Fertsman Analytics

How Canada can build more homes without higher housing costs - report

efertsman@gmail.com (Erik Fertsman) — Thu, 09 Nov 2023 14:43:58 GMT

Over the last decade, the cost of housing in Canada has risen so suddenly, and so rapidly, that it has caused a housing affordability crisis in most areas of the country. Governments are now starting to realize that solving this crisis will require building more homes, and faster than ever before. The Canada Mortgage and Housing Corporation (CMHC) estimates that Canada must increase the number of homes across the country by 3.5 million by 2030, on top of what is already expected (optimistically) to be built in order to restore housing affordability. CMHC also estimates this will require additional investments of $1 trillion or more.

But how can Canada build this many homes when the increased levels of investments - particularly bank mortgages - that are needed to build more housing have consistently led to higher housing costs? How do Canadian governments deal with this Gordian knot?

We've prepared a report that tackles these important questions, and it's available for download at the link below. This report outlines the main cause of the Canadian housing affordability crisis (an imbalance between bank mortgages and housing supply) and how governments across Canada can respond. We hope that you will find it interesting and informative enough to spread the word and engage with your local member of parliament (MP) and your local member of the legislative assembly (MLA).

If you have any questions or comments, please reach out to us on our contact page or on X (formerly Twitter) .

ADVERTISEMENT - ARTICLE CONTINUES BELOW

A disaggregated credit model of mortgage rates: forecasting the price of Canadian real estate loans

efertsman@gmail.com (Erik Fertsman) — Tue, 15 Sep 2020 17:15:44 GMT

Mainstream analysts usually say that interest rates on mortgages and home prices are inversely correlated. When interest rates fall, home prices rise. This relationship has little evidence behind it, unfortunately. So, we took a hard look at how things actually work and found that interest rates on mortgages actually lag mortgage credit growth (and, by extension, home price growth) by about 12 months. Causality is reversed in the sense that credit growth drives credit costs (interest rates). This makes much more sense and allows us to forecast rates on mortgages.

ADVERTISEMENT - ARTICLE CONTINUES BELOW

As you can see on the charts above, the statistics for average mortgage rate growth (for both insured and uninsured markets) and mortgage credit growth have a positive relationship when the former is lagged (if you don't lag it then there is no obvious relationship). The statistical correlation can be validated by what actually goes on in the real estate/mortgage world. Mortgage issuers tend to raise rates when there's a huge influx of demand. The cost of credit is like anything else that is at least somewhat rationed: when demand is high and folks pay, prices can be raised.

As of this month, our model suggests that average residential mortgage rates in the insured and uninsured markets likely bottomed out in August 2020 around 2.5% and that we'll probably see average rates rise marginally to around 2.8% in February 2021. Average rates will probably fluctuate between the 2.5% and 2.8% between now and June 2021. This model assumes market conditions remain the same as the previous 6 years. Where rates go from there depends a great deal on growth in the mortgage market.

If you found this article/model interesting, you may also like our home price model .

Cover image by: Alvaro Reyes via Unsplash

* The model and forecast presented in this article is for informational purposes only and does not constitute as investment advice or inform any purchase of financial products or real estate. Please consult with a registered professional before making any investment or purchasing decisions.

A disaggregated credit theory of home prices: explaining Canada's real estate bubble

Wed, 05 Feb 2020 21:59:56 GMT

Over the last 20 years, real estate prices across Canada have gone up by over 236%, but during that time the average weekly wage only increased by 75%. It's obvious that Canada is facing a real estate bubble.

For a while now experts have attempted to explain the cause of the bubble. From foreign money to supply issues to low interest rates, several theories have been put forward. However, many of these explanations - especially those considering interest rates - have fallen short, either because there's a lack of evidence or because they are based on questionable assumptions. What's more, the recent resumption in home price growth, despite the implementation of government policy designed to solve the issue, casts doubt on the degree to which public officials understand the underlying cause of the real estate bubble.

To fill this gap, we use an explanation of home prices that is linked to mortgage credit issued by commercial banks. In this article I present evidence that not only helps us better understand Canada's real estate bubble, but more importantly, offers some insight on how to solve it.

