If Canada’s biggest housing markets are bubbles, why aren’t they popping?

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Jordan Heath-Rawlings For years, these two Canadian cities were two of the world’s hottest housing markets. Then it was a little bit of a correction. Canada’s housing market is facing a historic correction that’s according to a new RBC report, the price of residential homes skyrocketed during the pandemic. But the major bank predicts the price of national homes will slump by 12% early next year. And now the question is, if it will go further than that, where do we begin? Toronto topping a list. Do we want to be at the top of this list? Let’s break it down. Nope. Nope. No. We are ranked as the number one city in the world for the potential for a housing bubble. Isn’t that just lovely? It is one thing to be declared a potential bubble and another thing entirely for it to actually pop. So is a housing collapse imminent in Canada, especially in Toronto and Vancouver? What makes a city’s housing market a bubble anyway? How dangerous would a dramatic drop in home values and prices be to people who have so much of their savings tied to that value? And on the other side, wouldn’t that decline maybe finally help some people who simply can’t afford a home get one? I’m Jordan Heath-Rawlings. This is The Big Story. Ari Altstedter is a reporter with Bloomberg who covers, among other things, Canada’s housing markets. Hello, Ari.

Ari Altstedter Hey, Jordan. How’s it going?

Jordan Good. Thanks for making the time for us.

Ari Altstedter No problem.

Jordan I want to start with what I think might be a simple question, but maybe sometimes gets lost in the terminology we toss around. So when we say that Toronto and Vancouver are among the biggest housing bubbles in the world, what is bubble technically referring to in that statement?

Ari Altstedter Right. Well, the tricky thing about a bubble is you don’t really know something is a bubble until it pops. But for the most part, a bubble refers to when an asset price, the price of any asset, really becomes inflated and out of whack with its fundamental value. And when that comes to the housing market, it really means that house prices are completely inflated compared to the economy, because house prices obviously have to be supported by the general economic condition of whatever market, whether it’s a city or a country, that they are a part of. And if they’re completely out of whack, then people say that they can be at risk of a bubble.

Jordan When we say that something is out of whack with their fundamental value, how do we determine what that fundamental value is? Isn’t a house worth whatever someone will pay for it?

Ari Altstedter I mean, that is true to a certain degree. I think if we’re talking about the housing market in particular, the economists look at it compared to, again, the economy. So are people earning enough money generally in that market? Are median or average incomes enough to support house prices where they are. That’s sort of one indicator people look at is there enough economic growth to warrant prices where they are. Often you look at rents, our price is completely inflated compared to what people are paying to rent a house, which is another part of the housing market. And so when the divergence between prices and all these kind of other indicators that theoretically we think should be supporting those house prices should underlie those house prices when they’re completely detached, people start saying, economists start saying this could be a risk of a bubble. So I mentioned Toronto and Vancouver.

Jordan The reason we’re talking today is a new report came out last week that kind of compared those two cities and many others in terms of how bubbly, I guess, for the want of a better term, that they are. So where do those two cities and where does Canada in general rank in terms of how bubbly our markets are?

Ari Altstedter Right, well, this was a report by the Swiss bank UBS, and they actually do this report every year. They’ve created a kind of measurement for how far house prices are detached from, again, these fundamental local economic conditions. They call it their house price Bubble index. This year, Toronto actually came out on top of all the cities they looked at in the world. Wow. The report doesn’t actually look at markets by country. They only look at markets by city as sort of a mantra in the real estate market, that all real estate is local. Real estate is so shaped by local conditions, sometimes even a neighbourhood or a street can impact the value of a house. But UBS looks at each year, they look at cities, housing markets around the world, and measure the house prices there, compared to a few of these more fundamental economic indicators that usually should be more determinant of house prices and try to get a handle on how badly things are out of whack in each city.

Jordan So Toronto was number one. Vancouver, I believe, was number six. And we’ve seen a little bit, I won’t say a lot, but you and I spoke, I think, a few months ago about this, a little bit of decline in the average prices in the Toronto home. So I guess would that mean that the other fundamental aspects of the economy you’re talking about have tanked by a lot more to kind of create this bubble situation? Is that why these two cities are so high?

Ari Altstedter Well, you always have to remember when looking at these kinds of reports, that they are, to a degree, backward looking. By the time Das can collect all the data from all these cities, from all over the world, it’s not going to always be the most current data in every single market. So they actually didn’t say exactly when the data was up to in all markets, but we can be pretty sure that it’s relatively backward looking. And a lot of the price declines that we saw in Toronto, which have been going on for the past six months or so, they probably hadn’t really got started when most of this data was collected. So in a lot of ways, it’s probably a snapshot of what the market was like before the correction we are currently undergoing got started.

Jordan So that correction then, is that the beginning of the bubble popping? If it is, how will we know?

