North America

8 Reasons Canadian Home Prices Might Fall

Canadian home prices have risen by more than 35% since 2006, while American home prices have declined by more than 10%.  This has been great for Canadian homeowners and for investors in the Canadian real estate market. It has, however, also terrified many Canadians, causing them to wonder whether it is only a matter of time until Canadian home prices fall just like those in the United States. They are right to be worried: there are a number of reasons to think that home prices in Canada’s major cities could fall sharply during the decade ahead.

1. Demographics

Today the typical Canadian is between 50 and 57 years old. In the next decade many will retire, and so will no longer need to base their housing decisions on job considerations. Many will want money to do things like travel, go out to restaurants more often, escape a month or two of the Canadian winter, buy or renovate a family cottage, save up for their approaching old age, pay for care for their elderly parents, and help their grown-up children to establish themselves financially.

At the same time, there is a large drop-off in the Canadian population below the age of 15. This means that the next ten years will see Canada’s youngest large age cohort – currently aged 15 to 20 – go from living with their parents to renting out a room or apartment on their own or living abroad. As a result, the typical Canadian will have an empty nest for the first time in the coming decade. They may therefore be tempted to downsize their homes in order to gain access to cash. This could be particularly true of divorced parents – and approximately 40% percent of Canadian marriages end in divorce – some of whom might have only kept a house in the first place because of their kids. Meanwhile, most 20 year olds living on their own for the first time will not be buying a home: the average age of buying a first residence in Canada is currently 29 years old, and is unlikely to decrease over the next decade because of the high youth unemployment levels that have existed since the recession of 2008.

Certainly Canadians will not need large houses to host family dinners: the Baby Boomers are expected to have only around three grandchildren on average, compared to four or five grandchildren for the generation that preceded them and six grandchildren for the generation their parents were a part of. An entire three-generation family – which by 2020 will typically be made up of two grandparents, one or two children, one or two children-in-law, and three grandchildren, for an average of just 5 adults and 3 youths – will in most cases fit comfortably around a single dinner table. This will make many Baby Boomers less hesitant to downsize their house in order to play host for the whole family.

Unless elderly Canadians begin to hold on to their homes for far longer than they ever have in the past (which, admittedly, could happen), demographic trends do not seem to be working in favour of the Canadian housing market. This is in sharp contrast to the United States, which has a significantly younger population.

2. The United States

When Canadians leave Canada, it is overwhelmingly to go to the United States. Approximately one million Canadians now live in the US, compared to just 70,000 Canadians living in Britain. There is a similar number of Americans who live in Canada, making the American population in Canada larger (not to mention wealthier) than any other national minority group. With the American economy having outgrown the Canadian economy by a significant amount during the past four years (after having grown quite a bit slower than Canada between 2007 and 2012), and with American housing prices having become much cheaper relative to Canadian ones than they were prior to the financial crisis of 2007, the United States could have a negative effect on Canadian real estate prices over the long term, if more Canadians are willing and able to move south and if fewer Americans are tempted to move north.

3. China

China has accounted for more than 20% of the world’s official economic growth since 2003. Over the next few years, however, it seems that China’s growth rate is likely to slow down, for a number of reasons including that the Chinese workforce is now much older and more expensive to employ than the workforces of most other countries in Asia. As it turns out, a Chinese slowdown could have a significant impact on Canadian real estate prices.

Canadian cities have been among the favorite places for Chinese to invest in, which is not such a surprise given that Canada has the world’s third largest Chinese population of any developed economy, behind only Singapore and the United States and close to double that of the next largest, Australia. The United States’ Chinese population is actually only around 2.5 times larger than Canada’s is, even as the total US population is almost ten times that of Canada’s total population. Of Chinese university students studying abroad, meanwhile, an estimated 12% are in Canada, trailing only the US (32%), Britain (17%), and Australia (13%), and far ahead of fourth-place Singapore (4%). China also finds investing in Canada useful because of Canadian natural resources: overall Chinese investment in Canada between 2005 and 2012 was roughly $35 billion, trailing only the US and Australia (both around $50 billion) and $10 billion more than the next largest, Brazil. As a result, a Chinese slowdown would arguably damage the Canadian real estate market.