ARTICLE CONTINUES BELOW

Explanations for the real estate bubble

Specialists often attribute the rapid price rises in Canada's real estate markets to speculative activity and foreign investment. They also point at increasingly lower interest rates on mortgages, which are thought to have made home ownership more appealing to consumers. More recently, housing supply issues have been blamed. The Bank of Canada blames "froth" when discussing the housing market.

Over the last couple of years we've had a chance to see how these theories perform through various government programs aimed at increasing housing affordability across Canada. In 2016, a foreign buyers tax was introduced in the province of British Columbia to contain speculative investments and laundered funds from going into the housing market. Meanwhile, in Ontario, the province setup the Fair Housing Plan, which put into place a number of things such as rent control, a non-resident speculation tax, a vacancy tax, a 5-year plan to build rental apartments, among other things. Most importantly, the Office of the Superintendent of Financial Institutions (OSFI) introduced and then bolstered the B-20 Guidelines by levying stress-tests on uninsured mortgage products (a huge chunk of the mortgage market). This stress-test qualifies mortgage applicants at interest rates that are higher than those posted by the market. The finance ministry also introduced programs that provide interest and principal-free loans to first-time home buyers that can be used as a down-payment.

Recent data show that national home prices are increasing once again and have broken previous all-time highs. Toronto's market is growing again, with prices increasing by 4.48% on a year-over-year basis in December 2019. Even markets in Western Canada like Vancouver and Calgary are starting to stabilize despite weak economic conditions. Canada's home price-to-rent ratio remains higher than that of the US prior to the housing crash of 2007-2008. Meanwhile, UBS's Global Real Estate Bubble Index still ranks Toronto and Vancouver within the top 5 cities in the world at risk for a housing bubble crisis. Many Canadian households continue to spend over half of their after tax income on housing. It is important to note that the initiatives introduced since 2016 remain in place.

The problem with conventional approaches

One reason why government policies have been ineffective at containing asset price inflation in the real estate market is because they rely on conventional assumptions that do not sufficiently account for the underlying cause of home price growth in Canada. In terms of speculation and foreign cash, according to Statistics Canada, the majority of residential property owners in Canada are individuals and residents of Canada (95.5% in Ontario, 92.7% in British Columbia, and 92.1% in Nova Scotia). In terms of supply, over the last 10 years, Canada's unabsorbed new construction inventory has been growing. This at least partially eliminates speculation, foreign cash, and supply problems as sufficient probable causes of Canada's real estate bubble. If speculation or foreign cash was a problem, we would see much more ownership concentrated in the hands of corporations or at least non-residents, for example. If supply was a problem, we would see low unabsorbed new construction inventory levels across the board.

In terms of interest rates, they are not correlated with home prices the way most think. I have put together two charts above that capture the relationship between interest rates and home prices. I use data from Statistics Canada (see the charts above) for the period between November 2011 and December 2018. I have also lagged interest rates by 12 months to better "fit" the data and simulate potential real world effects.

Recall that some believe low interest rates are the cause of high home prices, which implies an inverse correlation. By this logic, home prices can be understood as a function of mortgage interest rates , and we should be able to see positive home price growth when interest rate growth is negative . However, based on the charts above, this theory does not hold. In the scatter plot chart there is a strong positive relationship between interest rate growth and home price growth. This is easily observed in the line chart above. (I have also observed the data by not lagging interest rates, but the correlation is zero. In other words, there is no identifiable relationship between interest rates and home prices when rates are not lagged by 6+ months.) According to the data, lower interest rates are associated with lower home price growth and vice-versa. In fact, a 20% increase in interest rates is linked to as much as 4% growth in home prices. This goes contrary to conventional thinking.

So, why are we drawing conclusions about home prices by looking at interest rates?

The causal role of residential mortgage credit

We consider home prices to be a function of mortgage credit quantities in dollar terms, rather than the cost of the mortgages per se . Mortgage statistics can tell us how much people are spending on real estate because the overwhelming majority or real estate transactions involve a mortgage. And a mortgage is simply credit that is created by licensed commercial banks and sold at interest for the explicit purpose of purchasing a home via a deposit (money). It's a favourable measure of spending on real estate.

