What is behind buyer willingness to pay 40 to 50% more per year for homes?
As featured in our monthly Move Smartly Toronto Area Market Report - Read full report here
Low-rise home prices rising by 30% per year in the Greater Toronto Area is masking an even more alarming trend — that prices are rising far more rapidly than this in the outer suburbs.
It’s not uncommon to see homes selling for 40 to 50% more than what the current owner and/or investor bought the home for just one year earlier (without any modifications made to the home).
For anyone outside of the housing market looking in, house prices rising 40 to 50% per year understandably appears irrational, which of course raises the question — why are so many buyers willing to pay prices that seem irrational?
The answer to that question requires some thought into the beliefs and expectations that are driving home prices.
Clearly, enough buyers don’t believe it’s irrational to pay 50% more than what similar homes were selling for a year ago. If buyers thought this level of price growth was irrational and unjustified, they would stop buying. That’s typically how housing bubbles end, when buyer beliefs about the future path of home prices turns from optimistic to cautious and eventually pessimistic
So what is fuelling this buyer belief?
The simple answer is that the average home buyer is listening to what leading economists are telling them about the housing market.
Buyers are hearing that the current price growth is the result of a lack of supply and that affordability will not improve until we build more houses.
Now to most people, the above statement does not sound problematic or controversial at all. In fact, it’s the narrative we have been hearing for years about Toronto’s housing market. But when I hear these statements, I like to think about how they shape people’s beliefs about the housing market and how those beliefs explain the current house price dynamics we are seeing.
The Current Price Growth is the Result of a Lack of Supply
Lack of supply has been the dominant narrative Canadians have been hearing over the past two years as an explanation for the boom in Canadian home prices. Politicians at both the federal and provincial levels, economists from Canada’s big banks, Canada’s banking regulator OSFI and even some academic economists have repeatedly argued that the reason home prices are exploding in Canada is because of a lack of supply, and the only solution is to simply build more homes.
While there are supply constraints affecting the market (or more accurately a demand-supply disconnect as we are not building enough for our population growth as I discuss in my report last month and again further below in this report), the real question I'm thinking about in this instance is -- Does this belief in lack of supply explain the explosive price growth we are seeing?
When economists say that the 30% price growth we are seeing for low-rise homes in the Toronto area, and the 40 to 50% growth in the suburbs, is the result of a lack of supply they are making the case that this growth in house prices is being driven by fundamental factors (in this case a lack of supply) and that this growth is both understandable and rational.
The alternative thesis is that underbuilding may explain part of the price growth we are seeing, but not all of it. During housing bubbles, house prices get pushed up by the optimistic beliefs of home buyers and investors — the expectation that prices will keep going up and that real estate is a good and safe investment. During these speculative periods, the demand for homes significantly exceeds supply which of course drives home prices up even higher, making real estate look like an even better investment each day that passes.
By this time, this supply shortage is not due to a lack of new houses being built, but because there is a surge in demand from people looking to capitalise on rapidly rising home prices
While many experts claim that actual supply issues are causing home price acceleration, some have acknowledged that there is buyer belief issue at hand as well.
Recently, the Bank of Canada’s Deputy Governor Paul Beaudry did raise concerns that home price expectations have become “extrapolative”:
A particularly worrisome development is that price expectations in some areas may have become extrapolative. This happens when people think house prices will be even higher in the future, and it can lead them to rush into the market to buy.
Extrapolative is the term modern day central bankers use to describe a market driven by “irrational exuberance”.
But very few other economists today are raising any concerns that today’s price dynamics might be ‘irrational’. Instead, they keep encouraging buyers that this rapid price growth is an obvious and rational result of a shortage of housing supply.
Things Are Never Going to be More Affordable Until We Build More Homes
This is another important narrative that leading economists have been communicating lately.
“If we don’t fix this, if we don’t right-size the number of homes in Canada or Ontario relative to population needs, things are never going to be more affordable.”
- Jean-Francois Perrault, Scotiabank Chief Economist
Narratives like this one are quite important because they are forward looking statements about the housing market.
To say that housing is never going to be more affordable until we increase new housing supply is another way of saying prices are not going to fall until we build more homes.
It’s of course possible that Mr. Perrault did not intend this, but that is the narrative that eager home buyers are hearing. And to be fair to Mr. Perrault, he’s not the only economist making these types of forward looking statements.
If the economists arguing that ‘we just need to build more homes’ are correct, we shouldn’t see much downward pressure on home prices in the future because prices are being supported by market fundamentals (i.e., as there is not enough supply to meet demand).
But if they're wrong, and we see a decline in home prices, their assertions about supply will have been a part of the 'irrational' price growth we are seeing today.
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John Pasalis is President of Realosophy Realty, a Toronto real estate brokerage which uses data analysis to advise residential real estate buyers, sellers and investors.
A specialist in real estate data analysis, John’s research focuses on unlocking micro trends in the Greater Toronto Area real estate market. His research has been utilized by the Bank of Canada, the Canadian Mortgage and Housing Corporation (CMHC) and the International Monetary Fund (IMF).
Follow John on Twitter @johnpasalis
February 22, 2022Market | Video | Toronto and GTA | Report |