Ari Altstedter That’s a matter of debate right now. And it is tricky because, of course, you never really know if something is a bubble until after it’s popped. And even in terms of did it pop or not, there’s some debate about that. So right now, most mainstream economists and a lot of the economists that work for Canada’s big banks say what’s going on right now is probably not a crash, probably not a pop. They call it a correction. Maybe that’s more of a deflation than a pop home value, sort of grinding lower to the point when maybe they’ll become more in line with some of those economic fundamentals, like how much money people are earning, so that they may make a little more sense. That is, I guess, sort of the mainstream consensus view. But the worry, I suppose, is that it starts developing sort of momentum of its own. Things go faster and further than perhaps those economic fundamentals dictate, and things become a little bit disorderly and chaotic as they fall. As opposed to that would be people would call that a bubble popping. It’s not really what we’re seeing now. It’s not what most people who follow the space closely are predicting. But that is the danger that is the worst.

Jordan What would that actual pop look like when we say it would gather momentum and decline more rapidly? What are we talking about here, just sort of in real terms, is there some kind of percentage or some kind of threshold? Because here I’m asking this question for people in Toronto and Vancouver and other markets in Canada that have seen real increases over the past few years. A lot of their investment is tied up in those houses.

Ari Altstedter Right. Again, there is a certain amount of subjectivity, I think, in applying all these terms. It’s more an art than a science, I suppose you could say. Yeah, let’s take Toronto as an example. The benchmark price since it hit its peak in February, March sometime, is down about 17%, which is a big decline. People might look at that and say, wow. I mean, is that not a crash? That sounds pretty dramatic. But you’ve got to remember that in the period leading up to this decline, home values in Toronto rose by more than 50%. And that was in only the two years or so since the pandemic started, right? So it’s fallen fast, but you’d argue it rose even further and even faster. And so we’re only really down to about the values from the back half of last year. And so it’s not really a case of you’re just looking at the absolute decline or how much the decline is, or even the percentage decline, because it’s relative to what house prices did before, and it’s also relative to how much kind of payment is causing people, how many people are getting in trouble a lot of the time. Housing market crash or a bubble popping is associated with a lot of people getting into financial distress and having to sell their house at any price. That was my next question. What is the concern for homeowners? They already own the home, just live in it. Who cares what it’s worth in imaginary numbers as long as it’s safe for you? You’re right. And a lot of people who own their home outright, it won’t matter. But there are a substantial portion of Canadian homeowners who own it with a mortgage they borrowed in order to buy their home. And that is often where people end up running into trouble. If home values decline far enough, fast enough, some people may find that the market value of their home is less than their mortgage, which psychologically is kind of a depressing situation to be in. I owe more to the bank than this thing is worth. But even that in itself, aside from these psychological factors, wouldn’t necessarily force someone to have to sell their home. The problem comes when the debt on that home, the monthly payments, their mortgage payments, become unbearable to them. They can’t keep up with the monthly payments. And interest rates have risen very far, very fast in Canada the last six months. It’s basically what’s driving the house price decline. House prices have fallen because interest rates have risen. And rising interest rates mean people who don’t have a house and want to buy a house can afford a lot less house, and therefore prices have to fall. But the other effect of that is that people who already own their house and have a mortgage on it, if they have a mortgage with a variable rate, a rate that moves up when the benchmark interest rate moves up, they could wind up having to pay a lot more monthly. And the question is, can they afford that? And I think that’s where this worry of distress comes, is that if you find you’re in a situation where you can’t keep up with your monthly mortgage payments, you may have to sell regardless of how much you’re going to get for the house, because you can’t stay above water month to month.

Jordan We’ve covered the inequality in housing in cities like Toronto and Vancouver a lot, as you mentioned. It’s also probably one of the indicators that’s used for these bubble studies, looking at it from their perspective, is there a sweet spot, maybe for the housing market, where it corrects enough that some of those people can get into the market that it’s actually possible for them. But at the same time it’s not driving interest rates too fast or deflating so quickly that people who already own homes are struggling. It really feels like a balancing act.