Above, you will find two charts that capture the relationship between residential mortgage credit quantities (in Canadian dollars) and home prices (as measured by Statistics Canada's home price index). Because the majority of deposits attained from a mortgage are spent on real estate transactions, we can safely assume that residential mortgage credit has an effect on the residential real estate market (the Statistics Canada home price index is a measure of prices in this market).

Recall that we conceive of home prices as a function of mortgage quantities. On the charts we should be able to see a a positive increase in home price growth when there is a positive increase in residential mortgage credit growth. In other words, more mortgages in dollar terms should result in higher home prices in dollar terms, as well as the other way around. As you can see on the charts above, the relationship holds. In the scatter plot chart there is a strong positive relationship between residential mortgage credit growth and growth in home prices. This is also observable in the line chart. Moreover, there is no lag in the data! On average, a 6% increase in mortgage credit on a year-over-year basis should result in over 2% growth in Statistics Canada's home price index on a year-over-year basis.

We can now begin to better understand why home prices are breaking highs in December; mortgage credit grew by over 5% (rates on mortgages are still dropping though!). Taxes and other government policies had no overall effect in calming home price inflation since they didn't address mortgage credit growth (if anything, Trudeau's first-time home buyer program likely contributed to higher mortgage growth since it lowered a barrier to entry). Accounting for the role of bank-issued mortgage credit is crucial. We now have evidence that growth in mortgages leads to predictable consequences on the growth of home prices. The interest rate on the mortgage matters to the extent that it prevents or enables someone to get a mortgage, but if we want to clearly understand prices we need to look at credit quantities.

The causal role of residential mortgage credit

So, what should governments do? The information above can be used to craft clever policies that reduce the risks that have built-up in the real estate market. The immediate solution would be to curb commercial bank mortgage originations. A limit of mortgage credit growth would decrease the flow of newly created deposits (money) from going into the real estate market. This would have the effect of lessening the pool of money that is inflating home prices. From there, banks can focus on lending into other sectors of the economy, like the business sector in order to produce good jobs with high wages (the impact of bank-issued commercial loans on wages is similar to the effect of mortgages on real estate). Those wages can then be used to fund home purchases, rather than using bank credit.

Existing deposits (wages) are far less inflationary than credit (newly created deposits). Governments need not be weary of other sources of money that are going toward home purchases since the majority of home transactions are facilitated via a mortgage. Outstanding residential mortgage credit comes in at over $1.22 trillion Canadian dollars as of December 2019. To put this into perspective, there were only $2.07 trillion in deposits (money sitting in chequing accounts) that same month. Over half of all money in existence in Canada's banking system was created through real estate transactions. Policies that target the source of this money creation - bank mortgages - will be very effective.

Ultimately, it would be up to elected officials to decide how strict the limits on mortgage originations should be. But many challenges exist to any such approach. First, mortgages compose over 40% of total commercial bank assets (loans); nearly half of the banking industry earns fees and interest from mortgage activity. What's more, other financial products like home equity line of credits (HELOCs) tend to rely on ever increasing home prices . Secondly, somewhere between 10% to 20% of Canada's GDP is composed of transactions affected by mortgage activity. To make matters worse, over 50% of mortgages are insured by the federal government. So, it's unlikely that governments and banks are incentivized to embrace any policies that limit credit expansion, at least not until it's too late. This is the world we've created.

Cover image by: Markus Spiske via Unsplash

Why bank credit is the predictor of home prices, not interest rates

Tue, 13 Aug 2019 17:40:40 GMT

Money is cheap these days in advanced economies, and I mean really cheap. Unlike 20 or 30 years ago, you can now get a real interest rate of 2 to 4 percent on pretty much any big ticket item. Homes are being financed for these kinds of rates, businesses are tapping into loans at these prices, and consumers are often able to finance a brand new car purchase at zero percent, that's even lower! Unsecured personal lines of credit can hover around 5 percent.