4. Energy

Because China’s economy is based primarily around manufacturing and construction, its rise in the past decade helped to cause the biggest boom in commodity prices since the Second World War. The prices of electricity, oil, and natural gas soared. This has helped to keep housing prices high inside cities, since suburban sprawl is dependent on cheap gasoline for commuting, driving, shipping goods, plowing roads, mowing lawns and parks and golf courses, and moving around machines used in road maintenance and the construction of houses and roads — and it is  dependent on cheap electricity to light and air condition large suburban homes, cars, malls, and superstores, and on natural gas to heat them.

In Canada, higher energy prices also mean higher export revenues, which in turn means a stronger economy in general. To a much lesser extent, a similar thing is true of the cost of wood, which is also an input cost of the housing market as well as a significant Canadian export.

There is, not surprisingly, a strong historical correlation between oil and Canadian  real estate prices.  When oil prices reached their  modern-day lows during the mid-1990’s, Canadian home prices declined by roughly 5% in spite of rapid growth occurring in the general economy at the time. When oil prices reached their modern-day highs between 1979 – 1983 and 2008 – 2013, on the other hand, Canadian home prices went up by roughly 10% and 35%, respectively, even though the country’s two worst postwar recessions took place during 1982 and 2009.

Today, many people expect North American energy prices to fall, or at the very least not to rise rapidly in the way they did between 2003 and 2007. Looking at the futures market (financial markets in which people bet on what the price of something will be at some designated future time) you can see that the expectation is that the price of oil – from which nearly all gasoline is derived – will decline from around $105 a barrel today to $92 by April 2015, $84 by April 2016, $80 by April 2017, and $77 by April 2018 (Update: crude oil prices have dropped to $45 a barrel during January of 2015.) Natural gas prices in North America are not expected to rise during the next five years either. If the markets are correct about these prices, North American energy will become cheaper in the near future.

In addition to its affects on suburban development, cheaper energy also means cheaper airplane travel. For Canadians, this could make buying a place in a warm climate outside of the country more appealing. It could also let the Canadian population disperse itself more widely throughout its vast territories during the spring, summer, and fall. Most Canadian environments are not easily accessible by road, whether because of their ruggedness (particularly the Rocky Mountains, which cover almost all of British Colombia and parts of Alberta), or the fact that they are covered by incredibly dense clusters of rocks, lakes, and forests (particularly the Canadian Shield, which covers more than half of Canadian territory). Cheaper air travel could perhaps help to open up some of these enormous territories to development, which could hurt land prices within major Canadian cities, at least relative to those of smaller Canadian cities and the Canadian countryside.

5.          The Internet

The recent and ongoing spread of high-end smartphones and tablets in the developed world and of low-end smartphones, computers, and internet access in the developing world, and the fact that many of even the least tech-savvy Baby Boomers are now getting into the internet in a big way, means that at this very moment we may be smack-dab in the middle of the Internet Revolution, one of the defining events of our time. And it seems possible that, as cyberspace increases, real space – including real estate – could become less precious.  So, what effects might the Internet Revolution have on home prices in Canadian cities?

E-commerce, which has already increased massively in recent years, probably is not even close to as ubiquitous as it will become in the years ahead. The Internet and computer software have the potential to assist or replace a huge range of businesses. Books, e-books, furniture, household supplies, clothing, computers, bank withdrawals, and even groceries and pharmaceuticals can and increasingly are being ordered online. Coffee shops have already practically morphed into office spaces.

