robust immigration program are significant; and builders have shown an ability to meet the housing demand arising from our ambitious permanent resident targets. But, more than 800,000 nonpermanent residents in the past year have clearly been difficult for the market to absorb and are inconsistent with Canada’s ability to provide adequate supply.
Interest rates were cut to historic lows before the Bank of Canada began tightening policy in March 2022. Deeply negative real interest rates drove outsized gains in house prices, which bred speculative psychology (FOMO) in the market. This drove prices well in excess of underlying fundamentals. Higher interest rates have since broken this psychology and pulled average prices down by 15% nationally and by 20% or more in some markets. Yet, affordability hasn’t really improved due to higher mortgage rates, and won’t improve until rates fall and prices either drop further or rise very slowly, allowing incomes to catch up.
The high cost of ownership is keeping home sales in the tank (Chart 2) and creating a nation of renters. More households are leasing which, along with surging immigration, is causing rents to accelerate. Downsizing baby boomers are competing with younger millennials and Gen-Zers, many of whom can’t afford to buy their parents’ home and are wondering when they can get a foot on the housing ladder.
Of course, the location of the ladder matters. The country is largely divided between super-pricey British Columbia (especially Greater Vancouver, Victoria, and the Fraser Valley) and Ontario (notably Greater Toronto and Southwestern Ontario), and the still-reasonably priced Prairie Provinces, Atlantic Canada and Quebec. This regional dichotomy is shown in Table 1. For the median income family looking to buy a typical property, mortgage payments would consume about a fifth of income in many areas and less than a third in several large cities, including Montreal, Ottawa, Calgary and Halifax. But that percentage jumps to nearly one-half in parts of B.C. and Ontario and more than two-thirds in Vancouver and Toronto. The regional split means that the quest to restore affordability is most acute for families in B.C. and Ontario, which are home to half of the national population.
Interestingly, this disparity in affordability is the key driver of migration flows within a province, or across provincial jurisdictions. For example, movement out of the core of Toronto toward smaller Southern Ontario cities; and out of Ontario or B.C. and into Alberta. Indeed, the affordability ratio in some of these destination cities today is similar to that of Vancouver and Toronto way back in 2001 when housing in Canada was exceptionally cheap (in relative terms). For many younger households that need space, this might be their only play.
Returning affordability to pre-pandemic levels is going to take either plenty of time or a significant adjustment in rates, prices, and incomes.
Our current base-case outlook (Chart 3) sees:
a gradual decline in five-year mortgage rates to around 4.25% from around 5% currently amid Bank of Canada policy easing but higher neutral rates, mostly flat home prices for the rest of 2024 before picking up to a modest 3% annualized pace through 2027, and sturdy per-capita income growth of just under 3% per annum, just below the two-decade norm.
In this well-behaved scenario, affordability gradually improves but remains strained even by the end of 2027. To get closer to normality by that time, prices would need to stall and interest rates would have to fall more materially.
For further context, an immediate return to ordinary affordability levels would require either:
at least a 2-ppt decline in mortgage rates to 3% or lower (taking it back to the unusually low five-year average prior to the pandemic), a roughly 15% further decline in prices (taking them back to summer 2020 levels and largely unwinding the pandemic bubble), or a roughly 25% jump in per-capita income levels.
The reality is that some combination of these factors will likely play out in the coming years, as per our base-case view. Unless there is a significant recession—which would restore affordability quickly, but painfully—the remedy will likely involve the interplay of home prices and mortgage rates. Barring a productivity resurgence, per capita income growth is unlikely to bolt higher. The corollary is that, if our base-case rate outlook proves correct, it could put a cap on how fast prices can rebound (Chart 4). We likely won’t see a repeat of the V-shaped recoveries that followed the financial crisis and pandemic. In any case, the early-2022 market highs are a long way off, barring an unwelcome return of FOMO sentiment.
Bottom Line: Given where we think rates, prices and incomes are going, a pathway back to housing affordability for long-suffering renters and young people, especially in B.C. and Ontario, is doable but will take time. Part of this is the result of past policy action/inaction; and part of it is just the circumstance that comes with the tail end of a major cohort moving up the age ladder. Recent policies aimed at speeding up construction (including of affordable units) and slowing population growth can only help.