Even though interest rates for companies and consumers are basically hovering closer to zero than at any previous moment in time, there's confused as to why our economies are experiencing weak growth. Lowering interest rates is supposed "spur" economic growth, according to economists, pundits, and economic textbooks. Current logic dictates that cheaper money encourages people to spend more on goods and services, invest in productive business (because you're not going to get much of a return holding your money in a bank account), and help those with high debt-to-income ratios with their spending.

The gap between the logic and reality is big. Borrowing money for a car costs nothing these days, but car sales have been declining since 2013. Gross domestic product (GDP) in all advanced economies is coming in quite shy of historical performance, when double digit economic growth coincided with double digit interest rates. In Europe, rates have gone negative, but European economic growth continues to contract. Folks are now saying that the latest round of interest rate cuts in the US are not spurring growth in the US housing market.

Article continues below.

The weird situation in the Canadian housing market

The situation is even weirder in Canada, where low rates over the last two years have not helped a consolidating housing market. So, what the heck is going on? Shouldn't lower interest rates help more people buy a home and boost prices?

Home prices in Canada have been contracting, as measured by Statistic Canada's new home price index. This is the first time home price growth has entered negative territory since late 2009. See the chart below:

Home prices are now contracting, but interest rates remain historically-low. In fact, b ased on the chart above, housing price growth almost seems correlated with interest rates (you can see growth going down as interest rates trend down between 2009 and 2016). Admittedly, this is a head-scratching situation for any housing analysts, and maybe even for folks who are just trying to figure out if they should buy a home.

But, wait, what's that gray shaded data that looks like mountainous terrain on the chart? That's residential bank mortgage growth. More bank mortgage growth means more bank money has been lent out for the purpose of purchasing a home. Over time this growth has exploded, and so now we've ended up with a massive dollar figure. Total outstanding bank mortgage credit across Canada is now measured in the trillions! As it stands, about 1/3 of all bank credit issued in Canada has gone toward home purchases.

What's interesting is that Canadian housing prices have typically grown in lockstep with residential bank mortgages. In fact, from the chart above we can see that home price growth is correlated with bank mortgages, much more so than with interest rates.

How interest rates are poorly correlated with home prices

The correlation between home prices and interest rates is quite awful. And if you're working for a company or organization trying to figure out where things are heading based on the cost of credit, you'll likely end up with no answer.

Drawing on CMHC's 5-year conventional mortgage rate and Statistics Canada's home price index for the last 3 years, the relationship between interest rates and home prices is nonexistent in the data. Using a scatter plot chart, we see that there's an r-squared value of 0.302, which indicates little to no relationship between the two variables. The line running through the chart is also not representative of what conventional thinking tells us about interest rates and home prices. The line is supposed to run downward if higher interest rates mean lower home prices. Instead, the line of "best fit" seems to be telling us that there's a positive correlation, where higher interest rates are matched with higher home prices.

Basically, looking at mortgage rates as a factor in determining home prices over the last three years has been confusing, at best. But the Bank of Canada and other Canadian agencies have decided that interest rates are an effective tool to "steer" the home market anyway. Even the Trudeau's government thinks a first-time home buyer program that will offer a zero percent and principal-free loan will help boost home prices. It might, but according to the data, not because it's interest free.

Article continues below.

How mortgages are significantly correlated with home prices

With the latest data on home prices from Stats Can showing quite the deterioration in growth, it's worth pointing out that there's actually a correlation between residential bank mortgage credit and home prices. Below is a chart that uses Statistics Canada's national home price index and total national residential mortgages issued by the commercial banks.

Canadian Residential Bank Mortgages and Canadian National Home Price Index (Stats Can) - June 2016 to June 2019 (monthly)

Source: Fertsman.com | Statistics Canada

An r-squared value of 0.92 is a much more robust figure than the one we got for interest rates. Here, we can see how the quantity of mortgage credit measured in Canadian dollars is positively correlated with home price growth. Bank mortgage credit statistics explain growth to a statistically significant degree.

The thing that I hope you take away with you after reading (or listening to this article) is that interest rates don't steer home prices, bank credit quantity does.

Cover image source: Jon Cellier