Rosenberg: Let's focus on the supply side in addressing Canada's housing risks

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The Bank of Canada releases its semi-annual Financial System Review on Thursday and my forecast is that even more attention will be devoted to risks surrounding housing and household debt risks – which is a big statement since the central bank devoted no fewer than nine pages to these issues in its document released last December. If anything, these risks are even more acute today.

Now, when we talk about risks to the Canadian economy based on the housing market, it really centres on Toronto and Vancouver – which accounts for 25 per cent of the population but a higher and non-trivial 35-per-cent share of the housing stock and mortgage market

What happens in those markets can certainly have national repercussions, in contrast to Calgary where the turndown has not spread to other regions.

Despite income growth of barely more than 3 per cent, we have home prices in Vancouver soaring 30 per cent in the past year and 12 per cent in Toronto.

Prices in both metropolitan areas exceed $1.2-million for single-family detached houses, which compares with a range of around $300,000 to $400,000 in most other cities. (Toronto and Vancouver were last at these levels 13 years ago.)

The risks are not altogether financial, though it is a bit worrisome to have traditionally risk-averse Canadians move to variable or short-term mortgages – now representing 40 per cent of the flow of lending.

This helps contain debt servicing costs but if rates do go up, there is bound to be financial hardship for many folks.

There is a ton of leverage out there, and even what appears to be modest mortgage credit growth of over 6 per cent still exceeds trend nominal GDP growth (excluding the oil price collapse), of around 3.5 to 4 per cent.

Debt-to-asset and debt-to-net worth ratios look far less onerous than the parabolic move in debt-to-income ratios, indeed, but the denominators in the first two measures hinge critically on what happens to the price of the housing (because as the value corrects downward the liability does not).

It is a sign of the debt-heavy times that average household loan payments – interest and principal – are as high today with microscopic interest rates under Stephen Poloz as they were when rates were at punishingly high double-digit levels under the John Crow regime in the early 1990s.

Now that is cause for pause.

Let me say here and now that this is not a repeat of the United States circa 2007.

Canadian homeowners have much more skin in the game with homeowner equity relative to outstanding real estate valuation in excess of 70 per cent, not sub-50 per cent.

Even though subprime lending has been on the rise, Canadians have not been cannibalizing their home equity through mortgage equity withdrawals or cash-out refinancings, which were all the rage during the bubble years south of the border.

And in contrast to the United States, nobody in Canada is in denial over the excesses in Vancouver and Toronto. It is front page news.

The senior folks at the Bank of Canada (BoC) are on top of it. Same for the Office of the Superintendent of Financial Institutions (OSFI), which has forced the banks to step up their capital buffers when it comes to Canadian household debt. Even the banking sector, CEOs are expressing concerns, in contrast to the U.S. experience where the housing and banking sector believed in a new era of mortgage finance and home price appreciation, and the Fed and the Treasury stood by as accomplices.

In addition to OSFI, the central bank has applied subtle pressure on the banks through moral suasion, and lenders are tightening up their credit scoring.

Indeed, the Department of Finance has also been tightening up on Canada Mortgage and Housing Corp. (CMHC) rules, such as down payments, eligibility criteria and price limits.

There may be more done too; perhaps higher land transfer taxes on high-end homes as a means to curb the frothy enthusiasm in both Vancouver and Toronto.

But we have already seen CMHC tighten up four times in the past five years, and that's done little to cool these two hot markets.

After all, average prices of homes in Vancouver and Toronto are already more than 20 per cent above the $1-million mark, which is the limit for CMHC insurance.

The preponderance of the new mortgages being issued are not insured any more, but then by definition the buyer has to have at least 20 per cent equity in the unit.

So again, financial risks are not the issue.

For the first time, the government and real estate agencies are monitoring the vast foreign interest in the Canadian housing market, especially from China and apparently much of the buying from there are cash-only transactions.

There is growing chatter of placing a tax on these foreign-based sales, but that would have little impact on entities that are inherently price-insensitive, who are buying properties in Vancouver and Toronto because they are viewed as politically stable places in a global sea of instability.

Many wealthy Chinese families are seemingly willing to pay almost any price to get money out of the Mainland ahead of what could be a nasty yuan devaluation at some point or the spread of capital controls (at which point, it will be too late).

It is not just Chinese money but Russian money and American money flowing in, and Canada is a small, open economy, in need of foreign trade and investment flows.

The last thing we need is a tax war with other countries, especially considering the million or so Canadian snowbirds who own property themselves south of the border.

To many a foreign resident, Canada is not just stable but also desirable, especially the cosmopolitan makeup of Vancouver and Toronto in general – rich in sports, theatre and cultural diversity (Montreal is too, but the city's infrastructure is lacking and there is still too high a pro-sovereign sentiment reading in the polls).

The focus will likely remain on the demand side – higher down payment requirements, increased qualification criteria or higher transaction taxes on pricey units – but the real solution will lie on supply side dynamics.

The solution may be less from a federal demand-side response to a local government supply response. After all, real estate is local. And remember, the price of anything is the intersection of two curves: supply and demand.

What is curious is the lack of supply response we have seen in Vancouver and Toronto. New listings, backlogs of unsold homes and inventories are far too low.

The rental market is exceedingly tight as apartment vacancy rates are barely higher than 1 per cent in Toronto and below that in Vancouver.

Even with housing sales up 7.5 per cent in the past year in Toronto and by nearly 18 per cent in Vancouver, the real question is why it is that residential building permits are down more than 30 per cent in both cities? Why are single-family starts at the provincial level down by more than 6 per cent year over year in Ontario and 3 per cent in B.C.?

This is not the same as the U.S. situation nearly a decade ago, when the mantra was "build it and they will come" and next thing you know, we had a massively oversupplied residential real estate market and pernicious deflation.

The problem in Canada is that the builder response has been inadequate, and that is what needs to be addressed, whether through zoning laws, land usage, the approval process or other avenues. A key factor restraining the construction of single-family homes in both Toronto and Vancouver (and thus impeding the ability of supply to match demand) is the dearth of available land in these urban centres on which to actually build – releasing municipal lands for development, for example, could go some ways toward mitigating market imbalances.

The dilemma is really more social than it is financial (despite all the angst on this file, the number of mortgages in arrears, and this includes Alberta, are down almost 3 per cent from year-ago levels and are no higher today than they were 15 years ago); that a complete generation of young families is being crowded out of the housing market in these two highly desirable cities – $70,000 median incomes bumping against average $1.2-million homes does not compute, even with ultra-low rates. This does not lead to socially optimal results.

The bottom line is that Canada is suffering from a major affordability problem for young households who have been shut out of the homeownership market and relegated to raising their families in an apartment with no backyard.

Consider this – the nationwide affordability index is actually lower now with five-year mortgage rates at 3.7 per cent than was the case two decades ago when mortgage rates were north of 8 per cent (the situation is obviously more acute in Vancouver and Toronto).

Again, This is bound to create social problems at some point. We have reached a point where small, entry-level residential properties all the way out to Aurora and Milton are being gobbled up in bidding wars at prices north of $600,000 – that is considered "affordable" today even though it represents eight times the median family income and at least an hour's drive to the downtown Toronto core.

It may be time to get a little more creative at the policy-making level and, as I said, try something that hasn't been tried, rather than clumsy efforts to reverse the demand for housing in these specific areas.

David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.