Rarely does a week go by when there isn’t a new economic forecast about the real estate market. For nearly a decade, the negative forecasts have been predicting a 25% decline in house prices while the positive ones have been predicting a “soft landing” for Toronto’s real estate market. Both predictions have yet to come true.
Readers often ask me how this is possible. How can so many economists be so wrong about the market for so many consecutive years?
While there are a number of reasons why economists are poor forecasters (Nobel-prize winning psychologist Daniel Kahneman's new book Thinking, Fast and Slow suggests that most experts, like most humans, are not as clear-thinking as they'd like to be due to the way the human mind operates), I’ll focus on some of the key problems that have been top of mind with me lately.
Firstly, the real estate market has historically been the realm of the macroeconomist. Macroeconomists will study aggregated indicators like GDP, unemployment, interest rates and household income to understand their impact on the real estate market. While these kind of macroeconomic indicators are of course important and do impact the real estate market, they are far too broad to really give us a strong understanding of what’s going on in the actual market.
Even when economists look beyond national and provincial data to focus on indicators for a particular city, this too can present considerable challenges. In many instances the data economists use, through no fault of their own, is either inaccurate or misleading.
The real estate market requires a stronger emphasis on microeconomic principals if one truly wants to understand where the market is heading. Microeconomists study the individual decisions and behaviours of households and their impact on supply and demand. More importantly, they track the spread of such decisions and behaviours, identifying the trends that really shape the real estate market.
To illustrate my argument, I’ll look at two common macroeconomic variables that economists often use when studying the real estate market - average house prices and changes in rent - and why they are problematic.
The Renting Fallacy
Economists love to look at the relationship between rents and house prices. The theory is that house prices should be appreciating at a similar rate to rents. If house prices start to appreciate at a much faster rate than rents it suggests that house prices are overvalued and that there’s a significant premium attached to owning a home which makes renting far more attractive economically. Eventually, more people start renting until rents rise and/or house prices fall to a level where there is no material financial benefit to renting over buying.
Makes sense. But how are economists measuring the relationship between rents and house prices? What data are they actually using?
The data commonly used to track rents is the rental accommodations portion of the Consumer Price Index (CPI). The rental accommodations portion of the CPI tracks changes in rent paid by approximately 14,000 people nationally. One of the problems with this metric is that it is quality adjusted.
Imagine that someone paying $1,800 per month in an old 2-bedroom apartment moves to a new 2-bedroom condominium rental for $2,500. Statisticians will quality adjust the rent down to take into account the fact that the condo is superior in quality and has amenities that were not available at the previous rental. They quality adjust rents because they want to isolate what portion of the rent increase was due to rising rents versus a preference for a higher end rental.
The problem with this approach is that it does not take into account the fact that the rental stock in Toronto has changed fundamentally over the past ten years.
Very few purpose-built rental apartment buildings have been developed in Toronto over the past twenty years. Virtually all the new rental stock coming onto the market has been from new condominiums purchased by investors who are using them as rental properties.
These new condominiums are completely different in size, style and condition from old purpose built apartments. They are usually in more premium locations and have modern finishes and amenities that you do not find in an older apartment building. As a result, condos will usually rent for roughly 40-50% more than older apartments.
Condominium rentals are not a luxury upgrade that only a select few choose. This is the new standard in Toronto's rental market. With vacancy rents hovering around the 1% level in Toronto, most renters have no option but to pay this premium.
Because the rental accommodation index quality adjusts for these differences it significantly understates the actual appreciation in rents in Toronto. This makes the imbalance between house prices and rents appear to be much worse than it really is.
The Average House Price Fallacy
Looking further, economists also spend a lot of time analyzing changes to the average price for homes. Anyone who has a keen interest in the real estate market knows that the average house price is a misleading metric and yet it continues to be the cornerstone of most economic models.
What’s the problem with average house prices?
For starters, average house prices can be heavily skewed when a large number of higher end houses sell during a particular period. In July of this year CIBC reported that the average house price in Canada appreciated by 8.6%. But if they removed Vancouver from their calculations the number drops to 5.6%. If they removed Vancouver and Toronto when calculating the average price nationally the number drops even further to 3.7%.
Furthermore, a simple average of house prices can mask many micro trends and changes that are happening in the market. It's rare that all of Toronto's real estate market goes crazy at once - usually one segment (be it preconstruction condos or emerging neighbourhoods) are the ground zero of crazy, leaving other parts of the market relatively balanced.
For example, one current trend we are seeing in the pre-construction condo market has developers keeping the price of condos low by simply reducing the size of their units. So three years ago your $300K might have bought you a 600 square foot condo downtown while today you might only be able to get a 500 square foot unit for the same price.
If we just focused on the average sale price statistics for condos we would be missing a more important trend, that the price per square foot for condos downtown is increasing at a far more aggressive rate.
Furthermore, when we look at the average price growth for houses or condos in the GTA, we assume that prices are appreciating uniformly across the city, but that’s not the case. In a recent press release about Toronto’s pre-construction condo market, Urbanation reported that the average index price in the Toronto CMA (Census Metropolitan Area) was up 7.4%.
To his credit, Urbanation EVP Ben Myers was transparent about the fact that certain factors could be masking the fact that prices are rising more quickly.
Myers notes, however, that some factors could mask the fact that prices are rising too quickly, including the influx of lower-priced condominium projects in the ‘905’ and outer ‘416’ areas, which can pull down the overall average index price in the Toronto CMA.
Without this insight, the average price figure of 7.4% on its own is meaningless because it masks what is truly happening in the market. Specifically, that pre-construction condos downtown are appreciating at a much more aggressive rate than the 7.4% average reported.
A focus on the macro story of rising house prices in the city obscures perhaps one of the biggest micro trends in Toronto's real estate history (perhaps even beating out the new condo story that tends to dominate the headlines), one that is still unfolding: the 10-15 year long run in which the urban family neighbourhood has made a mass market comeback.
As long as the demand for urban homes in good neighbourhoods and school districts continues to outpace the supply of homes coming onto the market for sale, prices may have no place to go but up.
John Pasalis is the President and Broker-Owner of Realosophy Realty Inc. Brokerage in Toronto. A leader in real estate analytics and pro-consumer advice, Realosophy helps clients buy or sell a home the right way. Email John