Changes such as these can allow people to work and shop from homes, offices, shared working spaces, or warehouses in places outside of the downtown core of major cities, or even outside of cities altogether. In turn, this may allow for some prime commercial real estate – for example, a skyscraper with thousands of offices in it, or an Ikea or Walmart with a large parking lot – to be converted into residential properties. To give just one example of this, it was announced last month that the US Bank Tower in Los Angeles, the largest American skyscraper west of Chicago, will soon be converted into a residential property because it failed to fill more than half of its office space in recent years.

Computer technology offers the possibility of outsourcing huge numbers of jobs that in the past could not have been outsourced. Not only do computers allow for  interaction between rich and poor countries, they also allow people living in the developing world to receive an education more cheaply and easily. Computers may also help lead many jobs to become automated by software or machines. More outsourcing and automation could reduce Canada’s appetite for immigration, which, because most immigrants come to Canada in their late 20’s or 30’s, would mean there would be fewer adults around  to rent or purchase homes.

The Internet also allows people to live in suburbia, cottages, winter homes outside of the country, or small cities or towns more easily. This is because it can help people to work or study online, and because it can help people deal with the stuck-in-the-middle-of-nowhere feeling that has often made people feel cooped up or unsafe living in the countryside. It also makes it easier for people living in suburbia, towns, or rural areas to get from one place to another more easily and cheaply, by allowing people to do things like:

-create far more flexible, reliable, and efficient “smart” transportation systems, whether public or private

– use their computer devices to see exactly when buses or trains are coming

– see precisely what traffic and road construction is like on any given route

-have goods delivered quickly and directly to their house after having bought them over the internet

-coordinate snow plowing and de-icing in rural areas during the winter, so that areas far off the beaten track can be accessible by car or truck rather than by snowmobile on certain days

– access emergency health care, both via webcam and by making it easier for rapid response teams to find the house they are going to if they have to find their way in the dark

-find friends or strangers nearby that are looking to go to the same place as they are so that they can carpool or share a taxi with them. (Update: Uber now exists). 

-get work done or, read, or watch a video when using public transportation or carpooling

-use an app that automatically allows them to split gasoline costs or cab fare when they are carpooling or sharing a cab with other people

-avoid getting lost or stuck in bad weather when driving through the dark countryside at night

-look online to find homes or apartments to rent

-work from home during part of the day or part of the week in order to avoid commuting during rush hour or when the weather makes road conditions poor

For those who doubt how impactful changes such as these could be, I would keep in mind three things. First, that the “smartphone revolution” is still incredibly new; its potential to affect things like transportation and health care has barely been felt so far, but probably will before long. Second, even now, imagine how much easier it would be to live in the countryside than it would have been in, say, 1975 or 1995, before these technological revolutions took place. And third, consider how little of Canada’s territory is accessible by road at the moment. Canada only has around 15-20 thousand km of highways, in a country that occupies nearly ten million square km. There is still a ton of room to spread out in, in other words. This is true even in the southern areas of the country; for example, the population density of the southernmost 15% of Ontario’s territory (see map below), an area including both Toronto and Ottawa, is approximately 80 people per square km, roughly a third of that of Germany or Britain.

IR_F3_SatelliteImage_noBorder_091217 F

(Ottawa is not displayed on this map; the two main urban areas it shows are Toronto and Buffalo. Note, however, how small even the sprawling Greater Toronto Area is in comparison to the relatively small portion of Ontario’s territory shown in this picture)  

6. Cottages, Condos, and Capital Gains

Not only does Canada have a ton of land,  it is also home to more lakes than the rest of the world combined. A large number of these lakes, including all of the Great Lakes, are located within a manageable drive of Canada’s largest cities. This has given the country an enormous cottage industry. Cottage ownership is, in fact, the Canadian Dream.

Most Canadians still do not own a cottage, however. But many more soon might, as a result of several of the factors already mentioned above. Canada’s demographic trends support the cottage industry’s growth, for example, as people often buy cottages relatively late in life in anticipation of future grandchildren and to relax when they scale back their work hours prior to their retirement.