Ari Altstedter Yeah, it is to some degree. It is a bit of a zero sum game. Prices fall, it’s good for people who want to buy. And when prices rise, it’s good for people who already own. In terms of affordability right now in Canada, theoretically prices fall because they’re too high and people who might want to buy can’t afford them. So they have to fall to get to a point where the people who want to buy can afford them. That’s how it’s supposed to work. What we’ve seen so far this time in Canada, though, because this house price decline is being driven by a very fast rise in interest rates, which is to say a fast rise in mortgage rates. And most people need to take out a mortgage to buy a house. Affordability has actually decreased so far for most people who need a mortgage. Royal bank of Canada came out with a report recently saying it’s actually never been more unaffordable to buy a house in Canada than it is right now, despite the declines in house prices we’ve seen. And that’s because mortgage rates have risen even faster than prices have declined, and prices were so inflated before compared to incomes that most people are still really out in the cold. And so that’s sort of the tricky point in the market we’re at. And theoretically, prices have to keep on falling until they get to some level of affordability, even with mortgage rates where they are. But we’re certainly not there yet. And I think the really confusing thing about Canada right now is that most economists think that even as prices continue to decline, they’re probably not going to fall so far to really ease affordability for most of the people who want it. Because underlying all of this is a sort of theory that there’s just not enough houses in Canada for the number of people who want them and for the rate at which our population is growing. And so generally the expectation is that mismatch, that fundamental mismatch between supply and demand is going to put a floor under house prices that is probably still going to leave them pretty unaffordable for a lot of people. What’s happening right now is just, in a lot of sense, a kind of mathematical equation that prices have to fall to get in line with where interest rates are or where interest rates end up. But once that sort of equilibrium happens at a certain level, there’s still the underlying problem of just not enough houses for the number of people that want to meet them. How manageable is that equation you’re referring to? And by that I mean if we do start to see a massive decline that looks like it could be a bubble popping. What levers, if any, do governments have to try to preserve that value or even to try to manage the decline to a point where houses are affordable? I guess how much of this is just the market and how much control over it do our politicians have? So in terms of what they could do directly, it’s hard to say. I mean, the key thing would be economic growth, I suppose, if they were to just focus on making sure that the economy is growing and healthy and stable, which may allow the bank of Canada to start easing up on its interest rate increases or perhaps even lowering interest rate increases, that would broadly help the market. But in terms of directly stepping in, it’s hard to say what they would do and whether or not they necessarily want to. I suppose if housing crash were happening, there were serious concerns about destabilizing the whole economy. They may feel that they really need to. That the risks of doing that the moral hazard of stepping in, seeming to favor homeowners versus prospective homeowners. They may decide that that’s outweighed by the need to save the economy. But I think we’re a long way from that right now, right? Probably have to get pretty bad for them to feel that that’s worthwhile. A lot of Realtors would say real estate associations across Canada would say that one thing that they could already do right now would be to lower the stress test. If you’re going to buy a house with a mortgage in Canada, you have to show that you could handle interest rates a certain amount above the current rate. Because the idea is that we want to be comfortable that if rates do rise faster than we’re expecting, our rates rise from here, you can handle the higher payments. A lot of Realtors would say, or real estate associations might say, that maybe now that rates are so high and the market is slowing considerably, maybe now is the time to relax that stress test and keep the market going and make sure there are people who can buy houses when other people have to sell them. But the stress test was put there for a reason. It was to make sure things go badly wrong and interest rates rise and especially people can handle them. There’s a strong argument to say that now we need that more than ever because we don’t know what the economic future is going to be and we don’t know how much further interest rates may have to rise.

Jordan So last question then, and I’ll ask on the behalf of homeowners. Is there anything they can do to get out in front of this somehow, whether or not housing prices continue to slide? Or is it just kind of hang on and hope? Should they be looking to renegotiate their mortgage? Do they have any options or just brave well?

Ari Altstedter The most important thing, I suppose, would be easy to make sure that their financial house is in order and that they are able to handle higher costs. And that’s not just higher mortgage costs, but we all know that inflation is at or near 40 year highs in Canada right now. So there are rising costs from the grocery store to the clothing store to your mortgage and also credit card debt and auto debt. And so it’s really making sure that you can handle all those payments now and also you can potentially handle them going higher in the future. Right now, most economists are forecasting more rate increases from the bank of Canada, but of course, the current pace of rate increases that started in March have already gone faster and further than were forecasts, say at the end of last year or the middle of last year. So you also have to account for that. Things could move further and faster than even we’re expecting right now. There’s a lot of unknowns right now in terms of the economy and in terms of the interest rate outlook. And so I guess it’s more important than ever that people leave themselves some sort of financial leeway that they have room to account for the unexpected and to afford costs that are perhaps higher than they expect to be right now. Never a bad idea.

Jordan Alright, thank you for this. I guess we see what happens next.

Ari Altstedter Yes, it’s hard to say. It will be an interesting six to eight to twelve months.

Jordan Well, perhaps we’ll talk again. Thanks again.

Ari Altstedter Thank you.

Jordan Ari Alsteader, reporter at Bloomberg. That was the big story. For more from us, you can head to The Bigstorypodcast CA. I promised you I would share some more results from our listener survey. One of the questions that we asked you is if there were any subjects you are sick of us talking about. Now, 49% of you said you like all subjects, which is amazing. Even I don’t like all the subjects we cover on this show. I’ll give you one guess as to what number two was. Yep, it was sports. Does that mean that we’ll stop? Probably not. But I will tell you. It means that the bar has been raised in terms of what constitutes a big enough sporting event that I get to spend 30 minutes talking to somebody about it. You can find us on Twitter at the bigstory FPN. You can write to us and say Please no, I love sports. Talk about sports more by emailing. Hello at thebakestorypodcast CA. You can also call us, leave us a voicemail 416-935-5935. And as always, this podcast is available in whatever podcast player you prefer. If it allows you to rate and review, that’s amazing, please do it. If not, that’s OK. Just subscribe and download every single episode. Thank you for listening. I’m Jordan Heath-Rawling. We’ll talk tomorrow.