News: Higher rates will not cure what ails Canadian housing

In this week's Industry News (Week of 9 May 2022).

Higher rates will not cure what ails Canadian housing | CIBC Economics (by Benjamin Tal and Katherine Judge) Interest rates are on the rise, and the ultra rate sensitive Canadian housing market is responding. Sales are falling fast, and prices will follow. The adjustment in the market will be directly linked to the speed and magnitude of future rate hikes. However, the return to balanced conditions or even a buyers’ market will not cure what ails the Canadian housing market. It will just ease the symptoms for a short period of time. In fact, if history is a guide, the slowing ahead might worsen the supply-demand mismatch in the market. Therefore, entering a more relaxed housing environment should not ease the urgency in which the chronic lack of housing supply in the Canadian market is dealt with. After years of fighting supply issues using demand tools, governments at all levels finally recognize that over time, the housing affordability crisis will worsen without adequate supply policies. Housing demand is grossly undercounted When it comes to looking at the mismatch in the housing market, the variable to focus on to measure housing demand is household formation. And we assume that this number is measured accurately and is written in stone. After all, municipalities rely on those estimates heavily when they make decisions regarding land release and building permits. But the household formation numbers are far from accurate. They are derived by the CMHC by translating population growth into the number of households using estimates of headship rates, or the number of households created from a given number of people. However, plenty of information is being lost in that translation, leading to a gross underestimate of the real number of households in Canada, and thus demand for housing. And if demand is undercounted, then of course the supply released by municipalities to meet that demand will be inadequate. There is no way to precisely quantify the magnitude of the undercounting of housing demand due to the factors discussed earlier. Our conservative educated guess is that that number is close to 500,000 households. That is, official household numbers often used to estimate the demand in the market undercount the real demand for housing by about half a million households. But we won’t have to guess for long. While changes to the methodology and collection processes for the 2026 Census are necessary to resolve the undercounting, the upcoming releases of disaggregated household and dwelling data for 2021 from the long-form census will better inform us about the shortfall in the numbers used by CMHC to make household projections, and therefore should be used as a base for any supply-related policies.

Construction industry doesn’t have the capacity to meet governments’ elevated targets

The undercounting of demand means that the supply issue is real and needs attention. There is no shortage of ideas and suggestions to address this problem, and we have discussed many of them in the past. The most direct policy response by governments at all levels is a commitment to quickly build many more units. But not enough consideration is given to the simple fact that the industry’s capacity to reach those elevated targets is questionable at best. Our focus here is on one aspect of the issue: the rising cost and length of construction due to a lack of labour and trades. Chart 5 (below) tells the tale.

If time is money, then the ongoing increase in the average length of time for completions is a major challenge facing the market. It takes twice as long to complete both low-rise and high-rise units today than it did two decades ago. And a lack of labour supply is a major cause of those delays. While large developers are usually able to secure their own labour pool, that’s not the case for mid-sized and small operators that account for 30-40% of activity.

Increased competition for labour due to the growing number of large-scale infrastructure projects underway has added to the challenges in recent years. And the pandemic exacerbated that labour shortage. While demand for homes and renovations was supported by rock bottom interest rates and the shift to working from home, employment in the construction industry didn’t reach its pre-pandemic level until January 2022, as higher wages started to attract employees. That compares to residential investment which more than recovered by the third quarter of 2020, and stood 14% above those levels as of Q4 2021 (Chart 6) in after-inflation terms.

While overall immigration in 2021 was very strong, it didn’t even come close to denting the labour supply issue in the construction industry, as hardly any of the 400,000 new immigrants that arrived last year worked in construction (Chart 7). Clearly, in order to address the supply issue in housing, an immigration component is needed. In addition, policies aimed at training young Canadians in skilled trades would help to ease the labour shortage.

Moreover, higher labour costs combined with supply chain disruptions and higher fuel prices for transporting building materials have added to construction costs during the pandemic. Chart 8 (below) illustrates that issue. Since 2015, the cost of construction in Toronto has risen by 46% while the price of a newly built condo unit has risen by 42%. That narrowing in profit margins is starting to impact supply by making developers think twice before committing to projects. Higher interest rates will add to development costs, while at the same time it will work to reduce demand. Without a dramatic reduction in the cost of construction, look for overall new supply to soften notably in the near future. Even an undersupplied market can adjust or correct under the weight of rapidly rising interest rates. The ongoing slowing in housing activity will bring some sanity back to the market. The pause should be used as an opportunity to continue to implement and fine tune housing policies aimed at preventing a retightening in market conditions as we reach the other side of the current market slowdown. A much more accurate measure of housing demand is an absolute precondition here. Our rough estimate that current housing demand is undercounted by 500,000 households illustrates the potential size of the problem. The upcoming release of the disaggregated household and dwelling data from the long-form census should provide us with some necessary information here, and the 2026 census should be redesigned to overcome the issues raised above. Finally, the labour shortage is likely to ease as the market slows, but a long-term solution is needed. It’s easy to propose a significant increase in the supply of housing on paper, but it’s much more difficult to do it in practice when you don’t have enough trained workers to do the job.

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Shael Soberano, CFA Konfidis Inc. Chief Investment Officer

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