Being able to get work and other things done over the Internet could also boost cottage ownership, as could cheaper gasoline, less traffic, better public transport within cottage country, and the ability to use the Internet to more easily rent or share waterski, fishing, or sail boats, which many cottage owners cannot easily afford to buy, dock, maintain, and store during the winter. The Internet is also increasingly allowing cottage owners in Ontario and Quebec to earn income by using sites like Airbnb to rent out their cottages to Americans – who, since the recent fall in energy prices, also have a more powerful dollar to rent them with – since the northern US lacks the dense cluster of lakes that are found in the Canadian Shield.

This is significant, because Canadian tax law gives cottage owners less of an incentive to own an expensive city home. The Canadian government allows people to designate one of their properties as a “principle residence”, which lets them avoid declaring capital gains on their income taxes when the value of that home increases. This often saves people a huge amount of money.

Canadians who own cottages have the option of designating their cottage as their principle residence instead of their city home, however. In the past, this has not mattered much, since home prices have been rising so consistently that the capital gains on a home always far exceeded those on a cottage. Yet, if in the future cottage values begin to increase faster than city home values, Canadians with cottages that are relatively expensive could begin to save more from designating their cottage as their principle residence. In other words, Canadians who buy cottages – or renovate or winterize cottages they already own – will have less of a tax incentive to own a large city home. The same is true of winter vacation condos Canadians own in places like Florida. As such, many Canadians may become more inclined to downsize their city home, or to sell their city home and start renting out a home or apartment in the city instead.

7.    Conventional Real Estate Indicators

Most articles you will find discussing real estate prices will not look at many of the things we’ve discussed so far. Conventional economic analyses tend instead to focus on factors that are more technical and that impact the market in less roundabout ways than, for example, the way in which smartphone apps could alter home prices by reducing highway traffic.

Conventional real estate indicators include the ratio between a country’s average income and the price of its homes, the ratio between the price of homes and the cost of renting similar homes, the the yield curve of bonds (which indicate what the market predicts future interest rates will be, the idea being that lower interest rates facilitate higher home prices by making it easier to borrow money to buy a home or pay off a mortgage) and the ratio between household debt and income (since it is presumably more difficult for an indebted person to take out or pay off a mortgage).

It turns out,however, that there is little hope for Canadian homeowners to be found in these conventional indicators either. Canadian home prices are 8 times higher than Canadian incomes, a ratio greater than that of any developed economies apart from France or Belgium. Renting a home in a major Canadian city is an estimated 30 – 40 times cheaper than buying a similar home, a ratio greater than that of any developed economy apart from Norway. The ratio between Canadian incomes and household debt levels is higher than it has ever been in modern times; it is nearly one and a half times higher than it was as recently as 2001, one and a quarter times higher than it was in 2005, and higher than that of all but seven other developed economies.

Finally, the yield curve on Canadian government bonds suggests that the market expects Canadian interest rates to become one and a half times higher than they are today by the middle of 2016, and twice as high as they are today by the middle of 2017. This is a relatively sharp increase, considering that the same yield curve shows rates becoming just three and a half times as high as they are today between 2017 and 2044. Moreover, the yield curve does not have perfect foresight: interest rates will probably rise prior to 2016 if the economy grows faster than expected in 2014 and 2015. (Of course, the inverse is true as well: interest rates may be held lower for longer if the economy underperforms expectations).

8. Construction Costs 

Historically, apartment buildings and houses have been very expensive and time-consuming to build, even ignoring the cost of building materials. But this could change. Indeed, we may even see house-building robots before too long, capable of working 24-7, 365 days a year. (Oh, and check this out). Certainly we should be not surprised if construction labour costs decline going forward, as labour costs in general are being squeezed by both automation and outsourcing. In that case, why even take the chance? Unless you really need to, you might want to think twice about putting all of your money into urban real estate.

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